The markets were able to breathe a sigh of relief as ECOFIN Ministers announced in the early hours of the morning the broad outline of the EU/IMF rescue package for the Euro. Let us commend the fire fighters for having deployed sufficient resources to douse the blaze that was quickly spreading to the entire financial building, removing for the immediate future any doubts as to the political will to defend at all costs the single currency.
That having been said, there remain a number of uncertainties which have the potential of reigniting the fire at short notice.
First on the plan itself: the bulk of the support is contained in the €440 billion amount to be provided in the form of bilateral loans and/or guarantees. There is no indication of the level of commitments by individual Member States to provide this staggering amount and it is hard to see how those countries who were the subject of assaults on their sovereign debt (Portugal, Spain, Italy and Ireland and Greece) can be expected to do their share. This concentrates the effort on the 11 remaining EMU Members which is bound to raise strong opposition at national level. Bilateral loans (even if subject to a certain amount of coordination) are the perfect material to provoke both domestic and intra-European political tensions as demonstrated by the vote in Germany over the weekend, or the reactions of the Greek population to the conditions of their own bail out. Bilateral agreements are bound to lead to discrimination in terms of interest rates and conditionality rather than a show of solidarity among EU Member States which is a necessary precondition for re-establishing confidence in the single currency. These uncertainties are all grist to the mill of the sceptics that will be tempted, once again, to test the solidity of the mechanism.
A more transparent and effective solution (which I have been recommending for months) would have been to extend the existing 50 billion “balance of payments assistance” EU budget line by €450 billion and include as the potential beneficiaries EMU Members who are not currently eligible. Being in essence a simple “pass through” mechanism, it should have been possible to exclude this amount from the limits imposed by the financial perspectives. Such a single, easily understandable intervention mechanism, benefitting from the joint and several guarantee of all Member States (denying the UK the possibility of staying on the sidelines) would have served to calm market apprehensions. The rational for this structure is that all 27 Members can benefit from the mechanism; in addition the stability of the Eurozone benefits all Member States as the single market constitutes the most important trading area for all its Members; they have therefore a strong interest in supporting the scheme. Benefitting from a currently unassailable AAA rating (because of German participation), this EU program should provide the cheapest funding available to the beneficiaries without jeopardizing the already heavily constrained borrowing capacity of several Member States.
The second question raised by the Brussels communiqué is the inevitable consequences of the re-imposition of stringent budgetary discipline, to force EMU members within the limits imposed by the Stability and Growth pact. Two days ago, before knowing the outcome of the ECOFIN meeting, I wrote the following on this point:
Even if the ECOFIN agrees on a credible plan, it will not necessarily be sufficient to stop a further deterioration of the current episode of the financial crisis.
Indeed, as was the case after the Lehman failure, it is once again the financial sector that is in the eye of the storm, but this time the risks are far greater, at least in Europe. Then, the “subprime” crisis induced the freezing of the interbank market but Central Banks and Governments had the necessary resources to substitute for it. This resulted in a massive transfer of indebtedness from the financial towards the public sector. Now, it is precisely the Government securities, issued to finance bank rescue operations and general economic stimulus plans, which have been accumulating on bank balance sheets (encouraged by the apparently riskless arbitrage opportunities deriving from cheap and unlimited supply of liquidity by Central Banks) that are becoming the main source of fragility and systemic risk.
Furthermore, finding themselves compelled to submit to rigorous budgetary discipline imposed in particular by France and Germany and endorsed by the ECB, it is clear that EMU Governments, having reached and often exceeded the limits of prudent indebtedness, are in no condition to come a second time to the rescue of their banks. One can conclude that the correction of budgetary deficits can only take place by a combination of deep cuts in public spending and tax increases, repeating, but in the opposite direction, the errors of earlier “pro-cyclical” policies. The economic consequences can only lead to a renewed recession and further weakness of the financial sector.
Over the last two years, I have on many occasions drawn attention to the unstable equilibrium between the deflationary and inflationary pressures prevailing in the economic environment. The apparently orthodox appeals (with the notable exception of Gordon Brown) for budgetary discipline leads me to believe that the odds favour falling into a depression (the worst possible scenario) as compared with the lesser dangers of an inflationary spiral.
Despite encouraging signs of renewed growth in emerging countries as well as in the United States, such an outcome in Europe has a high probability of contaminating the rest of the world, as feared by a growing number of commentators interviewed in the media. Indeed, any real weakness of the Euro – that should still be considered strong at present levels – would seriously jeopardise the capacity of the United States to boost its exports and consequently the strategy on which American recovery is based. That is why the events in Europe took such a toll in the US markets last week. In such a scenario, all ingredients would be in place for reviving protectionist measures that, so far, the world has thankfully more or less avoided.
The relief provided by the weekend agreements offer a short respite to address the more fundamental long term implications for the Euro and the EU. At a minimum a form of credible “economic governance” must be introduced at EMU level, while at the same time the legislative process of reforming the financial system should be pursued with even greater determination. The events of the last weeks should also provide the necessary incentives to reinforce the proposals being currently considered, just like the Goldman, Sachs enquiry favoured tightening US legislation under discussion. At a minimum, the tasks assigned to the European Systemic Risk Council should be reconsidered by adding the monitoring of Sovereign Issuers to its mandate. The case for a “single financial regulator”, at least for the Eurozone, has also been considerably reinforced by the recent events.
At the end of the day, there is an inescapable price that must be paid for the excess of the last decades. I continue to believe that managing this reality by tolerating a certain amount of inflation (controlled if possible) is preferable to the economic and social havoc that a depression would provoke and which last time around led straight to the Second World War!
Brussels, May 10th 2010
Paul N. Goldschmidt
Director, European Commission (ret); Member of the Thomas More Institute.
Tel: +32 (02) 6475310 +33 (04) 94732015 Mob: +32 (0497) 549259