European leaders signed off on a second, 109 billion euro bailout for Greece overnight, while also establishing what has been described as an “infant monetary fund” to intervene if the bloc’s sovereign debt crisis reaches breaking point.
Both measures will no doubt be greeted as crucial in stabilising the euro and restoring confidence in global markets, but will they succeed in addressing the structural problems and broader economic inefficiencies that underlie this crisis?
Greece’s troubles are far from over, and as the spectre of debt crisis in Italy looms, the monetary and fiscal polices of the European Union are being put to the test.
Structural hurdles
The 27 countries of the EU are institutionally divided in two groups. Seventeen of them belong to the European Monetary Union formed in 1999 and characterised by a single currency, the euro.
The remaining 10 still have their own currencies – Britain, Sweden, Denmark and the new entrants from Eastern Europe (except for Slovenia, Slovakia and Estonia, who belong to the eurozone).
All the 27 countries are bound by the Lisbon Treaty, which came into force in January 2010 and acts as the de facto constitution of the European Union.
A centrepiece of the European Union’s institutional framework is the Stability Pact, signed in Dublin at the end of 1996 and given formal status in the Amsterdam Treaty of 1997. The pact commits EU states not to run a deficit above 3% of GDP and not to exceed a 60% debt-to-GDP ratio.
These are targets defined by law in the Maastricht Treaty of 1992, with which the European Community became the European Union. Countries that run persistently excessive deficits and debts are to be penalised by having to borrow short term on the private capital markets since, in principle, the national central banks are not allowed to sustain the deficits and refinance the debts by purchasing their own national treasury bonds.
We see therefore that the main pillar of the EU financial architecture is based on a complete de-linking of monetary from fiscal policies.
If Britain were to apply the same criteria as the eurozone, it would be in a situation as bad as that of Italy, with jolts and runs on its government bonds and a rising risk premium on them.
Although in terms of the Maastricht definitions, Britain has a lower debt to GDP ratio than Italy (86% against 120%), London displays a much much higher public sector deficit than Rome – 10% as opposed to the Italian 4.4%.
Hence we should have expected “markets” to doubt the UK government’s ability to refinance its national debt. Yet this is not the case because the link between the UK Treasury and the Bank of England is not broken. Britain is not part of the eurozone and is not subjected to the policies of European Central Bank.
Italian troubles
The Italian case highlights how damaging is the eurozone’s disconnection between fiscal and monetary institutions. From 1993 to 2008 Italy’s budget deficit was determined by government payments of debt interests. This meant that the primary balance has been in surplus and the overall deficit declined over the years.
Obviously with the financial crisis of 2008 the deficit rose in 2009, but in 2010 it fell again. This year, the deficit is expected to be below 4% of GDP – that is less than France’s and Holland’s.
Why then should then Italy require such a draconian austerity program as that passed on July 15? The answer lies in that, despite 18 years of drastic deficit reductions, the debt has not abated significantly. It was 115% of GDP in 1998 on the eve of the formation of the eurozone, it then fluctuated between 108% and 104% up to 2007 only to climb to today’s level of 120%.
The major cause of the persistence and renewed rise of the debt is the lack of economic growth, for which there are two main reasons. The first is that deficit reductions reduce demand and impact negatively on growth.
The second reason is more complex. Italy, after Germany, is Europe’s second-biggest industrial exporter in the whole of Europe. The bulk of the European countries’ exports goes to Europe itself. From 1971 to 1998 variations in exchange rates were one of the most important tools in fostering export competitiveness, but with the Euros this is no longer possible.
Thus wage squeezes relative to productivity have replaced variations in exchange rates. Every eurozone country is engaged in limiting wage growth, with Germany being the most determined of the lot.
Global European wage stagnation reduces demand and limits European growth, which then limits Italy’s exports. By the end of the day the growth rate falls below the rate which would permit debt sustainability. Hence the debt to GDP ratio may well rise. The crisis of 2008 has worsened the preexisting negative predicament for Italian public finances.
Yet, even the rise of the debt need not entail a state of perilous financial instability. Let us take Japan. Its gross debt level shot past Italy’s in 1999 and now Japan’s debt is above 210% of GDP.
Japan’s low economic growth cannot stabilise that ratio, so the debt level is bound to rise much further. There is no run on Japanese government bonds, thus they do not attract a high risk premium. In fact, the Bank of Japan has a near zero interest rate policy and keeps buying government bonds.
It is argued that Japanese debt is safe because 95% of it is held by Japanese firms, banks, and households. But this is true also of Italy’s debt, 85% of which is in Italian hands. Why then in the Italian case the debt is said to threaten the whole of the eurozone?
Intervention difficulty
The European Central Bank is not a federal reserve bank. It may buy the bonds of small countries like Hungary (illegally), or of Portugal and of Greece – but with big reluctance and only after Brussels and the IMF had set up bailout funds.
However, the ECB does not have the strength to buy bonds for the eventual refinancing of the Italian debt which is bigger than sum of that of Spain, Greece, and Portugal.
The Bank of Italy cannot do it either, as it has surrendered its monetary policy levers to the ECB. It follows that, by institutional design, the financial markets have become the arbiters of the national debts which are no longer sovereign.
It is at this point that the holders of the credit default swaps (CDS) derivatives which are attached to debts, either see the opportunity of speculative gains or, as it is now for Italy, become concerned that the value of their titles may evaporate.
Therefore, instability builds up through the rise in the risk premium on bonds and the government is compelled to pass measures that through cuts promise a budget surplus guaranteeing the payment of interests to bondholders.
But these very measures sink the economy and the debt is likely to get even higher. When the two main arms of economic policies, the central bank and treasury, are split apart, the financial architecture of the eurozone is bound to enter into a crisis for which no reliable solution appears on the horizon.