Attempts to redress solvency via fiscal austerity in the midst of a crisis are aggravating the problem born with the financial crisis.
The question is a quotation of Amalrik’s 1970 essay about Soviet Union; of course euro is a money, not a political union, but its end would be a strong stroke to the European Union. In this case we would know also the murderer: a wrong macroeconomic policy which pervades EBC, Ecofin and European Commission. The adjective wrong is used in the sense that the behavior of monetary and political authorities is aggravating the problem born with the financial crisis.
As we know, the crisis didn’t happen because of public deficits, but because of too much private debt, mainly among financial enterprises. A relevant part of this debt becomes public debt, both because of banking bail out and because of anticiclical fiscal policy. One may object the Greek case: admittedly the (revised) Greek deficit from 2001 onwards was almost always over five or six points, but the debt-gdp ratio was 105,4% in 2007, just slightly over the 103,7% in 2001, when Greece entered into the common currency; the jump of fifty points happened with the financial crisis.
The suggested solution to the rising debt and to the Greek, Irish, Portuguese, Spanish, and now Italian sovereign problems is a thigh fiscal policy. The sooner the better. Piigs countries are strongly suggested to introduce constitutional laws requiring a balanced budget. It is an idea more stupid than the excess deficit rules of Maastricht Treaty and Stability Pact. As Martin Wolf writes on Financial Times (September 7th) “if the fiscal deficit is to be sharply reduced, the surpluses in the rest of the economy must also fall. The question is how that is to be compatible with rapid deleveraging and expanded spending. In my view, it cannot be. A more likely outcome, in present circumstances, is mass default, shrinking profits, damaged banks and a renewed slump. That is what would happen if today’s contained depression ceased to be contained”.
How it happened that a liquidity crisis in Greece determined such a cyclone that threatens to destroy euro? As Paul De Grauwe said several times, the answer is the vulnerability of government bond markets in a monetary union. National governments in a monetary union issue debt in a foreign currency, i.e. one over which they have no control. As a result, they cannot guarantee to the bondholders that they will always have the necessary liquidity to pay out the bond at maturity. German credit default swops are slightly higher than those of UK; why, since Germany is performing better according all economic indicators? Just because UK got is own currency. The contrast between ECB and Germany produced a confidence crisis. As Charles Wyplosz writes (vox, august 22 Th), “history tells us that a loss of confidence can trigger a cyclone of doubt and falling bond prices. Once triggered, such cyclones can and have washed away even the mightiest”.
The mechanics is easily explained: when investors assign a positive probability to a sovereign default, nations must pay a risk premium to continue borrowing and rolling-over their debt. The higher interest payments raise the debt-service burden. The cyclone gains strength as this tends to undermine solvency, which in turn stokes doubts and raises the risk premium. Fiscal austerity is needed to avoid such cyclones, but attempts to redress solvency via fiscal austerity in the midst of a crisis may make things worse. Cutting spending and raising taxes can trigger or deepen a recession that lowers tax receipts and raises welfare spending – again undermining the debt’s sustainability. When markets see this, they ask for a higher risk premium and the cyclone gains strength. This is exactly what is happening with Greece; few days ago the IFM-ECB-EC troika found that Greek deficit was higher by something less than one per cent, because Gdp is decreasing this year by (minus) 3,5%, much more than expected. The troika asked for more cuts. As a matter of fact the only thing on which Jean Claude Trichet and Angela Merkel agree is a thigh fiscal policy for all European countries.The idea is that all euro countries should became like Germany, with a export led growth. Martin Wolf is right when he says that this policy is wrong and masochistic.
On September 7th the German Constitutional Court allowed the Government to finance EFSF, but with several limits; so euro is gaining time. Turning back to the initial question, in a few years we could see:
a) defaults of government bonds by some Piigs countries, leaving euro; defaults of government bonds by some Piigs countries, without leaving euro. In both cases countries are obliged to maintain a surplus budget, and banks have to recover from serious capital losses. In the case of leaving euro, if this should be possible without leaving the European Union, there would be the advantage of the devaluation of the (new) national money.
b) Sorting out from euro by Germany (probably with Austria, Finland and Netherland); piigs countries will gain by the devaluation of euro, but the interest rates on bonds (not only government bonds) will rise, requiring an higher primary surplus. France will face a difficult trade off: remaining, as a leader country, in euroland, or joining Germany.
In any case piigs countries will have hard times; there is a third hypothesis, that is pooling euro government bonds, issuing Eurobonds in order to finance investment projects all over Europe, and so on.. We have to wait after political elections in Germany (2013); Elpis (Hope), as we know, is the last goddess.