Obviously, the FT’s Martin Wolf has been listening to the same preacher I have because he is singing my song. In Tuesday’s FT he wrote about the recent Beggar-my-neighbour eurozone policy and how the policy response in Europe has caused him, like me, to question his previous position that the eurozone would never break up given the political costs.
Might the eurozone break up? Until recently I would have answered: absolutely no. This is not because I thought the currency union a wise idea. I thought it a risky idea, made more so by the decision to accept member countries so different from those of the zone’s northern core. But the commitment to make it work seemed fundamental to the policies of Europe’s principal powers. Is that still true? I do not know.
So what has gone wrong? What is happening now? What happens next? What does it mean for both the eurozone and the world economy?
On the first question, the European orthodoxy is that the crisis is, at root, fiscal. Marco Annunziata of UniCredit summarises it in a recent note: “In hindsight, it seems obvious that the flaw in the eurozone’s institutional setup is both extremely serious and extremely simple: first, a currency union cannot work without sufficient fiscal convergence or integration; second, the eurozone has been unable to create incentives for fiscal discipline.” Mr Annunziata’s chart (reproduced above) shows that this view is wrong. Just consider the frequency of breaches of the rules requiring fiscal deficits of less than 3 per cent of gross domestic product. Greece is a bad boy. But Italy, France and Germany had far more breaches than Ireland and Spain. Yet it is the latter that are now in huge fiscal difficulties.
Exactly right. I just wrote about how hollow this song and dance about German fiscal prudence is. Read "Spain is the perfect example of a country that never should have joined the eurozone." What’s key in this is an understanding that the Spanish and the Irish were subjected to what for the Germans was an adequate monetary policy. But for the Spanish and the Irish it was highly inflationary, both in terms of asset prices and labor costs. I can see the leaders last decade, Bertie Ahern and José María Aznar now:
Citizens, we are running budget surpluses right now. And the economy is booming. But, I intend to commit political suicide because I recognize there is an asset bubble forming which will cause our surplus to turn into double-digit deficits in no time. Therefore, I am asking the legislature to tax you more so that we can forestall this problem. Moreover, I want to ask you workers to take pay cuts now so that you don’t have to later.
I hope that sounds about right because that is the only thing the Spanish and Irish could have done, locked into the currency union as they were. Martin Wolf makes the same points:
The fiscal rules failed to pick up the risks. This is no surprise. Asset price bubbles and associated financial excesses drove the Irish and Spanish economies. The collapse of the bubble economies then left fiscal ruins behind it.
It was the bubbles, stupid: in retrospect, the creation of the eurozone allowed a once-in-a-generation party. Some countries had vast asset price bubbles; many had soaring relative wages. Meanwhile, Germany and the Netherlands generated huge current account surpluses. The union encouraged a flood of capital to the surging economies, on favourable terms. When private spending imploded, fiscal deficits exploded.
So, what are the politicians doing? Blaming the so-called ‘pack of wolves’ who are causing problems for this European experiment. Now the Germans are going so far as to institute short-selling bans to keep those wolves at bay. The short selling ban shows you politicians don’t get it. Europe’s problems are about debt, not speculators. And the markets don’t like it one bit.
This is how the Wall Street Journal’s blog Market Beat describes it in a post called Germany Goes Rogue:
Markets are definitely seeing the German short selling ban in a negative light, as yet further evidence of governments trying desperately to slap restrictions on investors in a bid to rein in volatility. The euro has fallen hard and notching fresh four-year lows, U.S. stocks have slumped and commodity markets have turned negative too.
Edward here. This is exactly the reason I have lost confidence in the Euro and the eurozone politicians. This is exactly why I no longer think a eurozone bust-up is far-fetched. I hope the shortselling ban on ten financial companies is is just a precautionary measure that presages a debt restructuring for Greece. That would be a welcome outcome.
In any event, the Euro is predictably collapsing – and by design I say. This is a competitive currency devaluation. Yes, the Euro is clearly overvalued on a purchasing power parity or Big Mac Index basis or whatever other measure you prefer. After all, it did come into being at 1.17.
And I should point out that the Europeans are following the model set by Japan, the UK and Switzerland who all have been printing money or intervening in currency markets to depreciate their own currencies. The Euro is still overvalued at 1.23.
The problem for the US, of course, is that the Obama Administration has said it wants to increase exports as a strategy to aid recovery and decrease deficit spending. The Chinese exporters to the region have razor-thin margins and Europe is China’s largest export market. Devaluation doesn’t increase global output, it just re-distributes it.
Wolf puts it well:
[T]he eurozone is moving towards fiscal tightening, with the offset, at least for the moment, of a weaker exchange rate. Americans will see this as a “beggar my neighbour” policy, unlikely to help global rebalancing. How much it will detract from world recovery is unclear. But it will not help.
Despite today’s gloom and doom, the eurozone will probably survive. But the view that everything would now be fine had fiscal rules been followed is wrong. The private sector’s irresponsibility was the biggest failing. Now, the emphasis is again on fiscal tightening. If this is to work, there must also be growth. Will the austerity itself deliver the growth, as some hope? I doubt it. The hair shirt alone will wear badly.