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Angela Merkel has a cure for the eurozone’s pesky debt crisis. Hair shirts and stiffer penalties. Aside from that, the German Chancellor has very little to offer by way of a remedy. In fact–what was so surprising about Monday’s widely-anticipated press conference with Merkel and French President Nicholas Sarkozy–was the absence of any new ideas at all. It was just a rehash of the worn Stability and Growth Pact (that limits deficits to 3 percent of GDP) with an added push to make “debt discipline” provisions legally enforceable. In other words, old wine in new bottles.
Still, the markets applauded the charade and rose accordingly until S&P spoiled the festivities by threatening to downgrade 15 EZ countries if they didn’t get their act together pronto. Here’s the story from Reuters:
“Citing “continuing disagreements among European policy makers on how to tackle the immediate market confidence crisis,” S&P threatened to cut the credit ratings of 15 countries, including Germany and France, by 1-2 notches.
It also warned of slowing growth amid so much austerity, predicting a 40 percent chance of a fall in euro zone output.
A downgrade could automatically require some funds to sell bonds of affected states, making those countries’ borrowing costs rise still further.” (Reuters)
So, with the ratings agencies breathing down their necks and the credit markets in turmoil, you’d think that French and German leaders would grasp the gravity of the situation and make a good-faith effort to clean up the structural problems with the single currency. But that, apparently, is not in the script. The plan is to trot out the same failed policies that have pushed the eurozone to the brink of disaster and re-label them “fiscal union”.
But is anyone really fooled by this public relations farce? Legally enforceable austerity measures and a ramshackle underfunded emergency facility (EFSF) do not constitute fiscal union, not by a long shot. If Merkel wants to keep the bond vigilantes at bay and prevent the eurozone from being ripped to shreds by market forces, she’s going to have to do better than that. This fiasco is fast reaching its climax.
So, what should Merkel and Sarkozy be doing?
Here’s what Nobel Economics prize winner Christopher Sims recommends:
“I think some kind of (joint) euro bond and some kind of European-wide fiscal authority will have to be part of any solution that is really stable,” Sims told Reuters late on Monday, dismissing the idea that simply tightening budget discipline would suffice.
“A euro bond that was clearly backed by some kind of euro-wide fiscal authority would have the same kinds of advantages that U.S. treasury bills do now.”….
“Fiscal integration needs to involve more than just budget discipline, more than just the centre telling countries they have to shape up and raise taxes or cut expenditures,” Sims said, lending his support to views that financial market economists have been pressing.” (“Euro zone needs own bonds and tax: Nobel economist”, Reuters)
Did we mention that Merkel is opposed to eurobonds, fiscal transfers, debt pooling, and lender of last resort? The problem is–while the German Chancellor is entitled to her opinion–these are the policies that make fiscal union possible, not budget discipline. Budget discipline merely creates a rules-based system that eschews real union. Here’s how authors Simon Tilford and Philip Whyte, explain it in their “must read” analysis for The Center for European Reform titled “Why Stricter Rules Threaten the Eurozone”:
“It is now clear that a monetary union outside a fiscal union is a deeply unstable arrangement; and that efforts to fix this flaw with stricter and more rigid rules are making the eurozone less stable, not more…..tighter rules do not amount to greater fiscal integration. The hallmark of fiscal integration is mutualisation – a greater pooling of budgetary resources, joint debt issuance, a common backstop to the banking system, and so on.
Tighter rules are not so much a path to mutualisation, as an attempt to prevent it from happening.” (“Why stricter rules threaten the eurozone, Simon Tilford and Philip Whyte, The Cernter for European Reform)
So, Frau Merkel can wheel her lawnmower onto stage and call it fiscal union if she likes, but it doesn’t make it so. Real fiscal integration requires a bond market that pools the debt of the member states , as well as a central bank that backs it debt with the eurozone’s “full faith and credit”, a blanket guarantee on government bonds. In some respects, Merkel has already agreed to this by confirming that bondholders will not have to “take losses on any future eurozone bail-outs”. (FT) This blatant giveaway to big finance was on top of Sarkozy’s list of demands. The “no haircuts” clause means that all future losses from sovereign restructuring will be foisted on EU taxpayers.
All told, the Merkle blueprint for fiscal union is just more of the same, more can-kicking and procrastination. It solves nothing. The structural issues have not been addressed nor has there been any effort to curtail the flow of capital to the perimeter. The reason the eurozone is in such dire straits to begin with is because policymakers have repeatedly misdiagnosed the problem and prescribed the wrong medication. The focus should never have been on profligate spending and deficits, but on the humongous macroeconomic imbalances that arose due to excessive bank lending to countries in the south. That’s where the real problem lies. Most of the countries that are now in distress were playing by the rules until the crash of ’08. That implosion triggered a reversal of capital flows which, in turn, sent bond yields soaring. In other words, there was a sovereign bond bubble that was caused by a combination of overconfidence, easy money and loose regulation. Where have we heard that before?
So, what Euro leaders need to do now is either control the flow of capital to the weaker states or implement fiscal transfers to help the deficit countries muddle through. Unfortunately, Merkel and Co. are no where near a settlement that will deal with these core-issues, so the problems will continue to fester and spread.
So, how does this all end?
We’ll let Simon Tilford and Philip Whyte answer that question with another ominous passage from their outstanding article:
“On current policy trends, a wave of sovereign defaults and bank failures are unavoidable. Much of the currency union faces depression and deflation. The ECB and EFSF will not keep a lid on bond yields, with the result that countries will face unsustainably high borrowing costs and eventually default. This, in turn, will cripple these countries’ banking sectors, but they will be unable to raise the funds needed to recapitalise them. Stuck in a vicious deflationary circle, unable to borrow on affordable terms, and subject to quixotic and counter-productive fiscal and other rules for what support they do get from the EFSF and ECB, political support for continued membership will drain away.” —(“Why Stricter Rules Threaten the Eurozone”, Simon Tilford and Philip Whyte, The Cernter for European Reform)