Saturday, January 29, 2011

Monsieur Trichet Is In Denial

On 27 January in Davos at the World Economic Forum the European Central Bank President, Monsieur Jean-Claude Trichet, stated boldly that “the euro is not in crisis”. He must have felt duty-bound to say that in an attempt to reassure international financial markets, regardless of what he really thought. If he actually believed what he said, then Monsieur Trichet is in denial, which is a poor foundation both for a fruitful discussion of the current crisis of the euro and for progressing towards its solution.

Of course, if one looked exclusively at the current exchange rate between the dollar and the euro and its recent trend, one would get the false impression that there is no crisis. On 29 January the euro stood at $1.37, a higher rate than before the Greek debt crisis erupted in February 2010 ($1.33), and much higher than the $1.18 rate to which it plunged in early May 2010 (and even that was 1cent higher than the initial exchange rate of 1.17 with which the euro started life in 1999). The euro recovery, however, was due primarily to the US Fed injecting $600bn liquidity over 8 months, compared with the comparatively restrictive policies of the ECB, and to US economic prospects being poorer than anticipated. After peaking at $1.42 last November, the euro fell again under $1.30 repeatedly (even a fortnight ago) with contagion spreading from Greece first to Ireland, then to Portugal, then threatening Spain.

Beside the exchange rate increased volatility, and the downgrading of credit ratings, a tangible and accurate measurement of the sovereign debt crisis of the euro is given by each country’s interest rate differential with respect to German bonds (usually taking 10-year bonds), the current yield on existing stock determining the rate at which the countries can borrow to rollover old debt or incur new debt. The spread over the German Bunds (whose yield has also risen as a result of the crisis, for fear of German exposure to baling out possible defaulters) has risen on average and significantly widened across countries over time, especially since the Greek crisis, and is now at record levels, higher than last May. Usually a 2% differential is regarded as the danger level; today Spain is just over, Italy just under that level; Portugal has almost 4% differential, Ireland over 6%, Greece 8 and a half per cent.

At interest rates higher than national growth rates (whether in nominal or real terms, as long as both are measured in the same way) national debt must increase relatively to GDP; debt is unsustainable and default looms. Even on the funds provided by the EFSF (the European Financial Stabilisation Facility set up last May) Greece and Ireland pay 5.8%, a rate lower than their market rates but higher than sustainable and signalling European lack of confidence in these countries’ ability to repay. Rescheduling of Irish and Greek debt – with lengthening of maturities and inflicting a haircut on investors – is now on the cards.

It is true that a recent bond issue by the EFSF was five times over-suscribed, but this was mostly “spurred by Basel III capital rules” set by the BIS, according to which AAA-rated sovereign bonds like those of EFSF “have a risk-weighting of 0%, which means that investors effectively don’t need to hold capital against it”. And that rating involves the EFSF over-collateralising its bonds reducing its operational capacity, and even EFSF bonds are subject to risk (for instance from the downgrading of one of the participating countries, which would require further capitalisation, see Klaus Regling, 27 January).

The ultimate source of euro vulnerability is its premature birth. The single currency was supposed to be the crowning of the economic integration process, after political and fiscal union, after the unification of labour and social policies and, come to think of it, after a common foreign policy and a common army (though these could wait). Instead of which the single currency has been used to promote the so-called finalité politique, i.e. that political union that should have been the pre-condition of the euro. This is like a person buying clothes that are too tight and do not fit in the hope that this might facilitate slimming, by forcing one to diet: it does not work for me, it did not work for Europe. The fiscal constraints imposed by the Maastricht Treaty and the Growth and Stability Pact, 3% public deficit and 60% public debt, have not been observed by too many countries for too long (including Germany and France, who were first to violate the 3% ceiling), to be treated as substitutes for a fiscal union. Thus the initial fall and convergence of interest rates that occurred after the introduction of the euro have been reversed. The global crisis has lowered tax revenues and raised public expenditures, not least for rescuing financial institutions. Europe has reacted too slowly and inadequately to the sovereign debt crisis over the last year; European leaders have spoken with dissonant voices, often making perverse announcements, whether from ineptitude or malice.

Can the euro crisis be solved, or at least be significantly alleviated, by the issue of a single European bond covered by a European guarantee, to replace a sizeable tranche of national debts? This we will consider in one of the next posts.


John said...

Very convincing. But what "perverse announcements"?

D. Mario Nuti said...

For instance, during the Irish crisis the German Chancellor Ms Angela Merkel said that it would be necessary for investors to take a haircut on their claims. Fine - except that she did not say when and on which bonds. Markets presumed it would be done on existing bonds, whose value plummeted. By the time she explainhed that this would apply to bonds issued from 2013 onwards the damage was done. Bonds recovered but not up to the earlier level.

Herman Von Rompuy, Jose Manuel Barroso and others discussed lifting the EFSF limit, and markets not unnaturally took this as a signal that the EU was already preparing bailouts for Spain, Italy and Belgium. Markets were upset, not reassured. This sort of thing should be done swiftly, not discussed in public beforehand.

In November Wolfgang Schauble told the Bundestag that the euro might not survive the crisis. Trichet's predecessor, Wim Duisenberg, would declare that "the exchange rate is a price like any other", effectively telling markets that the ECB would not step in to support the euro, which would fall like a stone. Bad enough, but Schauble was worse.

chilosi said...

Mario, you seem to forget all the previous troubles with exchange agreements between European countries and the nightmare of managing the Common Agricultural Policy with continuously changing exchange rates. But with the old fixed exchange agreements you have all the downside of having a single currency and none of the advantages. In order to maintain a regime of fluctuating exchange rates in the European Common Market you should have first of all to phase out the Common Agricultural Policy. This would be highly advisable but unfortunately hardly politically feasible. Both a single currency and fixed exchange rates require some harmonization of policies and institutions, in particular the institutions of the labour market. You cannot really have fixed exchange rates when in Italy or in Greece the labour market institutions are such as to lead to a wage push bringing about an intrinsic tendency to real revalutation in relation, in particular, to Germany. Joining the Eurozone is an implicit pledge to change your institutions in a way to avoid inflationary pushes leading to strong real revaluation, incompatible with balanced accounts and long run solvency, as well as to renounce to financial profligacy, such as in particular in the case of Greece (but also to lesser extent in the case of Italy). The real alternative is to transform the EU in a customs union with fluctuating exchange rates (but in which currency would the external customs be denominated?) or rather in a Free Trade area such as EFTA. This may be well correspond to the ideal choice for the UK establishment, but would be hardly compatible with having a single market, with the advantages it presents in terms of size and competition, and common, however highly imperfect, European institutions and policies, such as in particular competition and cohesion policies. The conclusion: "nulla salus sine Euro". But in order to allow the necessary changes in the real exchange rates as required by changes in relative competitiveness under the condition of a single currency, prices and wages should be made accordingly more flexible than what is allowed by the present institutional setup in EU countries. And perhaps the target rate of inflation by the ECB should be somewhat increased (say to 4%) in order to allow smoother relative price and wage adjustments.

D. Mario Nuti said...

I suppose a single currency is compatible with complicate arrangements under the Common Agricultural Policy, though I agree on the need for its reform and gradual removal: I always regarded CAP as a fragment of COMECON in the middle of Europe.

I agree also on the need of a common labour and social policy, as I did say. Back to national currencies floating against each other? Too late, costlier than sorting out the Euro problems.

A higher inflation target? It was been suggested, by Olivier Blanchard I believe, but it is very hard to change all these arbitrary fixed policy parameters (3% deficit, 60% debt, interest rates and inflation margins etc).

chilosi said...

"but it is very hard to change all these arbitrary fixed policy parameters (3% deficit, 60% debt, interest rates and inflation margins etc)."

Not too hard, apparently, as in 2004-2005 the fiscal parameters were de facto changed by implicit consensus, France and Germany happily included and in the forefront, with a decision that with the hindsight of the present does not seem to have been particularly felicitous, as to timing at least. Perhaps the best possible way to have presently some kind of common fiscal policy could be to act by explicit rather than implicit consensus, determining every year by agreement the fiscal stance that the countries of the Union should take. A treaties reform in this sense would be suitable (unless one wishes to go further and to create a real federal budget, such as in the USA, which at the moment is politically unthinkable), but some de facto reform in the Eurozone of this kind could be spearheaded by Germany by conditioning her financial support to some form of ritual co-decision as to what the fiscal stance should be, as well, in some subtle form, by the ECB, by conditioning the fineprint of its market interventions, perhaps. There are strong externalities in the fiscal policies of the Eurozone, and the best way to take them into account should be in principle some form of collective action taking considering the various contingent circumstances, rather than by imposing fixed parameters. Of course the obstacle here lies in the fiscal sovereignty of the national legislatures, but if the governments are supported by parliamentary majorities, they could well make a pledge to influence their decisions. In the unlikely case of a reform of the treaties the framework of the fiscal stance of the Union Members could be determined by a corresponding decision of the European Parliament, with a system of sanctions for the offending individual member states (including the exclusion from the European council of the minister of the offending state, as proposed by Merkel now and as I proposed in a paper in EJCE in 2007).