Brian Fallow 's Opinion

The Economics Editor of the NZ Herald

Brian Fallow: Europe's leaders at beggar's crossroads

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The tumult on global financial markets is a vote of no confidence in political leaders on both sides of the Atlantic and in their ability to get public finances on a sustainable footing.

Of the two, the European case is worse because the doubts extend beyond the calibre of the incumbent politicians to the very institutional framework of the euro area.

Standard & Poor's was clearly right to conclude from the political brinkmanship of recent months that the "effectiveness, stability and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges" and right to be "pessimistic about the ability of Congress and the Administration to leverage their agreement [last] week into a broader fiscal consolidation plan that stabilises the Government's debt dynamics any time soon".

There is not so much a gap as a Grand Canyon-sized chasm between the services Americans expect their Government to provide them and what they are prepared to pay for in tax.

When the US Government is borrowing 40c in every dollar it spends, the spectacle of backwoods Congressmen calling for a balanced budget but no increase in taxation does not inspire confidence.

US exceptionalism does not extend to immunity from the laws of arithmetic.

But at least the long-established institutions where the battle to get past this sort of nonsense will be fought out are not in question.

There is no existential threat to the US dollar as a currency.

Europe's leaders, by contrast, find themselves at a beggar's crossroads, that leads to disaster in every direction.

Every stop-gap deal they come up with, which placates the markets for a week or two and is then followed by fresh waves of fear and angst, only drives them closer to having to confront some really tough questions.

Is monetary union possible without fiscal union?

Is it sustainable to have a single currency but 17 national budgets increasing 17 national debts at 17 different rates? Is the price of preserving the euro an agreement for the member states of the euro area to guarantee each other's debts?

And what would be the cost, in fiscal autonomy, in sovereignty, for securing such an agreement?

Suppose that New Zealand, attracted by the prospect of Australian interest rates, adopted the aussie dollar.

Suppose further that the price of that was that before a Finance Minister could present a Budget to Parliament he had to run it past Canberra: "Nah, mate, come back with one with less spending and more tax. We won't underwrite this."

How would we feel?

In Europe's case, however, something like that may come to be seen as the lesser evil.

If the alternative to fiscal integration is monetary disintegration - with countries leaving the euro system and defaulting on their debts - what would it cost taxpayers in the remainder of the euro area to bail out their banks, when they are left holding the bag?

There has always been an inherent instability in having one monetary policy in a Europe where the power of the purse still resides with national governments. It is an invitation to free riding and moral hazard.

A treaty, the Stability and Growth Pact, was intended to deal with the problem by delivering a convergence of fiscal policy. It required euro area governments to keep budget deficits below 3 per cent of GDP and debt below 60 per cent.

The trouble is, as Otmar Issing, a former chief economist at the European Central Bank, says in Monday's Financial Times: "Almost all treaties promising European fiscal discipline have been broken time and time again. The worst example was delivered by France and Germany in 2002/03 when they violated the Stability and Growth Pact and even organised a political majority against the application of its rules."

Government debt in the euro area as a whole is 88 per cent of GDP and the European Commission projects it to stay there or thereabouts for at least the next three years.

In Italy's case it is 120 per cent. Before the euro, the markets could have responded to Italy's combination of such high public debt and sluggish economic growth by dumping lira. Currency depreciation would have boosted the competitiveness of Italian exports.

But that adjustment mechanism is of course unavailable under the single currency, leaving fiscal austerity and deregulation to do all the work.

With Spain and Italy the most recent dominoes to sway and totter, the stakes are much higher than with the "peripheral" economies of Greece, Ireland and Portugal.

The eurozone's "fighting fund", the European Financial Stability Fund (EFSF), is presently capped at €440 billion ($755 billion) and member states' parliaments have yet to endorse more flexible rules for using the money when private sector funding for sovereign debt evaporates.

To put that in context, Italy's debt is €1.8 trillion and, while the average term of that debt is relatively long, Italy and Spain between them are still expected to need to raise more than €800 billion by the end of next year.

Much of the EFSF is already committed to Greece, Ireland and Portugal.

Estimates of how big the fund would need to be if it were to be a credible weapon to defend the euro range from €1.5 trillion to €4 trillion.

German Chancellor Angela Merkel is pardonably unwilling to convince German taxpayers that they need to underwrite debts run up by Italian Prime Minister Silvio Berlusconi and other feckless southerners.

The Dutch Government has also opposed any increase in the EFSF.

Britain's Chancellor of the Exchequer, George Osborne, has called, in the interests of financial stability, for the establishment of eurobonds, which would see the debts of strong and weak eurozone countries combined. Britain, of course, is not in the euro area.

Issing, who is German, points out that a common bond would not only lower interest rates for the highly indebted countries, but push rates up for those which have earned credibility in the markets.

"A stronger case of free riding can hardly be imagined. Lack of fiscal discipline is rewarded, while fiscal solidity is punished."

In the meantime the European Central Bank has started buying Italian and Spanish bonds on the secondary market, reversing some of the ominous rise in yields.

It is an exercise in selective quantitative easing, utterly beyond the original inflation-targeting mandate of a supra-national central bank.

Issing again: "A monetary union with a stable euro can only survive if central bank independence is fully respected. This implies the ECB abstains from fiscal actions."

Such intervention, like intervening in foreign exchange markets, is only temporarily effective if it is at odds with where the weight of private sector money wants to go. If banks and other private holders of the troubled securities want rid of them it becomes a case of "ooh good, a buyer".

All in all, there is little cause to hope that the phrase "European sovereign debt crisis" is going to disappear from the news any time soon.

- NZ Herald

Brian Fallow

The Economics Editor of the NZ Herald

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