Will the Euro Survive?

Date December 10, 2010
Speaker Iain BEGG (Professorial Research Fellow, European Institute, The London School of Economics and Political Science (LSE))
Moderator YOSHIDA Yasuhiko(Director, International Coordination and Public Relations, RIETI)

Summary

Iain BEGG's PhotoIain BEGG

Yes, the Euro will survive!! When you look at what has happened with the Euro, it is important to see it from a European perspective. The news broadcast in Japan tends to reflect North American views on the subject. I hope to show a different perspective.

First, it is important to recognize that the euro is more than just a currency, because it functions as a system of economic governance. The European Central Bank (ECB) has a mandate which says that it must give priority to price stability. In the European system, only if price stability is maintained should other things such as unemployment be considered. It is only over the past year or two that the ECB has started to concentrate on things other than price stability. Fiscal policy is something that belongs exclusively to member states. There is no federal EU budget equivalent to those in the US or other established federations (such as Germany). There is a European budget, but it is only 1% of the area's GDP, and it is assigned almost entirely to regional development and agricultural policy. Supply-side policies are also mainly in the hands of member state governments. Another feature of the Euro area is that it has 17 members (with Estonia joining at the beginning of 2011), while there are 27 members in the European Union. What this means is that there is no central direction in the European system. Instead, you must rely on the coordination of national policies.

In understanding how the Euro functions, you must think about how the different actors in Europe work together. This is very complicated, because it involves member states, the European Commission, national central bank, various committees, dialogues, and the European parliament.

The Euro was set up as a compromise between France and Germany. This conflict is at the heart of many of the difficulties we see at the European level, even though the two countries often agree with each other.

The oversight of national policies has, up to now, focused almost exclusively on fiscal discipline. The Stability and Growth Pact was set up at German insistence in 1997 with a target of not exceeding a deficit of 3% at any point, and having close to a balanced budget or surplus over the medium-term. The discipline on this was very weak. In 2002, both France and Germany broke the conditions of the Stability and Growth Pact. Thus, even though surveillance measures of the Euro zone were, in principle, extensive, those for fiscal policy have not worked well. Much more significantly, many other elements of potential imbalance have never been examined at all. Internal imbalances are one such element, and this has been the cause of some of the difficulties we have seen in the last two years.

The way the Euro was set up did not really anticipate the eruption of a crisis. And yet over the last few months we have seen at least two potential sovereign debt crises, and possibly more may happen. There was nothing written into the Treaty on European Union or the Lisbon Treaty that provided a way to resolve these types of crises. There is something called the "No-Bail Out" clause, which says that the ECB is not allowed to monetize the debt of any country. Countries may not go to the ECB and say, 'we are issuing debt, buy it from us.' In practice, this means quantitative easing (QE) is not, strictly speaking, possible. However, the ECB has been prepared to buy up the debt of Member States from the financial system, rather than directly from the national Treasuries, a form of 'unconventional' monetary policy that comes close to being QE.

There is a very strange political economy in place to enforce fiscal policy at the EU level. In particular, even if countries are told that they must not exceed 3% deficits, the penalties for doing so are very low, and the advantages of being a free rider are very high. There is thus a high incentive not to comply, and in any case, many of the things countries are asked to comply with have to do with national political preferences about public spending and taxation, so that it is politically sensitive for such 'top-down' rules to be imposed by the EU.

At the start of the financial crisis in August 2007, interest rates in most European countries were almost the same. Progressively, as the crisis has unfolded, spreads have widened. This raises a number of interesting questions. Was it correct in the first place for there to be no spread? Did the markets get it wrong? Were the spreads too low because there was a false illusion that somehow the Euro would guarantee the bonds of every country? Looking at the start of 2008, there were normal spreads in which you have an element of credit risk for the countries which were taking the biggest risks with their policies. Finally, in late 2009, spreads go wild as countries finally realize that Greece is extremely at risk.

The Euro area's inflation rate has been just 24% since 1999, a respectable value. Germany has had the lowest inflation. Greece's inflation rate during this period is nearly double that of Germany's. When you have a single currency and such divergent interest rates, something has to give as it is not sustainable.

The same thing can be seen when looking at unit labor costs. I have measured cost change in the period from the start of the euro up to when the crisis hit. In this period, only Germany had a slight fall in unit labor costs. Over the same timespan, Spain's unit labor costs went up by nearly 30%, Italy and Greece went up by 25%, and Belgium and France both saw rises between the two extremes. Although these figures are not very dramatic, they represent an annual change; a difference each year of 1%-3% within the zone, which you may not notice year by year, but, when allowed to accumulate, can create great competitiveness divergences which go a long way to explain balance of payments positions. Since capital costs are more or less the same throughout the zone, it is these units of labor costs which have determined competitiveness.

All of this gave rise to what we saw in May 2010. It looked like Greece was going to explode by about May, and then we heard in November that things were only going to get worse and that we had Ireland coming into the picture. You can understand why these things have happened when you look at the very basic indicators that I have presented, as they reflect the unfolding divergences.

You read a lot in the press about core economies and peripheral economies, and the temptation is to say that Ireland, Portugal, Spain, Greece, and Italy are all peripheral economies, and that the core economies are Germany, Austria, the Netherlands, perhaps France, and perhaps Belgium. But I would suggest that there are actually three very different origins to the problems we have seen.

I will start with the easy one—the public sector, which is exemplified in Greece. Greece had a dysfunctional public sector. There were groups of public workers able to retire at 50 and to receive pensions that were 90% of their salaries; state owned enterprises such Olympic Airways was a protected and subsidized species—the State was becoming weak and overly costly. The debt in Greece as of early this year was up to 130% of GDP; the deficit was ballooning to 15%.

I would say that is very different from what has happened in Ireland, where there was a systemic banking crisis. Iceland, as you know, went bankrupt. Ireland's banking sector was seven to eight times the size of its GDP. It was lending furiously and many of its liabilities were owned by the financial system in other EU countries, especially the United Kingdom and Germany among continental European countries. The banking crisis in Ireland had to be picked up by Ireland's public sector, and that sector is now in trouble because the Government gave an open guarantee that deposits would be honored. Not just to consumers as depositors—everybody who had loaned money to the Irish banks was told: 'your money is safe'. That was a very dangerous thing to do in hindsight.

The third problem is related to unit labor costs. Greece, Portugal and Spain have lost competitiveness. Unit labor costs have risen in each country to such an extent that they face growth challenges.

How can we explain all of this? The first explanation is to think about Germany. Germany has changed its role. It always used to be regarded as the good European who would provide the money when other countries would not pay up. However, there is a new generation of leaders taking over in Germany. The country has faced more than 12 years of slow growth. It faces domestic constraints on its actions. This has meant that in the spring, when Germany was called upon to deal with the Greek problem, Germans were reluctant. Probably the Greek problem cost more as a result of how slow Germany was.

Six weeks ago there was a meeting in Deauville, a very nice resort in Normandy in France where Sarkozy and Merkel got together and decided that what is really needed in Europe is a crisis resolution mechanism in which bondholders would pay some of the costs. They are correct—bondholders have made foolhardy investments, and they should pay some of the costs. However, the trouble is, in making such a statement, they threw petrol on the flames of Ireland and Portugal.

What comes next? Europe has tried to create a new post, the President of the European Council, in order to create a central power authority. The new President, Herman van Rompuy, has made a series of proposals to create a new system of macroeconomic surveillance. This system will provide a more intensive oversight of Europe's macroeconomy. Second, he has proposed the creation of a range of structural indicators. Third, he has proposed pushing every country toward developing its own fiscal rules. Countries which break rules will be subject to sanctions.

All of this is being proposed without a treaty. It is being suggested that this will be done through a two-semester system for budget formulation. In the first semester, the European Semester, countries will submit their budgets to the European Commission for scrutiny. The second semester will be for national negotiations. There is supposed to be a new legal procedure called the excessive imbalances procedure, which will work to create alerts signaling countries whose economic policies are putting their neighbors in danger. This will only affect Euro area countries, however. The United Kingdom will not be affected, nor will it be forced to participate in the two semester system.

There was a debate when Greece was being rescued about the involvement of the International Monetary Fund (IMF). In developing a new system at the European level, an open question is whether Euro area countries should continue to rely on the IMF, and has the resources to do so. Germany has proposed a minor treaty change to make a formal crisis resolution mechanism legally robust. However, does the creation of a crisis resolution mechanism create incentives for countries to misbehave? Some are now asking this question.

There has been discussion about creating a European monetary fund. This might be one way of creating a sovereign debt resolution method. There has also been much discussion in the past few days about "Euro bonds," which provide a substitute for nation-based bonds which have bigger credit risks. This would also be one way of telling the markets that the region is serious about keeping the Euro going. Critics claim that Euro bonds would result in Germany needing to pay more than it does at present to borrow and would result in greater risk for the country when helping out other nations.

Finally, many in Europe are now talking about "fiscal union." While there is a big debate now about whether the creation of a fiscal union might be the solution to keeping the Euro going, it seems that no one knows exactly what is meant by fiscal union. Does this mean bailouts? Is it just instruction from above? Or is it German taxpayers paying for Greek pensioners? There is unfinished business here in addressing this issue. There are a wide range of political economy issues. Who controls the economy is an issue—what is the optimal balance between the ECB or national governments? When we talk about bailouts, who is being rescued—is it the Greeks, or the German and French banks who have been lending to the Greeks? Bank liabilities and sovereign debt have become very closely interlinked. What Germany does is going to be the key to all of this.

I think that there are many issues now being discussed which will eventually lead to greater financial stability in Europe. However, financial stability often relies on the presence of taxpayers to support it, and there are no European taxpayers, only national taxpayers. This ultimately undermines the legitimacy of the ECB.

Many Europeans now recognize that breaking fiscal rules leads to trouble. There is a new sense in Europe that devising rules and sticking to them is the right way forward. Ultimately, whether the reforms being proposed for the Euro area succeed or not depends on their being enough political will to push through the reforms now on the table. I believe that there is such will, and that a crisis management mechanism will be put into place as well. And as a concluding remark, I would say that although the Euro is part of a solution to the problems being seen in Europe right now, it is at a tricky crossroads.

Question and Answer

Q: Will the amount of political capital invested in the Euro help it to survive?

Iain BEGG
I think the Euro is more than just a political project. It is now very hard to find a group that does not believe that the survival of the Euro is in their best interest. For example, German exporters love the Euro because it has prevented currency appreciation. Bankers, debtors and creditors are all in favor of the Euro. Is there anyone who would benefit from the Euro collapsing? Devaluation may be a solution for uncompetitive countries. However, one of the reasons the Euro was set up in the first place was that devaluation-inflation-devaluation cycles were debilitating over the medium term for uncompetitive countries, and joining the Euro zone was a way to escape this. In most countries, devaluation has been achieved effectively by cutting wages. Countries are slowly learning that when they are in a currency union they must use a new set of supply-side policies to achieve their competitive aims. The US treasury might feel ambivalent about the Euro collapsing, but I believe that inside Europe there is support for the currency.

Q: It seems fair to view the Euro zone as an enlarged Germany. Is this view too simplistic?

Iain BEGG
Yes. One of the motivations for the European Union was to diminish Germany's power of hegemony, and one of the reasons for the Euro was to diminish the power of the Deutsche Mark. Up until 1992, when the exchange rate mechanism began to falter in Europe, the power of Germany was very strong in setting monetary policy. Now it is a central decision based on Euro area conditions. Germany sometimes complains that Euro area conditions do not suit it. I think there has been a spreading of power with the Euro.

One reason to suggest that Germany might be too powerful is that it is the country most in surplus. There is some evidence of there being a hard Euro bloc—Germany, the Netherlands, and Finland—and a weaker Euro bloc—Spain, Italy, Portugal, and Greece, with uncertainty about France. In any case, there will be a single Euro or a breakup; there will not be a hard and soft Euro. It would be a mistake to think of Germany as the only strong country imposing its will on the rest of Europe.

Q: Why did Germany become so strong? After the financial crisis, Germany's exports dropped sharply and it seemed that the country was in trouble. Yet, Germany is now a strong country again. Why?

Second, Europe now seems to be heading toward a "gold-standard" situation in which strong countries are forced to bear the majority of costs. What do you think?

Iain BEGG
The reason that Germany shifted from being a slow but growing economy to the star performer of Europe now is partly because of a process the country went through between 2000-2005 for supply-side reform. There was a sequence of actions called the Hartz I-IV initiatives, which were introduced to reform the labor market. It is one of the reasons why German labor costs remained static and competitiveness improved. The bounce back has also been fueled by export demand.

As for the second question, it is perhaps appropriate to refer to the Euro area as being like the gold standard because there is no margin of flexibility. It is a single currency area. There are no provisions in the European treaties for leaving. The various ways in which the economies are interconnected are also very significant. Supply chains are such that there is a single European market. There is a strong common interest in keeping this market together, because it is seen as an element of prosperity.

Q: I think there is a lack of balance of payments discipline in the Euro area. Has there been any talk of setting requirements to deal with this?

Iain BEGG
I think you are right, and that this is the direction the Van Rompuy proposals are going toward in calling for excessive imbalance procedures. These are intended to work alongside the Stability and Growth Pact and are aimed at trying to identify countries that are at risk of allowing imbalances which cause damaging effects that spill over to other countries.

Q: Where does the United Kingdom stand on the question of the Euro? Would the United Kingdom be willing to join forces with Germany to preserve the currency union in the future? Or has the current crisis convinced the British to stay away?

Iain BEGG
There are several answers. The current coalition agreement rules out the United Kingdom joining the Euro during the current parliament. At least until 2015, the United Kingdom will not join the Euro. Furthermore, on the plausible assumption that the Conservatives win the next election, you can probably rule out British membership for ten years.

That said, the British have been quite cooperative about the current troubles, even participating in the bailout of Ireland. Europe is interconnected. If you are interconnected, you do not allow your connections to fail, because it affects you.

In May this year, one of the reasons the new government decided to create a bigger fiscal austerity program was fear of contagion. It seems that fiscal problems affect any country with weak discipline, whether the country is in the Euro area or not. Some are even saying that bondholders may begin to argue that T-bonds are not as attractive as they used to be because of the growing debt and lack of political will to deal with the deficit.

There are three different ways in which Ireland and Greece have been bailed out: 1) IMF funding, which the United Kingdom pays into; 2) the European Stabilization Mechanism, which the United Kingdom pays into; and 3) the European Financial Stability Facility, which is only Euro area members. In the Irish case, Britain has also made a bilateral agreement with Ireland. I think it would do so with Spain as well, because British banks are at risk. Moreover, if Spain falls, Italy and then Belgium would rapidly become vulnerable as well. There is a natural Euro-skepticism in the United Kingdom, but the country has nevertheless been willing to participate in everything that is going on.

Q: How do you evaluate the political instability in credit-worthy nations such as the Netherlands or Germany?

Also, how reliable are British newspapers for information on the Euro? How neutral are they?

Iain BEGG
On the second question, the Financial Times is reasonably objective, but some of their columnists are volatile in their opinions sometimes. The paper has varied opinions but will give you solid analysis. Other newspapers are—shall we say—more partisan!

As for unrest in Germany and the Netherlands, there is certainly an objection to bailing out countries. If the contagion spills over to Spain, it would be catastrophic. The unrest is limited but understandable. It is worth noting that in countries notorious for protests, like Greece or Spain, the protests against the austerity measures have been far more subdued that you would expect given the extent of cuts being made. Even in France, protests about pension reforms have evaporated.

Q: Do you see any possibilities of Euro area deflation going forward? Do you think that the ECB will provide more liquidity to the market in order to fight against such deflation?

Second, what do you think the time horizon is for the expansion of the European Financial Stability Facility (EFSF)?

Third, who is going to persuade German taxpayers to pay more in the case that decisions are made for the expansion of EFSF or Euro area bonds?

Iain BEGG
I do not think there will be deflation, because Jean-Claude Trichet (European Central Bank President) made the early decision to pump in liquidity in 2007 and has made it clear that interest rates will remain low. The sense is that the ECB is willing to do whatever is necessary to avoid deflation and ensure there is enough liquidity. Deflation would require many more countries to move toward restrictive policies, and I do not think that is going to happen.

In regard to the expansion of the EFSF—the Irish bailout cost roughly 100 million Euros, and the Greek bailout cost 110 million. Of that, the expectation was that the IMF would cover a third and the European Stabilization Mechanism about a third. The amount to come from the EFSF is very low. Only if the crisis spilled over to bigger countries would you need a bigger fund.

How do you persuade German taxpayers? I think there has been a communication problem. German taxpayers are not giving money to the Greeks or the Irish, they are lending them money, and this needs to be explained better.

Q: What is the future of the France-Euro relationship?

Iain BEGG
France and Germany are the core of the Euro. The French economy has not been as affected by the crisis as other economies have. However, France faces supply side problems. It needs greater labor market reform for its smaller companies to become more dynamic. Over the next three or four years, France is likely to see a slow recovery, and although it is unlikely to catch up with Germany, it will still be positive.

France will continue to be a leader that will try to work with the Germans for the Euro. But there will always be tension between the positions of these two leading countries.

*This summary was compiled by RIETI Editorial staff.