More Euro misery
November 30th, 2010
On May 2nd members of the Euro helped complete a large bail out for Greece. They did so to avoid a rolling crisis moving the problems on from Greece to other Euroland countries. Welcoming the announcement, representatives of the member states governments and the European Commission implied that Greece alone was in difficulties, and that the Greek package would end the crisis of the Euro. Germany looked forward to all other Euro member states sorting out their budget deficits and economic imbalances, so the zone could return to smooth management.
Over the week-end of 20th and 21st November the EU and the IMF put together a loan package for Ireland. They acted in haste for fear of the markets. They acted because once again they worried about contagion. The markets were told the familiar story that the problem would not spread. The new discipline allied to the new loan would solve the Irish problem.
We need to ask what went wrong? Why did the world change from their predictions last May? What more does Ireland have to do, given the tough action it had already taken to cut spending and reduce its budget deficit? Why have the markets so far been unimpressed by both the Greek and Irish packages, leaving Greek and Irish bond rates well above German ones despite sharing the same currency?
The immediate trigger for the Irish phase of the running Euro crisis seems to have been the wish of the European Central Bank to cut back the assistance it was offering to Irish banks. The ECB is the lender of last resort for all banks in the Eurozone. It has been accommodating this year, seeking to see a number of banks through liquidity problems. The amounts sought by the Irish banks were becoming too large for the ECB’s comfort. This put pressure on the Irish state, which had guaranteed those banks and bought bank shares. Ireland was asked to find more money to buttress the capital positions of those banks. This was not money Ireland could easily borrow, especially given that the EU was making it more difficult for Ireland to borrow at the same time. Mrs Merkel had floated the idea of partial sovereign defaults or haircuts on the payments some states made to their bond holders. This caused alarm bells to ring in the bond markets for the weaker European countries. The EU had to issue a denial, saying that this idea would not apply to existing bonds.
The EU now wishes to exert much more control over member states economies and budgets, especially over those in the Eurozone. It is proposing five new Regulations, directly acting laws, and a Directive to provide stronger knowledge and direction of Euroland economies. The authors of the single currency scheme are belatedly realising that if you wish to run a successful single currency the centre does need to exercise some control over how much each member state can borrow in that currency, as the level of borrowing will have an impact on the common interest rate. In the meantime, states which have too high an accumulated debt and are seeking to borrow too much will be under increasing pressure to curb their deficits.
It is true that the original authors of the scheme did know that control over borrowing would be an important part of it. They recommended no state should have a stock of past borrowing higher than 60% of National Income, and no state should borrow more than 3% of National Income in any given year. If these disciplines had been enforced there would have been no Greek or Irish phase to the Euro crisis. For various political reasons these requirements were not enforced, leaving many parts of Euroland over-borrowed. The centre did not have the powers to control, or lacked the will to do so. It will take time to put this right, but it can be corrected if the centre is now serious about the need to do so.
Some worry that the result of this new emphasis on discipline will slow the poor growth rate of the EU as a whole even more. Several countries will be put on a meagre diet of spending cuts and tax increases. The EU needs to avoid creating a vicious cycle in any given member state where it cuts spending or increases taxes, only to find that tax revenues fall more and spending on welfare rises if the economy is depressed by the actions.
Normally in any IMF package to initiate recovery in an over-borrowed country the aim is to stimulate that country’s exports, by allowing or validating a fall in the currency to make the country more competitive. This is not available as an option to Greece or Ireland, as they share an exchange rate with Germany and France. The over-borrowed Euroland countries have to supervise a productivity miracle or wage and other cost cuts to make their economies more competitive internationally. We continue to recommend avoiding investments in Euroland for non Euro accounts, as it looks set to remain a slow growth area overall despite the recent good performance of Germany. We do not believe the Irish loan solves all the Euro problems. There is a lot more work to be done to bring the borrowing and spending of some member states into line, more to be done to make large areas of the Eurozone competitive again in world markets, and more to be done to sort out the overextended banks in the system.
As published in Investment Week
