Fixing Europe’s Unsustainable Nexus
Governments within the eurozone have been dithering on the problem of fiscal sustainability for over two and a half years. The intensity of market-related concerns surrounding fiscal policy conduct has, not surprisingly, increased over this period. Meanwhile, theUKgovernment took the different approach of engaging in severe austerity, because it believed that markets wanted this policy approach from the outset. These different approaches are both wrong! European governments, including theUK, have wasted too much time and resources in not been dealing with the root cause of the problem, namely an unsustainable nexus between governments and their banking systems.
The global financial crisis placed huge strains on government balance sheets in the G7 countries. Liabilities and losses of the financial system were transferred to taxpayers. The “socialisation” of losses could not, however, carry on into perpetuity, particularly in the eurozone. The current nexus between governments and their banking systems has resulted in a negative feedback loop: banks have found funding more expensive from the private bond market as sovereign debt ratings have either been downgraded or put on negative watch. Against this backdrop, it is easy to rationalise the inception of the Long-term Refinancing Operations by the European Central Bank (ECB).
There is an urgent need to re-designEurope’s financial system. A brief outline of some suggested amendments is given below.
Building a New European Financial System
The success of monetary union without fiscal union would always hinge on the integrity of member countries in adhering to the rules of the Stability Pact. The fact that bothGermanyandFrancebroke these rules with no punishment gave others the green light to do the same. If the single currency is to survive, then fiscal union is an obvious starting point. The outcome of fiscal union should be one where less creditworthy countries are available to tap the balance sheet of more creditworthy countries in return for a loss of fiscal sovereignty.
Banking union needs to accompany fiscal union. The relationship between sovereign governments and their banking systems varies on a country-by-country basis. Under a fiscal union, however, there needs to be harmonisation of government “safety nets” offered to banking systems to prevent moral hazard. Banking union would be required to prevent the contingent liabilities of the fiscal union becoming mutualised. At its simplest level, banking union will require a single banking regulator and a harmonised system of deposit insurance. The argument can also be made for the full separation of commercial and investment banking activities across all participating countries.
New Role for the ECB?
Central banks are charged with the primary responsibility of being lender of last resort to solvent banks during periods of market illiquidity. Fiscal and banking union will still require a monetary backstop and framework, particularly with respect to deposit insurance.
A more contentious view is that the ECB under these new arrangements would also need to become lender of last resort to sovereign governments. This role has historically been allocated to the International Monetary Fund (IMF). Eurozone governments have contingent liabilities in a currency they do not issue. On this basis, it is argued that access last resort borrowing from the ECB would reduce the risk of bank runs.
Will Politics Triumph Once More?
The inception of the euro is seen by many economic commentators as being the ultimate triumph of politics. Powerful vested interests still present the most formidable barriers to the rapid implementation of full fiscal and banking union. There would also be great resistance to giving the ECB extra power. It will probably require more pain within the eurozone to get governments thinking on the same page.
Creating a Redemption Fund?
There are potentially many ways to achieve fiscal union. The two popularly-cited ways are: 1) joint liability Euro bonds, and, more recently, 2) a Euro Redemption Fund (ERF). There is significant disagreement across governments about the feasibility of Euro bonds. Under the ERF approach, government debt in excess of the Stability Pact’s limit of 60% would be placed into a fund backed by up to 20% collateral. The fund would have a lifespan of 25 years. We are in the early days of discussing the ERF, which was promoted byGermany’s Council of Economic Experts in November 2011. The main problem facing the ERF is opposition by the current German government. Opposition parties inGermanyappear to be more open-minded.
The ERF is not a panacea. Markets would need convincing about its structure, credit risks and details of which entities are guaranteeing the fund. If these issues can be resolved, the fund could attract significant interest from private investors, particularly those aiming to boost portfolio duration.
Dealing with Capital Flight from Weaker Countries
One dramatic symptom of the bifurcated eurozone has been capital shifts from weaker to stronger countries. This has made fiscal deficit financing more difficult and costly in the weaker countries. Conversely, the same shifts have reduced the sovereign cost of capital forGermany. In order to solve this specific problem of capital flight, sales of public debt by member governments to foreigners should be prohibited. Government borrowing would, therefore, be financed by the domestic private sector. This restriction should have been implemented at the euro’s inception. Free capital mobility on private security purchases within the eurozone should still be allowed.
Stability Pact Requires Suspension
When the Stability Pact was drafted, balance sheet recessions, which are driven by de-leveraging, did not feature highly on the list of future scenarios or concerns. Countries experiencing balance sheet recessions will accentuate economic weakness in their attempt to meet the criteria of the Stability Pact.
If countries are to escape the clutches of a balance sheet recession, there must be at least two policy instruments deployed. It will require the simultaneous easing of fiscal and monetary policy with the full blessing of the European Commission and ECB to support growth. The monetary and fiscal stimulus would probably need to be prolonged. Once the private sector has repaired its balance sheet, then fiscal and monetary policy can be normalised. Finally, member countries of the eurozone need to implement the restriction on foreigners buying government debt outlined earlier and set a date for its inception. The Stability Pact needs, therefore, to be suspended in its current form and re-written.
There will be political opposition to these suggestions, particularly fromGermany. The supreme irony is that German banks solved their balance sheet recession in the aftermath of the technology bubble in 2000 by buying much higher yielding government bonds in the southern eurozone. The resultant capital inflows simply added fuel to the fire on housing bubbles in those countries.
Summary and Conclusions
The euro was fundamentally flawed from the outset due to the rigid structure of the Stability Pact and by allowing participating governments access to non-national funding for borrowing requirements. The euro can still survive as a single currency if there is the political will to institute fiscal and banking union, along with a willingness to recognize that the Stability Pact makes no sense in a balance sheet recession. It could well require more market pain to institute these required changes.
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