Fighting the Wrong Battle: The Misguided Reform of European Macroeconomic Governance
Fighting the Wrong Battle: The Misguided Reform of European Macroeconomic Governance
The European Council of heads of state and government of the European Union (EU) will meet in March 2011 to agree on sweeping reforms to the framework for macroeconomic governance both among the group of countries that have adopted the euro as their common currency (the eurozone) and across the EU as a whole. The proposals under consideration work along three different axes:
1. There will be common measures to better coordinate the conduct of fiscal policy so that member states set their budgets within a common calendar (the 'European semester', which has already been agreed upon) and in accordance with tighter national constraints on public debts and deficits
2. There will be procedures to monitor and correct any loss of competitiveness in the form of relatively high wage increases from one member state to the next,
3. And there will be measures to create more immediate (and yet not automatic) sanctions for member states that fail to live up to the obligations they have to one-another and to the EU as a whole.
The presumption underwriting these reforms is that the absence of a clear framework for macroeconomic policy coordination including sanctions to enforce fiscal discipline and to avoid current account deficits is the most important explanation for why Europe is experiencing recurrent crises in sovereign debt markets. The peripheral countries of Europe are now in trouble because they borrowed recklessly and spent with abandon; worse, they misinterpreted the emergence of asset bubbles in real estate and elsewhere as indicators of real wealth and so rewarded themselves handsomely with wage increases that made it easier to import goods from other countries than to sell domestic manufactures abroad. The solution, therefore, is to take away the punch-bowl before the party can start all over again. If the peripheral countries like Greece, Ireland, and Portugal can be convinced (or coerced) to behave more prudently, so the presumption runs, there should not be any problem. Europe can avoid another crisis in sovereign debt markets without the Germans (and other frugal countries) having to bail anyone out.
Unfortunately, that presumption is wrong. As a number of commentators have pointed out - Financial Times columnist Wolfgang Munchau chief among them - neither fiscal imprudence nor a loss of competitiveness is responsible for the current situation in European sovereign debt markets. Indeed both hyper-indebtedness and excessive wage claims are symptoms of problems located elsewhere. As long as Europeans refuse to recognize that fact, and as long as they are unwilling to address the root cause of their current situation, efforts to reform European macroeconomic governance are not only doomed to fail, but are also likely to generate frustration and bad feelings that could poison useful aspects of European macroeconomic coordination looking into the future.
This is a sweeping indictment that rests on a broad number of interlocking claims. Nevertheless, it is worth unpacking the arguments if only to better understand the situation faced by the United States. The problems within Europe replicate the macroeconomic imbalances at the global level. There are distinguishing features to be sure, but the basic structure is similar enough that understanding achieved at one level offers real insight at the other.
Consider the problem of indebtedness. The real culprit behind the huge increase in European public debt is to be found in private sector bailouts and not in the profligacy of the public sector. In this sense, the Greek case is the exception and not the rule. Ireland and Portugal are closer to the norm. Indeed, Ireland was a model of fiscal rectitude in the two decades before the onset of the financial crisis - having paid off or grown out of public debt worth roughly 88 percent of gross domestic product (GDP) over the period. In 1987, the debt-to-GDP ratio in Ireland peaked at 113 percent; by 2007 it was down to just 25 percent. The need to bailout the Irish banking sector has put that progress into reverse. By 2012, Irish public debt will account for 114 percent of GDP, which is worse than it has ever been before.
The Irish situation is dramatic but not unique. Belgium has experienced a similar reversal of fortunes. Again the bailout of the private banking sector is largely to blame. More than a decade of painful fiscal consolidation was wiped out in the span of just two years. Spain and Portugal could be counted as similar cases but for the fact that they never had serious indebtedness problems in the first place. Such problems arose only when the crisis set in and as the governments of both countries tried to stabilize domestic financial institutions.
Finally, it is worth reconsidering the Greek case. Now that the country's fiscal data is better understood, the pattern of evolution is different from the standard European narrative of the crisis. Greek debt increased dramatically in the 1990s, before the country joined the single currency. It stabilized at a high level in the 2000s, fluctuating at around 100 percent of GDP. Things suddenly worsened in 2006 shortly before the crisis set in. From 2008 onward, Greek debt started to grow dramatically.
The irony in this story is that for much of 2009 bond markets charged lower premia on Greek sovereign debt obligations than they demanded to hold Irish debt. Clearly the bet was that Ireland would crack first; whatever the fiscal situation, the Irish financial system was far weaker than the Greek. In the end, that is not what happened. The Irish government was able to hold out just over six months longer than Greece before calling for assistance. The lesson to draw from this experience is that even dramatic fiscal consolidation like that undertaken by Ireland cannot insulate a country from the effects of a banking crisis; that said, the lack of fiscal consolidation as in the Greek case can make matters marginally worse. Perhaps Greece could have weathered the storm if its government accounts had been in a better condition. Clearly for Ireland it did not make any difference.
The competitiveness story is more complicated. The core assumption is that countries export more than they import when domestic costs and prices are lower than elsewhere; countries import more than they export when domestic costs and prices are too high. Moreover, since any excess of imports over exports must be paid for in foreign currency, countries with relatively high costs and prices end up borrowing money to cover their import bills from abroad. The loss of competitiveness leads to foreign indebtedness; only a restoration of competitiveness can ensure that foreign loans are paid off.
Unfortunately, this conventional wisdom about competitiveness confuses cause and effect. It is possible for countries to import more than they export even if they remain cost-competitive. All that it takes is an inflow of foreign investments. These investments can be in plant and equipment. But they can also take the form of bank deposits, bond purchases, and share holdings. All that matters is that more money flows into the domestic economy than is earned through domestic production.
Of course international capital flows cannot force a bank, firm, household, or government to borrow money. Someone in each of these organizations must take on the debt. That is why so many people in Germany, the Netherlands, and elsewhere in Europe take solace in blaming the Greeks, the Irish, and the Portuguese for risking insolvency. The problem with this logic is that it assumes that debt is disconnected from the estimated rate of return on investment, employment, or tax receipts. As the money flows in, it pushes down the cost of borrowing, making it reasonable for banks, firms, households, and governments to take on more debt against a lower expected rate of return.
At this point it is possible to tie off the story about competitiveness. Prices did rise more in the peripheral countries than in Germany. That is hardly surprising given the amount that investment, consumption, and government spending increased in those countries in response to lower interest rates. Nevertheless, this rise in prices did not translate into higher real wages in most countries - meaning wages adjusted for inflation - and neither did it undercut manufacturing employment nor export market share. If we look at the data from 1991, when the process of monetary integration started in Europe, to 2007, which was the last year before the full force of the crisis came to bear, the combined performance of Portugal, Ireland, Italy, Greece and Spain looks even better than that of Germany itself. Global export markets shares fell by only 15 percent during that period, despite the dramatic rise of China and other emerging market competitors, while Germany's much larger export market share fell by 18 percent. Meanwhile, manufacturing employment remained roughly constant at 10 million workers in the peripheral country across the whole of the 17 year period; German manufacturing employment declined by more than 25 percent, from 10.5 million in 1991 to 7.5 million in 2007.
Competitiveness was not the problem for the peripheral countries. Rather, the problem was the influence of lower interest rates. The key here is to understand the meaning of a lower 'expected' rate of return. That term can translate into lower income investments at the same risk rating or higher income investments at higher risks. This is not profligacy. It is a standard feature in any model that sets investment, consumption, or government borrowing as a declining function of domestic interest rates. The Greeks, the Irish, the Portuguese and others did not change as a result of financial integration; they simply responded to a drop in the relative cost of capital in the same way that any bank, firm, household, or government would be expected to do.
As it turns out, many of the risks that were assumed by the borrowing countries were correlated - meaning they all went bad at once. This is how the global financial crisis became important. The crash in the value of mortgage related assets in the United States pricked the real estate, banking, and sovereign debt bubbles in Europe, leaving everyone holding more debt than money or income to make payments. Governments responded with guarantees to keep Europe's integrated financial markets from collapsing. And tax payers were left with the tab. The difficult reality is that everyone shares complicity in this process, from the Dutch and German workers who expected higher rates of return on their pension savings, to the banks who sought to profit from interest rate swaps or foreign lending, to the property developers and home owners who reaped the rewards of rising real estate prices. The regulators, finance ministers and central bankers also earned a share in the blame. No one was innocent. Europeans need to accept that fact and move on to make the system more secure.
The current set of reforms under discussion will not remedy the problems caused by financial integration and the resulting effects on nominal interest rates. They will not stop banks from channeling savings to those investors, consumers, or governments who offer the highest rate of return. They will not prevent borrowers from failing to identify hidden forms of correlation and so underestimating risks. And they will not protect governments from having to bailout losses in the private sector to prevent greater damage from unfolding across the European financial system. The European Union may succeed this March in reforming its macroeconomic governance, but that reform will not be effective in resolving the current crisis or in preventing the next.