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11 July 2011

Either political union of the eurozone OR disaster is at hand: a 7-point plan to restore confidence

With the eurozone’s future now at stake, leaders must find the courage to “do whatever it takes”. Eurozone leaders must act courageously - and now - by accepting Parliament's "six pack" and expanding/opening up the EFSF.

In the next couple of weeks, the leaders of the eurozone  must agree with the representatives of the peoples of Europe the exact terms of the economic governance deal that should ensure that no eurozone members will fall into disarray in the future in the way that Greece has. Agreement on robust measures of collective eurozone oversight of the totality of economic policies for euro members is now essential. These very same leaders have repeated regularly since the debt crisis broke in May 2010 that they would “do whatever it takes” to ensure the stability of the euro.

They signed up to the principles of the current plans many months ago. It is now extraordinary that any of the States are hesitating to agree the detailed policies proposed by the European Commission, enhanced in some parts by the European Parliament and which is strongly supported by the European Central Bank. Remarkably, it is France and Germany that lead those who would dilute the proposals – the very same countries who undermined the Growth and Stability Pact in 2005 – opening the door to the current situation. French Finance Minister Baroin stated his sound fiscal aims last week in very clear terms yet now seems to want to avoid tying his own, and his successors’, hands to ensure that sound policies are pursued long into the future – the spirit of the Maastricht Treaty. WHY? The obvious answer is that these ministers want to preserve the freedom to pursue unsound policies. That is a dangerous message to send at this delicate moment.

Most media commentators have completely overlooked the significance of the “six pack”. Instead they write that the eurozone is simple throwing good money after bad in supporting Greece. In reality, the conditions attached to the Greek loans are intended to return the country to competitiveness. Unsurprisingly, those Greeks who have benefited from the feather-bedding that is under threat are likely to raise some objections!

The eurozone’s leaders learnt the lesson in May 2010 that all States had to maintain or - in some cases – restore competitiveness. Rigorous mutual policing of this process is the reason for the six-pack of legislation so it represents the long-term, permanent component of the resolution of the current crisis. Without it, markets will soon realise that there is not a long-term solution being put in place. Both they and taxpayers in the lending countries will soon ask why money is being wasted now when the whole problem could recur in a few years time.

Indeed, the deepening crisis already shows that markets doubt the commitment of the political leaders to deliver on their promises to “do whatever it takes”. Sensible long-term investors – for example pension funds investing to be certain of giving their pensioners an income in 30 years time – will attach little weight to promises from a group of finance ministers who may already be gone when the issue arises of “haircuts” for bondholders after 2013. So it is natural that bondholders will already be pricing in the risk of a haircut in 18 months time. The certainty of paying pensioners their coupon in 30 years time is a tough test.

The new pricing has already launched a slow, but certain, fiscal strangulation of say Italy. The decisive move of long-term spreads well above 200 basis points will cost Italy an EXTRA 3 per cent of GDP annually once it has rolled into the entire debt portfolio in the next few years, pushing the interest burden back above 7 per cent of GDP. Accommodating such a surge within the current envelope of total expenditure would require offsetting cash cuts of 6 per cent of public spending elsewhere – a politically challenging task! The markets now look as though they will automatically apply a sanction that is more than five times that which finance ministers are debating currently.

Some commentators argue that Europe now faces a banking crisis – but one that started with the default of US citizens on their sub-prime mortgages. The crisis has now moved far beyond that as the real issue is the sustainability of the eurozone’s public debt. When this author came into the financial markets, public debts amounted to around 30 per cent of GDP. Forty years later, debts are close to 90 per cent of GDP.  Spending 60 per cent of GDP on behalf of future generations does not seem to have purchased happiness for the citizens of Europe. But the banking system is one of the principal intermediaries betweens the citizens’ savings and those debts.

The success of the single market has created a Europe-wide financial market so doubtful public debts are distributed throughout the European Union. The bank “stress tests” will be published shortly and should reveal the precise distribution of these debts. Bank depositors will then be able to make up their own mind on which banks they regard as sound – and move their deposits as necessary and prudent.

Finance ministers have repeatedly promised to have back-stop arrangements in place for those banks revealed to be “vulnerable”. But they have carefully obscured whether they mean vulnerable on the basis of the official “stresses” or the foreseeable judgement of the markets. For those Systemically Important Financial Institutions (SIFIs) that are “too big to fail”, the markets will look to their host state as guarantor. If the guarantor is seen as dubious, then the situation becomes ever more grave – an exceptionally nasty, vicious circle.

But the eurozone as a whole is in reasonable shape – the primary deficit (i.e. excluding interest payments ) of the group is forecast by the European Commission to be under 1 per cent of GDP even in 2012 – and  far below the 6 - 7  per cent of GDP of the US and Japan! Growth cannot be expected to be substantial when the population is barely growing and confidence – of consumers, business and investors alike – is battered every day. But the current account remains in small surplus – versus the continuing 4 per cent of GDP deficit of the US. Perhaps the market’s recognition of the soundness of the underlying collective position explains the strength of the euro just as the British media gleefully forecasts its explosion. Even Greece is expected to have a primary deficit that is a fifth of that of the United States – based on the current, average interest rate of about 4.5 percent.

However, if the Greek debt portfolio were rolled over at current market interest rates, then debt interest would explode to more than 25 per cent of GDP - taking up half of all government expenditure. Manifestly, that would be completely unsustainable and the dominoes would start falling with a vengeance: first the Greek banks; then perhaps some other European banks (to be observed after the stress tests are released; then State X that is the guarantor of such banks (and especially if State X itself is already giving cause for concern; then another round of banks that hold excessive quantities of the debt of State X; etc. The decline in the share price of some banks and the rise in yields of their associated guarantor suggest that such a vicious downward spiral may already be starting.

So the political leaders of the eurozone must now cease to look at their own opinion poll ratings and fulfil their commitment to “do whatever it takes”. They must fulfil the role of statesmen and stateswomen regardless of any personal short-term cost. After all, they expect their armed forces to be willing to make the “ultimate sacrifice” on behalf of their country and a political career seems a rather more modest sacrifice. So they must focus now on the long-run benefits to the peoples of Europe – which include their own citizens.

"Whatever it takes” surely includes the following:

1) Agree immediately to the final element of Parliament’s proposal on the six-pack – enabling a courageous European Commission to propose prompt corrective measures to any State that is losing competitiveness due to unsound overall economic policies. The Member States could then only override such proposals by Qualified Majority Vote (QMV) – a tough requirement that would probably only be met in the event of manifest error by the Commission. These policies would underpin a strong probability of good economic behaviour into the foreseeable future;

2) Change the EFSF’s terms of reference to enable borrowing on demand by any State whose economic policies have been approved by the Eurogroup during the “European Semester”. However, that right to borrow would be subject to intrusive and regular checks to confirm that the State is maintaining its performance. If it is not, then any eurozone State would continue to be able to veto further borrowings. Such exclusion would send a very powerful signal to markets that lenders were now at genuine risk and a substantial rise in solo borrowing costs would be the natural result;

3) Expand the size of the EFSF to at least €1 trillion immediately – with a commitment to expand it as required by borrowers. The EFSF is a mechanism that exists today; can be used immediately; is not a fiscal/transfer union and does not need tortuous Treaty change;

4) With such facilities in place, it would be difficult to argue that existing bonds could be in default – because they would be repaid on time;

5) The future borrowing costs of Greece (and other States at risk) would be reduced to levels that would make their debt burdens sustainable. (Doubtless their electors will still wish to pass judgement on the political class that created such burdens for the next couple of generations.);

6) With these guarantees in place, the ECB should have no qualms in continuing to accept Greek etc. government bonds as “good” collateral. Indeed, an expanded and aggressive programme of bond purchases might capture some useful profits for the European public purse; and

7) Confidence could revive rapidly as the daily media drumbeat of imminent disaster would vanish. Banks would not need to absorb investment capital against systemic risks that no longer exist and could boost lending to the economy instead. Declining long- term interest rates in many states would be a policy easing in itself.

What is required now is for the leaders of the eurozone to have the courage and vision to turn their words into action: finally “do whatever it takes” - and do it very soon. If they cannot find the courage, then their names will certainly be engraved in the history books.

Graham Bishop’s recent book: "The EU Fiscal Crisis: Forcing Eurozone Political Union in 2011?" expands on the analysis above. Click here for details and to purchase the book.

Selected recent events:

23 June 2011: Parliament seals its position ahead of European Council on Economic Governance.  This EP position will form the backbone of the talks between MEPs and Member States, which are set to continue in earnest in order to reach a final deal as soon as possible. View

22 June 2011
: Commissioner Rehn: The Commission will work until the last minute to achieve a satisfactory solution on economic governance.  Speaking in ECON committee, Rehn stressed that he will be worried if the economic governance package is not soon agreed. He also said that neither the Council nor the Parliament should think that they can successfully shift the responsibility onto the other. View

21 June 2011
: Economic Governance Package of six proposals: Council offers compromise to Parliament.  Mr Matolcsy, Hungarian Economy Minister, said the Council will continue to disagree with the expansion of reverse majority voting on the prevention part of the S&G Pact. Nevertheless, he was optimistic that the Council has made so many concessions that the EP will ultimately endorse the package. View

21 June 2011: ECON committee: Finance ministers have not moved enough for good economic governance.  The ECON committee said ministers have not done enough to prevent EU countries' budgets from derailing and were backtracking on commitments to look at high-export countries as well as sources of imbalances. View

© Graham Bishop

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