Tag Archives: euro crisis

The Euro does not need a federal superstate to prosper

The Euro crisis is in one of its quiet phases. But few are foolish enough to think that its future is now secure. It is often said that the currency is destined to fail because of a fundamental economic law which means that you cannot operate a successful currency without the full authority and resources of a state behind it. The Euro needs to the apparatus of a federal superstate to survive, it is said. One Tory MP even suggested that the Euro’s promoters were committing fraud to suggest otherwise. But, for all that many in Brussels want it, establishing such a superstate is not politically feasible. And yet it is possible to see emerging the institutional architecture that will allow the Euro to survive and prosper without it. It’s a hard road, but there are enough benefits for the currency’s members to persist with it.

There are four key elements to the architecture. The first is an obvious one: a powerful European Central Bank (ECB), able to do what it takes to ride out the various crises that financial markets will throw at the system. The current ECB has proved up to the task, albeit by pushing at the boundaries of its formal powers, for example by buying the debt of member governments on the secondary market. Confidence that it can handle future crises is growing, adding to the overall stability of the system. And yet this power has its limits; it cannot transfer taxpayer funds from one country to another (referred to as “fiscal transfers” by economists), in the way a federal government could. The Euro has to find a way of existing without the sort of massive fiscal transfers that you see in the United States, for example.

In its place is the second element: provisions for states to default on their debts. This has been resisted tooth and nail by Euro federalists, but at long last it has been implemented for Greece. Alongside this, a crisis infrastructure is emerging, including crisis funds to support governments that are in the process of restructuring their obligations. This whole process needs to go further: publicly held government debt, e.g. that bought by the ECB, needs to be included, for example. Greece will surely need another restructure. But we are seeing the different nations’ bond prices reflecting the risk of default, and this imposes a discipline on government finances. And no government will want to follow the humiliating path of Greece into default, if they can help it.

There remains the problem of managing the banking system, which is very much run along national lines. While Greece got into trouble because of a profligate government, Ireland, Spain and Cyprus were brought down by banking crises. At first the response to a banking crisis was for governments to underwrite all banks’ creditors in order to restore confidence. Many applauded the Irish government when they did this early in the crisis; but it is a terrible idea, transferring liabilities from various people who should have known better to taxpayers who could ill afford it. Therefore the third element of the new architecture is to force bank creditors to pay, or at least contribute to, bailing out bust banks, referred to as “bailing in”. This solution was put in place for Cyprus, and hopefully will be the pattern in future. Of course it remains possible for financially strong governments, like Germany’s, to stand behind their own banks – but this should be discouraged. It is essential for discipline to be brought back into banking, and the system whereby bankers keep the profits and pass losses on to taxpayers has to be terminated.

But this approach is undeniably destabilising; it adds to the risk of bank runs. The obvious solution to this is to establish a Europe wide deposit insurance scheme, just as America has its federal scheme. Initially European governments seemed to favour this, but as they grew to understand its full implications, possible taxpayer transfers between states and increased central regulation, they have backed off. This has left us with the fourth and final element of the new architecture: emergency capital controls. This has been implemented for Cyprus, where depositors at Cyprus banks are suffering severe limits to their ability to move money out. It is an ugly process, and represents a big step bank from the integrated ideal of the Euro. The third and fourth elements in particular mean that a Euro held in a German bank is worth more than one held in a Portuguese one, say. But this is better than the alternatives, which attempt to wish financial risks away into an anonymous federal centre.

I believe that these four elements can evolve into a system that will give the Euro long lasting stability, and a better distribution of risk than a federal system would. We must remember that systems of human relations are only in a small part dependent of formal laws and powers, and much more based on expectations of how people should and will behave. This is how the management of the Euro is evolving. In the early days those expectations were wholly unrealistic, and ultimately required some kind of federal system to underwrite them. Now that we know this cannot be, new expectations are evolving. This is a bit like the way the British constitution and Common Law develops.

But is it worth it? Is it a loveless marriage between southern economies locked into permanent austerity, and more dynamic northern ones which are constantly being dragged down by their neighbours? (And France which manages to be on both sides of this equation at once!) If so the enterprise will lose political support and die anyway.

This question deserves a post all to itself, but I believe that all this pain has benefits to both sides. For the southern economies, joining the Euro was all about converging with their rich northern neighbours and their higher standard of living. Unfortunately they at first thought this would be easy. Lower interest rates and hot money from the north created a short term boom, but could not do the trick. Endless tax transfers (like between north and south Italy), are not on offer, and probably wouldn’t work either. In order to raise living standards the southern economies will have to undertake a painful series of reforms, rather in the way Britain did in the 1980s, Sweden in the 1990s, and, to a lesser extent, Germany in the 2000s. The process is starting, and the new disciplines of the Euro zone help this.

And for the northern economies of Germany, the Netherlands and Finland? Being in the Euro gives them a more stable economic environment, at a time when the global economy has been destabilised by the rising of China and other emerging markets. With a lower exchange rate than otherwise they have been able to preserves their exporting industries and maintain a degree of social stability. You only have to look at Britain to see what might have happened otherwise. There a short-term boom and appreciating exchange rate led to a flooding in of cheap imports and a hollowing out of export industries. Living standards grew for a while, but it could not last. The country is still struggling to escape the bust of 2008/09, with exports remaining weak.

The first decade and a half of the Euro has not been a happy experience, taken as a whole. But these are difficult times for developed world economies. In these circumstances the Euro remains a good idea, and indeed eastern European countries are still queuing to join. In the rough, interconnected world that is the modern economy, living with a freely floating currency is much harder than many would have you believe.

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Europe and the US: the tortoise and the hare

Comparing the European economy to that of the US reminds me of Aesop’s fable of the race between the tortoise and the hare.  The US’s flexible labour and product markets, and decisive interventions in time of crisis, give it the ease of the hare.  To US politicians you only have to mention Europe to conjure up a picture of stagnant, over taxed and socialist economies.

But the tortoise wins the race in the fable.  And indeed, if you look beyond crude GDP growth statistics the race looks close, depending on the precise time frames and so on.  GDP per head tells a different picture to aggregate GDP (this is regularly quoted by The Economist, though I haven’t found a recent example to link to).  Other statistics on the incidence of poverty, life expectancy and so on, show Europe in a better light – though the US still does well in self-reported wellbeing, but not as well as Scandinavian countries.

All of which demonstrates how commentators, especially in the US and here in the UK (whom I shall collectively call the Anglo Saxons, following French practice – though this is a dangerous shorthand) don’t understand the dynamics of European economic policy.  As the EU lurches into another round of crises, this is worth taking on board.   Once again the US hare looks better placed than the European tortoise.  But look closer, and it isn’t so clear.

This is not to underestimate the scale of the crisis facing the Eurozone in particular.  Massive problems confront the economies of Greece, Spain, Italy and Portugal; the French economy is not in a place of safety either.  But Anglo Saxon commentators tend to relentlessly focus on the short term problems, to the exclusion of longer term issues, which they assume best dealt dealt with at a later time.  Europeans (from which I exclude the British, for now, though for most purposes the British are very much European) tend to look at the problem differently.  A crisis is one of the few opportunities to tackle longer term problems, and fixing the crisis while neglecting the long term is criminal.

The southern European economies are inefficient by developed country standards, and uncompetitive within the current Euro structure, and can’t sustain the level of social benefits that their electorates have come to expect.  This lack of competitiveness was not invented by joining the Euro – it predates it, and is based on decades of poor economic leadership.  Joining the Euro gave these economies a boost by reducing government borrowing costs – but this boost was used to put solving the bigger problems off until later.  Their northern European partners are to blame for going along with this, until a crisis threatened to engulf them all.  When the Euro project was launched, its supporters advocated it on the basis it would force governments to confront the inefficiencies of their economies, rather than rely on devaluation to put the problem off – a strategy that ultimately leads to stagflation, and even hyperinflation.  But somehow these supporters seemed think that the omelette could be made without breaking eggs.  But Europe’s leaders are keenly aware of their mistakes now.

The position of the southern European economies is not unlike that of Britain in the 1970s.  A massively inefficient and uncompetitive economy had been kept alive by a benign international economic climate, until the 1973 oil shock knocked it over.  There was no quick fix, no macroeconomic palliative to ease the pain.  A floating currency hindered rather than helped.  The turning point came in 1976, when the Labour government had to call in the IMF.  Then started a painful process of government cuts and market reforms.  This wasn’t what the party had promised when elected in 1974, and the government was grudging in the reform process.  They lost the election in 1979, with Margaret Thatcher being swept to power, redoubling the pace of the reform process through the 198os.  This cut huge swathes through much of British industry – making the current economic crisis in the UK look like a picnic, whatever the GDP figures say.  It took about a decade of pain from 1976 before clear benefits started to show.

A similar hard road awaits the southern European economies.  Leaving the Euro and devaluing won’t help (during the Thatcher years, to continue the comparison, the pound stayed high), and is institutionally much more difficult than most Anglo Saxon commentators assume.  Europe’s politicians know this, and so aren’t looking for quick fixes.  They are looking at a process of near continuous crisis in which the institutions, and political culture, required to make the Euro work are gradually put in place.   Greece may be a casualty – it faces a real danger of being expelled from the Euro and probably the Union as a whole (it’s difficult to disentangle the two).  It is slowly but surely being isolated to make that option less and less of a threat to the zone as a whole.  But unlike many British commentators assume, Greece will find life no easier outside the Euro.

Martin Wolf’s gloomy article in today’s FT illustrates the difficulty Anglo Saxon commentators have in viewing the scene – and Mr Wolf is no shallow commentator.  He makes reference to the comparison with Britain, thus:

This leaves “structural policies”, which is what eurozone leaders mean by a growth policy. But the view that such reforms offer a swift return to growth is nonsense. In the medium run, they will raise unemployment, accelerate deflation and increase the real burden of debt. Even in the more favourable environment of the 1980s, it took more than a decade for much benefit to be derived from Margaret Thatcher’s reforms in the UK.

Structural reforms are dismissed as taking too long.  But is there any other way that such necessary reforms can be taken forward?  Surely the British case illustrates that miserable economic performance for an extended period is unavoidable?

How different from the US approach!  By comparison, the US’s economic problems are nowhere near as great as those facing southern Europe: at the core the US economy remains wonderfully competitive.  But they have a terrible problem of government finance and social justice, which neither politicians nor public want to confront.  Instead we get a series of short term fixes, which look decisive, but which simply increase the scale of the problem that has to be tackled later.   Americans have to choose between higher taxes and reduced Medicare and Social Security benefits, or some combination of both – and yet neither are seriously on the political agenda.

In the fable the hare loses the race because he is so confident he takes a nap.  A similar misjudgement by America’s political class, abetted by British and American observers is in the process of unfolding.

 

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Is this the Eurosceptics’ Moscow moment?

Nearly 200 years ago, in September 1812, Napoleon reached the maximum limit of his nominal power when he entered Moscow with his army drawn from right across Europe.  His empire covered France, Germany, Poland, Italy, much of Spain (his lieutenants were in the process of driving back an advance by Anglo-Spanish forces that had temporarily liberated Madrid) and now much of Russia, including its Asiatic capital.  But he could not hold it; by the year’s end he had been forced to abandon Russia altogether, his army destroyed, and he was completely crushed within a year and a half.  For the Russians 1812 had proved a time of incessant retreat, as they avoided battle until just before Moscow (at Borodino), where they lost and were forced to abandon Moscow without a fight, but ultimately a year of triumph.

Is this a fair metaphor for the British Eurosceptics in their moment of victory at the British veto at last week’s EU summit?  Certainly their triumphalism is unbearable.  Bill Cash was described by one of our outraged local Lib Dem members as “the cat that got the cream.”  This follows one long process of retreat by British Europhiles as they conceded the political initiative to the sceptics, practically without a fight, time and again.

But the initial reaction of leading Lib Dems was strangely sanguine.  Nick Clegg was initially quite supportive of David Cameron.  On Friday night the deputy parliamentary leader, Simon Hughes, painted a positive picture to party members at a social event which I was attending.  Mr Clegg has changed his tune today, of course.  Whether that is because of the sceptics’ reaction, or because further details of what actually happened at the summit have emerged (for a flavour of this read the Economist’s Bagehot blog) I cannot say.

But the initial relief at the summit result shown by Mr Hughes has some logic behind it.  A treaty would have required ratification by the UK parliament, and demand for a referendum.  This sort of battle plays to the sceptics’ strengths – strong support by the press and a widespread wariness of extra EU power.  A referendum on a treaty change is the battle the europhiles least want to fight.  The sceptics can deploy a “have your cake and eat it” argument for a no vote – a vote not against the Union as such, but to protest against “Brussels”.  There will be no such battles now.  If there is a referendum it will be about whether we stay in the EU at all.

Instead the sceptics’ position might start to come under the sort of scrutiny that it has hitherto lacked, and be shown to be no more tenable than Napoleon’s hold on Moscow.  The summit has started that exposure process.  The sceptics’ armchair negotiators have said that we can use the British veto to negotiate major concessions, the “repatriation of powers”; but Mr Cameron proved unable to do this.  It has also been said that we were not isolated in the EU, and we could lead a gang of pro-market non-Euro members.  This against has been shown to be a hollow idea, as Germany has greater influence over these potential allies than we do.  Indeed a horrible spectre emerges, that the British blocking tactics make many of the EU’s institutions irrelevant while the other countries set up alternatives over which the British have no say.  The sceptics often complain about Britain shackling its fortunes to a corpse – but the corpse could be the official EU structures, rather than the European project itself…and that would be an outcome entirely of our own making.

And further eurosceptic fantasies will soon be exposed.  Their aim is to set up some sort of free-rider relationship to the Union, where British products enjoy free access without to European markets without our businesses having to comply with those pesky social regulations.  Some think the country can do this within the EU, using opt-outs, others that it can be done outside it, in the European Economic area (like Norway, Iceland and Switzerland).  But this requires the other 26 countries to agree with it.  All of them.  Why should they?

Just as the Eurozone optimists are having their ideas tested to destruction in a gruelling series of financial crises, so the eurosceptics might find themselves on the wrong side of the argument.  In both cases it is clear that the only tolerable escape route involves further European integration, not less.  Perhaps, like Napoleon’s collapse in 1812, it will happen quicker than we think.

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The Euro end game

It’s been a tough year for Europhiles, especially those, like me, who have always supported the single currency and thought Britain should have been part of it.  Most of them have been very quiet, and no wonder.  Whatever one says quickly has the feel of being out of touch and in denial.  And now this week the Economist asks in a leading article  Is this really the end? that has been tweeted over 1,200 times and picked up over 500 comments.  In today’s FT Wolfgang Munchau article is headlined: The Eurozone really has only days to avoid collapse (paywall).  Is now the moment to finally let go, and admit that the whole ill-fated enterprise is doomed?

There is no doubting the seriousness of the current crisis.  While most of the headlines have been about sovereign debt (especially Italy’s) what is actually threatening collapse is the banking system.  It seems to be imploding in a manner reminiscent of those awful days of 2007 and 2008.  The Germans’ strategy of managing the crisis on the basis of “just enough, just in time” seems to be heading for its inevitable denouement.  Unless some of their Noes turn to Yeses soon there could be a terrible unravelling.

The most urgent issue is to allow the European Central Bank (ECB) to open the floodgates to support both banks and governments suffering a liquidity crisis.  “Printing money” as this process is often referred to, seems the least bad way to buy time.  Two other critical elements, both mentioned by Mr Munchau, are the development of “Eurobonds” – government borrowing subject to joint guarantee by the member states – and fiscal integration – a proper Euro level Finance Ministry with real powers to shape governments’ fiscal policy in the zone.  Most commentators seem to be convinced that some sort of steps in both these directions will be necessary to save the Euro.

I have a lingering scepticism about these last two.  I thought that the original idea of allowing governments to default, and so allowing the bond markets to act as discipline, had merit.  The problem was that the ECB and other leaders never really tried it before the crisis, allowing investors to think that all Euro government debt was secure.

Still the short term crisis is plainly soluble, and most people will bet that the Germans will give the ECB enough room to avert collapse.  But that leaves the zone with a big medium term problem, and two long term ones.  The medium term one is what to do about the southern members whose economies are struggling: Spain, Portugal and Greece especially, with Italy lurching in that direction.  The stock answer, which is to enact is reforms such that their economies become more competitive, seems to involve such a degree of dislocation that we must ask if it is sustainable.  This treatment is not dissimilar to that meted out by Mrs Thatcher to Britain in the 1980s (an uncompetitive currency was part of the policy mix here, deliberately or not), for which she is still widely loathed.  And she was elected (though “democratically” is a stretch given Britain’s electoral system).  How will people react to unelected outsiders imposing such treatment?  Better than Britons would, no doubt, since there is so little confidence in home grown politicians , but it’s still asking a lot.

And that leads to one of the two long-term problems: the democratic deficit.   A lot of sovereignty is about to be shifted to central institutions, and it won’t be possible to give electors much say.  The second long term issue is dealing with the root cause of the crisis in the first place, which is how to deal with imbalances of trade that develop within the Euro economy.  Germany simply cannot have a constant trade surplus with the rest of the zone without this kind of mess occurring at regular intervals.  But there is no sense that German politicians, still less their public, have the faintest grasp of this.  For them the crisis is the fault of weak and profligate governments elsewhere.

So if the Euro survives the current crisis, there is every prospect of another one down the road, either political (one or more countries wanting to leave the Euro and/or the Union) or financial (say an outbreak of inflation).

My hope earlier in the crisis was that it was part of a learning curve for the Euro governments.  As they experienced the crisis institutions would be changed and expectations made more realistic, such that zone could get back to something like its original vision.  I am afraid that there is a lot more learning to do.

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Does the Euro need a Big Bazooka?

It is a commonplace amongst Anglo-Saxon policy makers that the Eurozone leaders need to use a “big bazooka” to solve the currency crisis that is engulfing the continent.  David Cameron has been particularly conspicuous in using this expression.  Is it all it is cracked up to be?

So what is a bazooka?  Originally it was a tubular musical instrument made famous by the comedian Bob Burns in the 1930s (Mr Burns and instrument in second picture).  It then became the colloquial name for an American tubular hand-held antitank weapon introduced in the Second World War (the illustration above is in fact of a more modern and shorter weapon).  This was a revolutionary innovation, using recoilless technology and the so-called HEAT armour-penetration system – which allowed infantry to threaten tanks in a way not previously possible.  The Germans quickly copied it with the bigger and better panzerschrek (“tank terror”).  They also developed countermeasures, including thin armoured outer skirts to their tanks, which set off the HEAT system before it could inflict serious damage.  In the 1960s the weapon became obsolete, replaced by more powerful technologies.

A “big bazooka” in the current context is used to mean the deployment by the state (central banks and/or governments) of overwhelming financial resources to bail out troubled banks and others in a financial crisis.  The idea is to break a vicious cycle of declining confidence in banks and others, whereby lack of confidence becomes a self-fulfilling prophecy as creditors seek to move their money into safer places.   The mere proposition of such resources can be enough to break the cycle, if credible, and prevent the resources ever having to be deployed.  The Americans can proudly point out to the use of the technique to solve a series of financial crises, from the Savings & Loan crisis of the 1980s, to the LTCM collapse of the 1990s and the Lehman crisis of 2008. Such tactics are conspicuous by their absence in the Euro crisis, fiercely resisted by the German political class in striking unanimity.

There is an irony that the original bazooka was quite a small weapon – but I suppose it was big for one held by a single infantryman, and the German version conveys all the imagery the metaphor needs.  A more telling parallel is that the bazooka, revolutionary when introduced, steadily became obsolete as the world got used to it.  No doubt the Germans will point out that the American use of “big bazooka” tactics on repeated occasions shows that there is a flaw.  The American financial system suffers a systemic crisis every 10 years or so.  This is the first such crisis the Germans have endured since their currency was refounded after the war – and that is because the Germans aren’t running the show.

The have a point.  The financial markets are amazingly short-sighted – for example that idea that the US and UK are safe havens because their central banks can overcome any crisis by “printing money”, or monetising debt, in the manner of Zimbabwe.  But the long term logic always wins in the end.  There seems to be a slowly dawning realisation amongst Anglo-Saxon commentators (for example last week’s Martin Wolf column, as well as the Economist) that the German position in all this amounts to a strategy, “just enough, just in time”, and not the absence of one – even if Mr Wolf grumpily calls it “too little, too late”.  The short-term costs of the German strategy are doubtless higher than the American way – but the longer term position is much less clear.

 

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Markets aren’t people – BBC’s Peston is taking anthropomorphism too far

Yesterday there were some rather worrying developments in the market for Euro area bonds, affecting even French and Dutch government stock.  This caught the journalists on BBC Radio 4 off guard, including the famed Robert Peston.  They quickly fell into the lazy habit of describing the markets as if they were thinking and breathing people, albeit in a plural form, like “Bond markets looked on the Italian government’s plans sceptically and yields rose over 7%”.  This formula is usually used to link the movements in market prices to some new information or news event, regardless of whether any such link is actually significant.  The idea of this mythical person or people breathing down the the necks of governments is clearly an attractive way to communicate a point.  The trouble this morning was that there was no such easy link to make…which led at least one commentator to go a bit apocalyptic, that “the markets” had lost faith in the Euro completely and were expecting it to break up.  This was more or less where Mr Peston ended up.

I have always hated this anthropomorphism of markets, which is by no means confined to journalists – market participants clearly enjoy the false sense of power it gives them.  But markets are not people, they are mechanism by which buy and sell orders (in this case for securities) are resolved by striking a mutually acceptable price, often by computers these days.  When nobody is buying or selling much, and market makers have to quote prices, then indeed human sentiment plays a major part in price movements.  The market makers are usually part of a small and social group where collective sentiment can develop and they don’t mind telling outsiders.  Journalists can find out what these sentiments are by talking to a couple of people.  In this case the anthropomorphism does bear some resemblance to reality.

But as soon as the real money enters the market, then all this sentiment is mere chatter. And it often takes a bit of time for the real reasons for market price movements to emerge.  People have to guess, and journalists usually go no further than to tap into the chatter.  What moves the money?  There are whole variety of things, many which economists would not recognise as rational – like a fund manager simply dumping shares to avoid an awkward situation with a client.  Or, sometimes it can be plain errors.  Then, of course, with so much automated trading it can simply be the unforeseen interaction of computer algorithms- as happened in the notorious “flash crash” in May 2010.

So what happened yesterday?  I don’t know, of course.   But the best explanation came to me via the Economist’s Buttonwood column, itself quoting one Michael Derks at a company called fxpro.  In essence the Euro zone recapitalision of banks is having some malign effects.  The idea was that banks should reserve more capital against their assets, so that they are better able to withstand losses.  Reasonable enough (and vital to bring incentives at banks back into the real world, in my view), but banks can comply by dumping assets instead of increasing capital.  That is what many banks are doing, and they are choosing relatively liquid government bonds to dump – including those of the French and Netherlands governments, as well as the usual suspects of Italy and Spain.  It is a battle to prevent bank ownership being diluted, not a considered opinion on the future of the Euro.

Mr Peston should have known better, and helped his listeners try to understand what was going on, instead simply plugging this lazy and narcissistic drivel  Shame on him!

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Solving the Euro crisis means a stronger ECB

I do not regret paying my access fee to the FT website.  This morning there are two excellent articles on the Euro crisis from the two regular Wednesday morning columnists: Martin Wolf and John Kay.  It has helped clarify the way ahead for me.

Mr Kay comes in at high level to give an overview of the crisis.  It is not comfortable reading for supporters of the Euro project like me, but, as usual for this author, pretty much spot on.  The main problem is not that the currency area lacks appropriate institutions at the centre, but that local institutions in many member countries are not strong enough to cope with the pressures of being in the single currency.

The eurozone’s difficulties result not from the absence of strong central institutions but the absence of strong local institutions. A miscellany of domestic problems – rampant property speculation in Ireland and Spain, hopeless governance in Italy, lack of economic development in Portugal, Greece’s bloated public sector – have become problems for the EU as a whole. The solutions to these problems in every case can only be found locally.

So the answer will not come from strengthening the EU’s central institutions.  This goes back to the original design of the Euro: the whole idea was to put pressure on governments to reform themselves, by denying them the easy escape route of devaluation. Unfortunately the EU’s politicians forgot this in the first decade of the Euro, so no real pressure was brought to bear, making the crisis infinitely worse once it hit.

This article does not say much about how to go forward from here, beyond suggesting that grandstanding at summits like today’s may be part of the problem rather than the solution.  Mr Wolf’s looks at one aspect of how to manage the crisis itself.  This in turn in is based on a paper by Paul de Grauwe of Leuven university, who literally wrote the textbook on the Euro (I know, since I read it as part of my degree course).

Professor de Grauwe points out an interesting fact: the bond markets are much harder on the Euro zone fringe economies of Italy and Spain than they are on the UK, even though the underlying positions of the countries is not all that different.  The difference is that the UK markets are stabilised by having the Bank of England as a lender of last resort which is able to deal with liquidity crises (i.e. an inability to raise cash for temporary reasons rather than underlying insolvency).  The European Central Bank does not do this, or not enough, for the Eurozone economies.  Mr Wolf, who structures his article as an open letter to the new ECB president Mario Draghi, argues passionately that it should.  This would stop the contagion spreading from the insolvent economies of Greece and maybe Ireland to solvent but challenged economies like Italy, Spain and indeed France.

This must be right.  The Germans, who are the main sceptics, must be persuaded – and convinced that such interventions would only apply to liquidity crises and not solvency problems, and that the ECB has the integrity and independence to tell the difference, in the way that politicians never do.

Giving the ECB a wider and stronger remit will be a big help.  This should extend to supervision of the European financial system (preferably for the whole EU and not just the Eurozone).  This will help deal with one of the biggest problems for modern central banking – that of coping with spillover effects, as described in this thought-provoking paper from Claudio Bono of the BIS (warning: contains mild economic jargon, such as “partial-equilibrium”).

So a reconfigured ECB will help the Euro through the crisis and prevent self-fulfilling prophesies of doom in financial markets having to be solved in grandstand summits.  That still leaves the longer term problem of how the less competitive Southern European economies can have a long term future in the zone.  But then again, I think they would have just as challenging a future outside the zone – even if it were possible to devise an orderly exit mechanism for them.

 

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Understanding the Euro Crisis

My favourite contemporary economist is UCL’s Professor Wendy Carlin.  She was my tutor at UCL, and led my second year macroeconomics course, and a third year course on European institutions.  Her patient, dispassionate analysis is worth so much more than all that shoot-from-the-hip banging on by celebrity economists, Nobel Laureates and all.  It was her analysis, well before the current crisis broke, that demonstrated to me that the last government’s economic “miracle” was unsustainable (the combination of an appreciating real exchange rate and a trade deficit being the giveaways).  She also helped me understand the Eurozone, and pointed out the trouble ahead, again well before it happened, arising from diverging real exchange rates within the currency bloc – in other words Germany was becoming more competitive while Italy, Spain and others were becoming less so.

So I was delighted to read her summary of the Eurozone crisis – 10 questions about the Eurozone crisis and whether it can be solved.  The is a wonderfully clear summary of the whole situation, written in early September.  Her central point is that the zone’s banking system is at the heart of the crisis, and tackling the banks will the heart of any solution.  European politicians have been trying to avoid this, no doubt because it shows that Northern European countries have played an important role in creating the crisis.  However, not least thanks to the new IMF chief Christine Lagarde, this is changing.

Of course Professor Carlin cannot point to an easy escape.  She points to two alternatives paths, other than the breakup of the zone:

Scenario #1 – a more decisive approach based on current policy (bailouts)
Policy-makers need

  • the existing bailout schemes to be successful and to be seen to be working in the next year
  • to keep Italy out of the bailout regime
  • to develop a replacement for the high moral hazard regime for banks and for governments but to do this in a way that does not undermine the bailout regime in the meantime.

Scenario #2 – large-scale restructuring of bank and government debts (defaults)
Policy-makers need

  • to move decisively now to end the high moral hazard regime by accepting that default on bank and government bonds on a much larger scale than envisaged in Scenario #1 is necessary
  • to engage in restructuring sovereign debt and bank debt by, for example, forcing bond-holders to swap existing short-term bonds for long-term
European politicians are attempting the first path, but the problem is contained in Professor Carlin’s third bullet: devising a financial scheme that avoids moral hazard by banks and sovereign states – this reckless behaviour in the belief that it will be underwritten by everybody else.  The favoured answer of many is a “Eurobond” – i.e. government borrowing underwritten collectively, combined with a toothier version of the failed Stability & Growth pact.  But this decisive step towards a more federal Europe runs well beyond any democratic mandate.  The German Chancellor, Angela Merkel, is rightly suspicious.
Which leaves the second scenario, which is favoured by American commentators, based on their experiences of Latin American debt crises.  This is surely much more convincing, and I hope that the IMF will use its influence to push down this path.  Bank regulation clearly needs to change, but beyond that it doesn’t need a more federal Europe.  We can use bond spreads to act as a break on government profligacy – which is how the Eurozone should have been run from the start.
A final point worth making from Professor Carlin’s analysis is that dropping out of the Eurozone wouldn’t really help Greece or any other country that much.  They would still have to run a government surplus, and so still have to go through a very painful reform programme sucking demand out of their economies.  Of course the hope is that a rapid devaluation would kick start exports – but it does not stop the need for painful supply-side reforms if these countries are to recover anything like their former standards of living.
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Time the British woke up to the crisis in Europe

It is a commonplace for Britain’s politicos to sadly shake their heads and complain that the Euro crisis demonstrates a woeful lack of political leadership.  Regardless of the fairness of this charge in respect of Angela Merkel, say, it clearly has resonance for Britain’s own leaders.  There seem to be two camps: ravingly impractical Eurosceptics, and sheer paralysis from everybody else.  The mood amongst Europhiles (as I witnessed at fringe meeting at the Lib Dem conference) is akin to deep depression.  It is time for this to change.

To be fair some key players have been showing something less than paralysis – George Osborne and Nick Clegg have both been conspicuous in raising the seriousness of the situation with their international colleagues – but their pronouncements are hardly more helpful than anybody else’s.  They aren’t bringing anything to the party and they aren’t trying bring our own public alongside.

The first point is that the Euro crisis has serious implications for Britain, much though most people seem to think it is happening to somebody else.  This is for two main reasons.  First is that this country would be caught up in any financial disaster.  Our oversized banks are deep in the mess; Euro zone countries are vital trading partners for a country very dependent on trade – especially given that international financial services are so important to us.  Our fragile attempts at recovery risk being completely blown off course.  Forget Plan B if this lot breaks.

The second reason it matters to Britain is that resolution of the crisis could take the European Union in a direction that is against our interests.  Britain leads the single market wing of the union: the chief Euro zone countries are more protectionist in their instincts.  We risk being shut out of the design of critical architecture – much as the Common Agriculture Policy was put together in our absence.

How to proceed?  We need to tackle the dark spectre head on: the best resolution of the crisis involves changes to the European treaties.  To change the treaties will require a referendum here (let’s not weasel out of it this time).  If we face up to that challenge now, it will show real courage, and help get things moving.

But, of course, we would need to see something in return.  Changes to the treaties that would further our interests.  These need to be to promote the single market, to protect London (and Edinburgh) as centres for financial infrastructure, and to reduce unsightly bureaucracy and/or operating costs of the Union (the siting of the European Parliamnet at Strasbourg needs to go on the table, at least).  Given our understanding of finance, we might well have useful things to say on the Eurozone architecture too – even though we clearly can’t be part of it.

To do this our leaders (the Prime Minister and the Deputy Prime Minister in the lead) need to build two sets of alliances.  The first is within the British body politic, so that the referendum can be won.  This needs to cover Tory pragmatists (David Cameron, George Osborne and William Hague), the Labour leadership and, preferably, the SNP.  The Lib Dems have an important role in making this hold together since, by and large, they understand the Union the best.  Mr Clegg’s experience of deal-making in the European parliament counts for a lot.  The next set of alliances is within the Union itself, to create a Single Market bloc.  The obvious candidates are the Nordic countries, Ireland and the Netherlands, together with many of the newer members in central and eastern Europe.

This will be very difficult.  That’s the point, almost.  The reward is a stabler EU, constructed more to our taste, even if we must concede some powers to an inner core of Euro area countries.  Everybody wins.  And by taking on the wilder Eurosceptic fringe, including their newspaper backers, it will cheer all right-thinking people up.  It’s time we stopped being paralysed by fear and came out fighting.

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Memo to Miliband: break some eggs

As a political insider it’s very easy to be carried away by partisan emotions, but very dangerous.  Thus I have been watching (not literally) the Labour conference with a great deal of caution.  I want to scoff, but my better self tells me to be more careful.  And that applied especially the Labour leader Ed Miliband’s speech delivered yesterday.  After reading the commentary in the papers I decided that I had to read the text of it too.

Let’s start with the good bits.  It set out a clear narrative for the past present and future. His starting point was Mrs Thatcher and the 1980s.  Some good reforms but she started a culture of heedless self-advancement.  New Labour was a step forward because it invested heavily in public services and in tackling poverty – but it didn’t do enough (anything?) to change a reckless business culture, and this brought the whole system down in the financial crash of 2008-09.  After the crash the current government is doing nothing to address this underlying sickness, and its austerity policies are choking off growth and making things worse.  For the future, Mr Miliband wants to transform society by making government more moral, and finally taming the monster that Mrs Thatcher unleashed.

Mr Miliband’s core constituency, the “squeezed middle”, remained firmly at the centre of his narrative – although he wisely did not use that phrase.  These are people who are neither rich nor poor, and whose living standards are being steadily squeezed, as government largesse is focused on those who are poorer.  Mr Miliband identified this key group at the start of his leadership, and he is maintaining his aim.  He is clearly more successful in this than the Liberal Democrat leader Nick Clegg, who has identified the same group as decisive (using the phrase “Alarm Clock Britain” to describe them, to general derision), but has struggled to hit the right note.

It is easy to pick holes in the narrative, but that would only hint at its main weaknesses. Firstly that to most people it will sound abstract and irrelevant, and second that he failed to tackle the hard choices that would show he meant business.

Irrelevance?  Britain stands in the middle of a global financial crisis, lurching towards another episode on a par with the crisis of 2008.  The Euro zone is at the heart of this crisis, and thus the European Union, this country’s main diplomatic and economic partner, is facing the biggest challenge in its history.  And Mr Miliband’s answer to this global challenge?  To fiddle with VAT rates and implement the government’s cuts a bit slower.  The world situation got hardly a mention.  No doubt the idea is to set a time-bomb for the government, so that as the economy fails to approve he can say “told you so”.  But since Labour’s explanation of the 2008 crisis was the world economic situation, what answer do they have if this government says the same thing?  As George Osborne and David Cameron  scurry round the globe trying to stave off disaster, Labour stays at home and whinges about VAT.  This doesn’t look very convincing.

And he did not have much else to say that would help his squeezed middle voters in the pocket, rather than replicating their complaints about benefit cheats and fatcats.  In fact he did not have much to say on specific policies at all.  He wants to cut university tuition fees (which would in fact help the better off more than anybody) and that’s about it.

The problem is this: change hurts.  People know that instinctively, so that to convince them that you are serious you have to do painful things.  Tony Blair did so by taking on a number of Labour shibboleths: Clause 4 of the party constitution, not raising income taxes and (as few now remember) sticking to the then Tory government’s austerity plans to tackle the deficit.  David Cameron did similar things on socially liberal issues, while eschewing tax cuts.  What will Mr Miliband do to show that he is serious about his mission to transform Britain, and win back trust?

Here are some things he might do:

  • Accept more publicly the logic of the Government’s austerity policies in order to create the funds for tax cuts to the squeezed middle as the economy improves.  We did get statements that they could not reinstate all the government’s cuts, but the delivery of these was so muffled that I don’t think most Labour activists noticed them, still less become angry.
  • Call for reform of the European Union so as to address the unfolding financial crisis, throwing down the gauntlet to Tory Eurosceptics.
  • Pick a serious fight with the trade unions about public sector strikes and participation in Labour politics.
  • Call on the government to get serious about coasting schools and sub-standard health services by in the first case getting tougher on teachers and the second closing sub-critical hospitals and putting serious heat onto GPs.
  • Challenging ordinary voters by pointing out that they also contributed to the crisis by living off credit cards and going for ever bigger mortgages.

Each of these would require a lot of courage – but that’s the point; he must make a lot of people  in his party angry.  Instead we get some rather bland ideas about favouring “good” rather than “bad” businesses.  But these sound rather like things that the coalition is already putting forward on banking reform and reshaping the economy towards manufacturing and green businesses –  Mr Miliband even quoted Lib Dem Business Secretary Vince Cable in his support on the radio this morning.  Other ideas sound like more bureaucracy.

To make an omelette, they say, you have to break some eggs.  Until Mr Miliband starts breaking eggs nobody will take him seriously.

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