Germany, and Angela Merkel in particular, seem to be attracting considerable criticism for not being willing to take sufficient steps to resolve the Eurozone crisis. How much of this criticism is justified and how much is wide off the mark? More importantly exactly what measures need to be taken; by whom, and over what period? The measures taken at the end of June 2012 are sufficient only to provide time for more substantial measures to be taken. One thing is for sure, this is not the time for a blame game or finger-pointing. It is the time for serious actions.
Eurozone crisis: Result of a complex set of factors
There is neither shortage of criticism of Germany and of the European Commission in terms of their responses to the Eurozone crisis, nor advice as to what should be done. Some of the advice from outside the Eurozone obviously upset Manuel Barosso, the President of the European Commission. At a press conference in Mexico, on the occasion of the G20 meeting he hit back, stating that “This crisis was not originated in Europe … seeing as you mention North America, this crisis originated in North America.” In retrospect he probably regrets saying something that is, at best, a half-truth. A number European banks were substantially involved in the banking crisis in 2007/8; to suggest that the financial crisis was an American or Anglo-Saxon crisis and not a global crisis is to ignore the interconnectedness of the banking and wider financial systems.
In fact the Eurozone crisis results from a complex set of factors. Some of these originate from beyond the Eurozone. But a number of others originate within the Eurozone itself, and are connected to the flawed structure of the economic and monetary union ‘prefigured’ in the Maastricht Treaty, and followed through in the Eurozone institutional structure.
If we start from the problems outside the Eurozone we may detect the extended nature of the 2007/8 global financial crisis, with many banks still repairing their balance sheets, with this banking sector deleveraging ironically being encouraged by the too precipitate imposition of new global and regional bank regulation. (It would, for instance, be preferable to see the Basel 3 capital adequacy requirements phased in over a period of 3 years).
Financial markets, including the sovereign bond market, have remained febrile and prone to both irrational movements and to speculative attacks on exposed countries. The high yields being paid, for instance, on some tranches of Spanish and Italian debt is because of the speculation of the bond markets that further bail-outs may be on offer. The problem is that bail-outs provide a one-way bet in favour of market speculators. They should have been punished early on by a default; it might have stopped the deliberate speculation from going further. Interestingly Merkel has always been in favour of ‘haircuts’ for the private bond-holders. This represents a difficult global financial environment for the Eurozone, which is not entirely of its own making.
If we now turn to the Eurozone itself we discover a number of problems, both in relation to the causes of the crisis and in seeking a resolution.
The main cause – exposed by the external behaviour of bond markets and the utterly unhelpful behaviour of the Credit Rating Agencies (see CRAs) – lies in the way in which the inadequate structure of the Eurozone monetary system has amplified the aggressive export-led growth strategy of Germany since 2000. This has created an escalating banking crisis within the Eurozone.
First, Germany’s economic behaviour has led to an underlying balance of payments crisis within the Eurozone. Germany is running a permanent balance of payments surplus with the remainder of the Eurozone. (It is also, accompanied by China and Japan, running surpluses with the rest of the world. The idea that there is something morally superior in running surpluses rather than deficits is economic nonsense. Permanent surplus countries are the reason why, at Bretton Woods, the ‘hard currency’ clause was inserted in the IMF constitution, to achieve symmetric adjustment of current account imbalances. It has never been invoked!).
The imbalance in the Eurozone, created by a combination of average German productivity growth (actually Germany’s performance is well below that of Greece!) plus, as the major factor, a deliberate suppression of wages and prices in Germany since 2000 (i.e. below the 2% ECB target set for all Eurozone countries) and hence depressed domestic demand. The ECB phrasing is “below or close to 2%”. The “close to” is the recognition that unless deliberately engineered 2% is the likely minimum absolute price level ‘friction rate”, given on-going relative price adjustments in the economy. In fact it will often be higher (as the Bank of England has found).
It should be recalled that Germany was roughly in current account balance in 2000; it now has an 8% of GDP current account surplus! Germany has chosen to follow an aggressive export-led growth strategy to the detriment of not only the remainder of the Eurozone (with the exceptions of the small countries of Netherlands, Finland and Austria). The initial appreciation of the Euro from 1999 intensified Germany’s exports to other Eurozone countries. Over the past few years the depreciation of the Euro has, partially, decreased this earlier trend.
The second problem is that from 2008, Germany has also become an importer of capital from other Eurozone countries (flows of 15 billion euro in the 2nd and 3rd quarters of 2011). Much of this capital inflow results from German banks’ repatriation of funds from the peripheral countries. Flows in the other direction were close to zero. This has resulted in quasi-permanent imbalances, between the Eurozone national central banks, in the ‘autonomous’ TARGET 2 (Trans-European Automated Real-time Gross Express Settlement System) mechanism which, effectively, amplifies the internal Eurozone debt problems when there is a permanent balance of payments surplus generated by one of the major countries, i.e. Germany.
Hence, Germany’s strong financial sector integration within the Eurozone is even greater than its real economic integration. Indeed, Germany has suggested either limiting the ECB long-term financing or requiring annual settlement of the TARGET 2 imbalances between national central banks. Neither would work, or be permissible, and in any event would not solve the underlying trade and payments imbalances. In passing it should be noted that in the case of any default, say due to a Greek exit, the default amount would be shared proportionately between the remaining countries: for Germany this would be a 27% share only.
The TARGET2 system means that inward capital flows to Germany are occurring in the form of net creditor positions in the TARGET system, i.e. in the form of credits to the Bundesbank and debits to the central banks in Greece, Ireland, Portugal, Spain, and, particularly Italy in 2011 and 2012. The credit/debit balances are now over 500 bn euro. This represents capital flight as banks in the deficit countries are unable to obtain funding from other commercial banks and are being funded via the ECB.
The problems associated with TARGET 2, though soluble (see below) are indicative of the unfinished nature of monetary (let alone fiscal) union. In the US the Californian ‘central bank’ is simply a branch of the Federal Reserve Bank. In the Eurozone system the central banks are independent, except, of course, that critically they cannot issue currency.
Germany is not the only ‘sinning’ country since the Euro was established. The two countries, excepting Greece for the moment, which have had major national banking crises, are Ireland and Spain. Prompted by the bond market’s irrational behaviour – the bond yields of all of the Eurozone countries until around 2007 (actually including Greece!) were almost identical – in Ireland and Spain the residential and business construction sectors expanded beyond any reasonable assessment of demand. In Ireland three years ago and in Spain more recently this, predominantly private sector, boom translated into a major banking crisis requiring either banking closures or mergers and substantial recapitalisation. However, it should be noted that both Spain and Ireland ran national government budgetary surpluses prior to their banking crises, unlike Germany after the Eurozone was launched. They were not profligate in fiscal terms and stuck to the Maastricht criteria. Greece, as we all know, is a different case, but not because of an indolent workforce as some suggested: Greek workers work some of the longest hours in the Eurozone.
So much for apportioning blame: even though a crucial part of the Eurozone crisis is attributable to it, it is not all Germany´s fault. The situation is not helped by the tendency of German commentators and politicians to claim moral superiority when the underlying economic analyses point the other way.
Now we know why we are here. The question is, what to do and how to do it, over a period which is politically and institutionally feasible. Too much time has already been wasted on half-hearted, stop-gap measures; radical solutions are now required. It is imperative that a plan with a time-line needs to be established. A summary of such a plan is sketched out below.
German Constitutional Problems
For a start, to be fair to Angela Merkel, it is worth exploring the constitutional reasons why the Germans appear to be rather reluctant to embrace solutions such as Eurobonds or turning the ECB into a genuine central bank and allowing it to operate in the same way as the Federal Reserve or the Bank of England. (It should be said that Eurozone countries other than Germany will also have constitutional problems).
There are severe obstacles presented by the German constitution (and particularly the conservative interpretation of the constitution by the current Karlsruhe court) in respect, not only of the issuance of Eurobonds, but also the freedom of action given to the ECB and also the assumption of liability for the debts of other Eurozone countries, i.e. via the ‘bail outs’. However, they are not insurmountable.
There are two points to make on the current position.
First the changes required to permit the issuing if Eurobonds (an overt mutualisation of Eurozone debt which will ease the immediate financial problems of the Eurozone) are relatively minor in terms of the constitutional changes required (both to the German constitution and the TFEU). In fact, strictly, the TARGET imbalances and the ESM (European Stability Mechanism) pose the same legal problem.
Second, the key problem in Germany is the desire of the Karlsruhe Court to protect the permanent (Ewigkeitsklausel: eternity clause) democratic essence of the German constitution. This is expressed in Article 20 (Basic institutional principles; defence of the constitutional order). The second of the four points involved is critical to understanding the problem, and the solution.
(2) All state authority is derived from the people. It shall be exercised by the people through elections and other votes and through specific legislative, executive, and judicial bodies.
It is clear that any interpretation should distinguish between governance and democracy (in essence voting). Hence, providing the Bundestag is able to control the budgetary spending relating to any unlimited incurred liabilities linked to Eurobonds or other debt liabilities, then the constitution – perhaps for clarity, requiring a relatively minor amendment – should not provide an insurmountable barrier.
The fact that the Eurozone Fiscal Pact commits all 17 Eurozone countries to balanced budgets (which should be defined by economists not lawyers) means that this condition is met. This point has been made already by the Court. It should be noted that, politically, any such amendment would require the assent of a two-thirds majority in both the Bundestag and the Bundesrat.
In extremis, if the monetary union itself is massively threatened and Eurobonds become the only way out, then they will be adopted, whatever constitutional barriers appear to be in the way.
A Summary Plan to Resolve the Crisis.
- The proposed Banking Union should be set up as soon as possible and actions taken to close or to take over failing banks which cannot be recapitalised, as judged by the ECB. This action has already been taken in both the US and the UK. This would improve inter-bank lending and liquidity. Accompanying the Banking Union should be a protocol indicating that after 3 years the individual Eurozone central banks should become branches of the ECB.
- Steps should be taken to amend the TFEU and the German constitution to put both the ESM and the later Eurobond issuance on a sound constitutional legal footing, and achieve the essential mutualisation of Eurozone debt.
- The above actions should enable reflationary measures, including increases in debt, to be adopted across the Eurozone, particularly in Germany. These measures should coincide with fiscal consolidation (essentially measured by budget deficit reduction) targeted on a 3-year timescale to achieve the Maastricht 3% deficit target. (It should be pointed out that all of the countries which have improved their trading positions have done so over a long period and in the context of strong external global economic growth. This is also the reason why it is a growth, rather than an austerity and anti-growth strategy that the Eurozone situation currently requires).
- It should be made clear to all Eurozone countries that the 2% inflation target should be adhered to, and inflation rates lower than this rate will be penalised. (This applies particularly to Germany whose rate should ideally remain at 2% for the next 3 years)
- All countries should have a target of a zero balance of trade within the Eurozone.
- A plan to achieve a full Fiscal Union over the next 3 years should be established and all the steps needed in order to achieve this target should be taken by all Eurozone countries.
It is unlikely that all of the above steps will be taken in the proscribed time period, yet unless they are achieved, the future for the Eurozone is likely to be one of continuing crisis, with a high risk of breaking up. This is really not the time for a blame game or for finger-pointing. It is time for action, and time for the heads of Eurozone governments to show leadership.
The author, Michael Lloyd is a member of the Editorial Board of Read-Online.Org. He is a Senior Research Fellow, Global Policy Institute, London, and Director of LCA Europe Limited. (Contact: Michael.Lloyd@read-online.org)
Opinions expressed in this article are those of the author and do not necessarily reflect the editorial views of Read-Online.Org
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