Published in Business Spectator (Melbourne), 2 December 2010
Over the past three years we have had to get used to numbers with lots of noughts. Stimulus packages, bank bailouts and public debt figures have reached dimensions well beyond the imagination of the average person.
It also appears that dealing with these fantastic sums on a daily basis has led policymakers to lose perspective. What else could explain current speculation that the Euro rescue fund may have to be expanded?
In May the European Union and the International Monetary Fund had agreed to found the EFSF. Though the acronym smacks of science fiction, it is actually refers to the European Financial Stability Facility. Backed by guarantees totalling €750 billion, or just about $1 trillion (a number with a mind-boggling twelve noughts), it was meant to stop speculation on the collapse of the euro or any of its member countries.
But it only took the markets a few months to find out there was actually a great deal of fiction involved. For a start, the EFSF included commitments of €162 billion given by Portugal, Ireland, Italy, Greece and Spain – alas the very same countries it was meant to save. The PIIGS guaranteeing their own debt is like real pigs running a butcher’s shop – not very credible.
The main problem with the EFSF was, however, something completely different. It never addressed the eurozone’s fundamental problems of debt and economic diversity. One cannot solve a poor man’s debt problem by giving him more credit. Likewise one cannot bring back a country from the abyss of sovereign default by providing it access to emergency loans and saddling it with more debt.
Besides, the EFSF did nothing to improve the competitiveness of struggling economies. The austerity conditions first imposed on Greece and now on Ireland will condemn both countries to years of economic decline and, potentially, social unrest.
Despite these strategic flaws, European policymakers continue to believe that the EFSF mechanism is their only hope. Not even the prospect of it running out of funds can stop their enthusiasm for the monster they have created.
First it was Axel Weber, head of Germany’s central bank, who opined that “if €750 billion won’t do, then we’ll have to increase the commitments correspondingly”. A few days later, Der Spiegel reported that Marco Buti, Director General for Economic and Financial Affairs at the EU Commission, had suggested doubling the EFSF to a total volume of €1.5 trillion.
Whether even this figure could stop the spread of the euro crisis remains doubtful, though. Ireland is set to receive €85 billion from the EFSF. If both Portugal and Spain were to require similar loans, this would cost just under €1 trillion given their larger economies. However, the EFSF can only give loans for about two thirds of its volume in order to be able to refinance itself while keeping its AAA rating.
This means that even under a doubling of the rescue package, the guarantees may only just suffice to bail out Portugal and Spain. Worse still, there is no guarantee that under such a scenario markets would not shift their attention to the next weakest link in the euro chain, which would be Italy. At this stage, at the very latest, the game for the EFSF should be up.
Isn’t there a way out of this chain reaction under the euro? There is. In fact, there are three ways but none is particularly appealing.
Under the first option, the Germans and their fellow European paymasters may decide that they have had enough of bailing out their poorer cousins. The result would be a domino effect of defaulting economies around the eurozone fringe. Eventually, the richer nations would still have to pay: not for other countries but for their own banks which would need to be recapitalised. This would make Lehman Brothers look like a small financial hiccup – and it would certainly be felt in Australia as well.
The second option is not particularly pleasant either. Resigned to the fact that Europe has collectively run out of money, politicians could amend the EU treaties and instruct the European Central Bank to print more of it. In theory, the ECB’s status as an independent central bank should prevent such monetary recklessness. In practice, its independence has already been weakened in the recent crisis when the ECB was forced to buy up sovereign debt from the PIIGS countries.
This leaves the third option which, given the political forces behind the European monetary union, still remains the most likely outcome. Unwilling to surrender their prestige project of the euro, European politicians could transform the EU into a fully-fledged fiscal union. According to Professor Kai Konrad of the Max Planck Institute for Intellectual Property, Competition and Tax Law, such a transfer union would cost the richer economies between €340 billion and €800 billion annually, depending on the level of fiscal equalisation. Needless to say, this option would only prevent sovereign defaults without solving the economic imbalances within Europe. It wouldn’t do much to promote harmony between the peoples of Europe, either.
In short, under their self-chosen monetary corset the Europeans now have the choice between the mother of all banking crises, hyperinflation à la Weimar Republic, or painful and unpopular financial transfers in perpetuity. And there is no guarantee that in the end they will not get a mixture of all three.
There remains only one potential escape route from this unfolding and utterly predictable disaster. It would, however, begin with a collective mea culpa by Europe’s political class that the continent had not been ready for monetary union in the first place.
Is this likely to happen? As sure as the pigs running the butcher’s shop might fly.