German Chancellor Angela Merkel and French president Nicolas Sarkozy have overnight laid out plans for a stronger European integration that seeks to control deficit restrictions on member countries and save the flailing eurozone.
This latest move comes in the wake of the European Central Bank buying up 22 billion euros of Spanish and Italian debt, widely viewed as a necessary, if somewhat risky, move to calm European markets.
In recent weeks, concern over debt problems has moved on from Greece, Portugal and Ireland to Italy (countries collectively referred as the PIIGs), where public debt is now above 100% of GDP.
The comparison is superficial. First, the Italian economy is much larger than Greece and is built on a strong export-oriented industrial base in percentage terms (and produces a trade surplus). Greece, on the other hand, has a much smaller industrial base and relies on tourism for export income.
Further, Italy has demonstrated it can produce a surplus, while Greece has difficulty doing so. And Greece has a much higher proportion of its government debt funded from offshore than Italy.
The grand experiment?
The bigger question Eurozone countries must grapple with is this: has the European Union been an experiment in grandeur economics, or can it survive and flourish?
We have witnessed a situation where the US dollar and the Japanese Yen have appreciated despite the fact that both the US and Japan suffer major economic growth problems and high debt levels comparable to the PIIGS countries.
The fear, uncertainty and doubt in the Eurozone area were exacerbated by the recent political gamesmanship around the US debt ceiling and subsequent downgrade of its AAA rating by Standard & Poor’s.
Greece and Italy are not in the position of adopting the US strategy of simply printing more money and buying back its own debt to maintain the price of its bonds.
This is a luxury only available to the country that has the world’s reserve currency as its own, and a currency that is seen as a safe haven relative to the Euro.
Future of the Eurozone
So what lies ahead for the Eurozone? This ambitious model, the brainchild of a small core in Europe including Germany and France, was originally intended as a trading bloc to improve the smaller sluggish economies of Western Europe to balance what was seen as the growing dominant economic might of the United States.
Under this model the EU would operate under a common monetary policy regime, with a single currency, but a separate fiscal regime to preserve national sovereignty.
The analogy in a household would be my wife managing the bank accounts and credit cards without the knowledge of what wages I earned, the money I spent on my consumption, home improvements and the spending supporting my kids who do not work.
Crazy, you say - because my credit card would be stopped when I hit the limit and if I didn’t pay, I would lose my assets.
The bailout for Greece and some of the other PIIGS countries taking a lay view is worse — because the credit providers are lending them more money to pay off the debt they incurred in the first place.
This is to avoid a default of payments on the “credit cards”.
When governments overspend and print money in the process, their economic bravado is usually tamed by a depreciation of the currency, a rise in their interest rates and an immediate consequence for domestic consumption that imposes fiscal prudence.
This critical missing link between monetary policy and fiscal control demonstrates why the Euro idea is not sustainable.
Merkel and Sarkozy’s recent plans for greater integration of budgets, tax policy and on making balanced budgets a constitutional requirement are what is needed at a minimum. But there are still significant differences in tax regimes, culture and services and subsides provided by government.
A notable example is the major chaos from strikes by farmers in France at the hint of reducing agricultural subsidies which under a common fiscal policy not be achievable. Thus the Sarkozy-Merkel pronouncements of greater integration seem ambitious and unlikely to appease the markets.
Under the EU pact, member countries have already agreed to limit deficits to an agreed 3% of their GDP. But recessions in France and Germany for example, saw this rule broken so that they could stimulate their economy back to recovery; the same two countries making these ‘new’ commitments to quell the markets. These kinds of restrictions within the pact are seen by some as unworkable and undermine sound economic management in times of crisis. It is the very reason that Sweden stayed out of the Eurozone.
As someone put it to me, the Greeks saw the Euro as an opportunity for cheaper money to fund their grand plans for the Olympics, rather than a sign of European Unity.
In the face of a second round of bailouts for Greece and what looks like a much larger crisis in Italy, it was predictable that alarm bells would ring when Italian and Spanish bond yields jumped, approaching 7% recently, before intervention by the European Central Bank saw them fall.
This is a big problem for a sluggish Euro economy trying to stimulate growth. Recently, the volume of Italian credit default swaps - used by investors to insure Italian bonds from default - doubled compared to the volume that was traded over the previous week.
The spreads on these derivatives have risen to just under 300 basis points, or 3% of the debt being insured. This prompted yet another crisis meeting for Eurozone leaders to consider a second round of bailouts of Greece for some $150 billion.
There was a recent hasty proposal by France for a process whereby future bailouts can be funded by imposing a levy on banks.
This funding would have augmented the $450 billion bailout fund with funds to go towards buying back and reissuing problem bonds such as those from Greece, an impost on the taxpayers, depositors and investors in Europe.
This idea was scuttled by Germany and investors are now being forced to swap new longer term bonds in exchange for the shorter term non-performing bonds.
This avoids a technical default, but the follow-on is that unless there is more certainty on the resolution, investors outside the EU will be reluctant to provide capital, resulting in the costs of funds rising even further.
That is notwithstanding the temporary resolution to the US debt ceiling political impasse which is based on promises of inadequate cuts and tax collections culminating in the S&P downgrade.
Good money after bad
In the countries funding the bailouts, the popular narrative portrays the Greeks (and to a far lesser extent Italians) as being dominated by a lazy, tax avoiding culture.
Thus the solution to this crisis is as much political as it is economic, in that taxpayers will see the bailouts as throwing good money after bad. So why not “cut our losses”, as London’s mayor, Boris Johnson was quoted as saying.
The new crisis that has developed with Italy is a more critical case purely because the size of the bailout, if needed, is far in excess of available funds in the EU.
The consequences of failure by the EU to adequately resolve and manage the PIIGS sovereign debt will be painful for European banks, particularly in the UK, Germany and France, who are holding Greek and Italian bonds.
This has major implications for taxpayers and depositors in those countries who will end up with higher taxes to fund the bailout of their banks in the event of default by any of the PIIGS countries.
Sorry, PIIGS cannot fly.