This article is based on a speech by Mr. John Bruton, former Irish Taoiseach (Prime Minister), in which he shares insightful analysis on the euro crisis at a meeting of local authorities from both the north and south of Ireland, organised by Cooperation Ireland, on Wednesday 16thNovember at the Knightsbrook Hotel, Trim, Co Meath.
I want to speak to you today about the crisis facing the euro, a crisis that has implication for both the part of Ireland that is in the euro, and the part that is not, but which relies on the European market for its commerce.
The views I will express are personal ones, and not representative of any organisation with which I am associated.
I will start my speech with a quotation from Martin Wolf in today’s Financial Times.
He writes, “What is at stake today is not only the stability of the European, and perhaps the world’s economy, but the most successful and certainly most civilized effort to unite Europe since the fall of the Roman Empire 1535 years ago.”
He goes on to criticise what he calls the “just enough, just in time” approach of EU leaders to dealing with the rapid loss of confidence in the sovereign bonds of eurozone countries. This approach has turned out to be too little, too late.
At this stage, I believe we need the outline of a comprehensive solution, with a timetable for its implementation, at the level of each of the seventeen eurozone member states and at the eurozone level. Each must fit into, and be contingent upon the other. Seventeen national plans and one European plan, synchronised each with one another, would give the markets a sufficient sense of direction that they would stop their destructive fear driven flight from the bonds of one European country after another.
Why is it that Europe is under pressure, when its debts are less than those of the United States?
This year the governments of the euro-area countries combined will have a budget deficit of 4.5% of GDP, whereas the United States Government will run a deficit of about 10%.
In the eurozone, the aggregate government debt to GDP ratio is 87%, whereas in the US it is 100%.
In all the eurozone countries, there is broad agreement on measures to reduce excessive deficits and debts where they exist. While there is some difficulty in certain countries regarding implementation of such measures because of low growth rates and vested interests, the situation is better than in the US where the Congress and the President are unable to come to any agreement at all.
In that sense, the eurozone has the makings of a plan, whereas, so far, the US has none; it instead has a deadlocked all party committee of politicians who are trying to place each another in a false position. So why is it then that Europe has a problem, and not the United States?
The United Kingdom has an even bigger debt/deficit/and private borrowing problem than the corresponding problem faced by the eurozone. Yet, the UK is regarded as a safe haven while lenders flee from Italy, which actually has a primary surplus that is to say that, apart from interest payments, its government revenue exceeds its spending.
The four reasons
So why then is it that all the pressure is on eurozone debts, and not on US or UK debts? I see four reasons for this phenomenon.
1. Although they are not willing to do so right now, the US Federal authorities have the legal capacity to levy taxes to pay off debts, whereas the EU does not itself have that authority. It has to rely on its individual member states to raise the taxes.
2. There are bigger problems with Europe’s banks. The gross debt of the eurozone banks is 143% of the eurozone’s GDP, whereas the debt of the US banks is only 94% of US GDP. Furthermore, eurozone banks owe twice as much, as a proportion of their assets, as US banks do.
3. The assets of eurozone banks are disproportionately in the form of bonds issued by governments. So, if governments are in financial trouble, that means more trouble for banks in Europe, than would be the case for banks in the US. In Europe the banks’ problems are the governments’ problems and vice versa, in ways that they are not in the US. This unhealthy situation was, in part, the perverse result of rules designed to make banks sound, which encouraged banks to buy government bonds as reserves, but which assumed, wrongly, that government bonds were risk free.
4. The US Federal Reserve can, and does, ease money supply (print money) to keep the economy moving, whereas the EU Treaties make it much more difficult for the European Central Bank to do this, partly because of historic German fears of inflation. For example, Article 123 of the Treaty on the Functioning of the European Union forbids the ECB to extend credit to member states. In a sense, it could be said that the euro was designed as a “fair weather currency”, and not as a currency that would be able to cope with foul weather.
What is to be done?
As I said earlier, I believe that the eurozone needs a five-year plan, synchronising what is to be done at EU level, with what is to be done at the level of each of the seventeen member states.
Not everything in these plans needs to be implemented immediately, but people need to believe that the plans will actually be implemented within a reasonable period.
The crisis we face is really as much a crisis of belief, as it is a crisis of finance. At the moment, the finance is actually there, but the belief is lacking. Part of the reason for the lack of belief is that markets sense that there is no shared understanding among European leaders about what is to be done.
Germans and their allies initially seemed to believe that the sole problem was one of foolish and blameworthy borrowers. Now everyone recognises that the problem is also one of foolish and blameworthy lenders. That is why a haircut is being imposed upon Greek sovereign bond holders. Understandably that has led to fears among bondholders of other states. Those fears were foreseeable and must be catered for.
There is also the belief that, if everybody adopted the German model of super competitiveness, reducing wage costs and enhancing savings, we could come through the difficulty. The difficulty with this approach is twofold.
First, while Germany already is an export oriented economy, the eurozone as a whole is not. In fact, it exports as little as a proportion of its economy as the US does.
Second, for Europe, or Germany, to run an export surplus to pay off its debts, someone else must be able to run an import surplus. More importantly, someone must be willing to finance the borrowing undertaken to finance that import surplus. It is not obvious who that will be. Both the US and China are cutting back.
For these reasons, I find the prescriptions for Europe laid out in the resolution on Europe, passed at the CDU Conference this week in Leipzig, incomplete and unconvincing.
They are right to condemn deficits, but wrong to ignore chronic surpluses that create those deficits.
They are wrong to rule out a euro bond unconditionally.
They are wrong to try to change the voting weights in Europe in favour of big countries, but right to say that Europe needs more democracy and that the EU President should be elected by the people, not selected on a take him or leave him basis by heads of governments meeting in private.
1. The first thing that needs to be done is to give the ECB the discretion to act in the same way as the British and US central banks do, and be a lender of last resort. This will involve, in effect, printing money. In the very long run, that may build up inflationary pressures. But we will have time to prepare for that. I fear that if the ECB does not exercise wide discretion now, there will, in effect, be no long run for Europe’s economy.
The ECB must act decisively, and with discretion, if it is to discipline the markets and return them to sanity. It must also act independently of governments, so that no government can rely on the ECB buying its bonds, as a substitute for getting its own finances in order.
2. The second thing we need to do is deal with Europe’s banking problem. Our banks have been allowed to become too big to fail, relative to the small size of the tax bases of some of the countries that implicitly or explicitly guarantee their depositors. Banks should be in a position that they can be allowed to fail, like other businesses.
If we had a Europe wide retail banking market, a Europe wide deposit guarantee scheme, and a Europe wide banking supervision system (as envisioned in the Maastricht Treaty but strangled by big countries who wanted to keep prying eyes away from their banks), we could allow banks to fail because few if any of them would be too big to fail in European context. Those that might be too big could be forced to divest themselves of part of their business.
3. The third thing we need to do is enforce a eurozone wide system to remedy economic imbalances. This should include excesses of private borrowing as well as excesses of government borrowing. It should also address excessive surpluses, which often destabilize markets as much as deficits do.
There are provisions to do all this in the recently agreed EU excessive imbalance procedure, which is not confined, as was the Stability and Growth Pact, to government finances only. If there have to be EU Treaty changes in this field, they must address all types of economic imbalance, not just fiscal imbalances.
4. The fourth thing we need to do is produce a credible proposal for a euro bond that could act as a much better and timelier means of disciplining government borrowing than the fines under the Stability and Growth Pact.
I think we will only get our economies going again, if we can restore belief in a fixed measure of value that will provide a capital base for banks, the role that gold performed in the past, and which the sovereign bonds of wealthy countries did until recently.
That is where the proposal for a euro bond could be helpful. It could be a lot more than a short term fix. It might work as follows.
All the seventeen euro-area governments could agree that they would all mutually guarantee the repayment of a new collective euro bond, and that in addition it would have first call on, say, a fixed share of all VAT receipts.
They might also agree that, while no euro-area country would be obliged to issue euro bonds, it could do so in limited circumstances, as described below.
– That the government’s budget law, and five year projections, had been approved in advance by the European Commission, and
– That the euro bond could only be issued to cover a limited proportion of the government’s total borrowing, as long as their overall debt/GDP ratio was more than, say, 60%.
This would have a number of advantages.
It would guarantee a minimum borrowing capacity to all euro-area states. Because of the collective guarantee, the interest rate on the euro bonds would be less than that on most national bonds.
It would, however, penalize countries for allowing their debt/GDP ratios to be over 60%, because they would be forced to borrow commercially and pay higher rates of interest on the extra borrowing, which would be a strong incentive to them to get their debt level down as quickly as possible to 40% or below. That would be a better discipline than retrospective fines, which are the form of discipline we now rely on.
Because the new euro bond would be guaranteed by all euro-area governments, and have a prior call on VAT receipts, it would have real credibility globally, as well as within the EU.
Banks who held such new euro bonds would then have something of real and certain value in their capital base, on the strength of which they could confidently base their lending decisions. In that way, credit would start flowing again, jobs would be created, and permanent structural damage to our economies would be avoided.
If this happened, Europe, rather than being the world’s economic problem, could be the provider of a part of the world’s economic solution.
The views expressed in this article are the author's own and do not necessarily reflect Fair Observer’s editorial policy.
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