Hard Choices

The Malta Independent on Sunday

2^nd January 2011

As a new year pushes the old one into history it inherits the problems that straddle the calendar divide searching for a lasting solution.    On the economic scene one such crucial problem is the Euro Monetary Union (EMU), the sustainability of which came in for serious questioning during 2010.

The EMU is a pressure cooker on burning coal building internal tensions which unless checked will ultimately explode.   Countries experiencing very contrasting economic fortunes are locked together in a single currency which prohibits rather than aides the adjustment needed to regain the harmonisation necessary for the longevity of a monetary union.

As the anchor of the union, Germany has a restricted menu to choose from to avoid a violent explosion as financial markets continue to question EMU sustainability and will certainly test the political will to go beyond lip service and actually do what needs to be done to restore it to sanity.

Basically there are four choices, three of which are very painful for Germany whereas the other is very painful for the deficit countries but quite beneficial for the surplus countries chief amongst which Germany.  Unsurprisingly Germany is trying to impose this option on the rest.

Germany is currently attempting  to force deficit countries ( Greece, Portugal, Ireland and Spain in particular) into a painful and extended adjustment process which goes against all economic logic as it imposes sharp mandated fiscal consolidation on economies that are already suffering from stagnation or outright contraction.  Keynes would be turning in his grave!   Never in the history of humankind have such fiscal adjustment programmes been successful when unaccompanied by economic growth strategies.   As the mandated fiscal consolidation spread over a number of years delivers contraction rather than growth, unemployment rather than job opportunities, poverty rather than riches, popular acceptance will wear out, aptitude for sacrifice will disappear and disenchantment will lead  to toppling of  incumbent governments with a grave risk of electing irresponsible nationalistic demagogues who promise an easy escape from new bondage. 

All this economic austerity is the price deficit countries have to pay for accessing cheaper sovereign financing from purposely created central EU mechanisms, temporary or permanent yet to be seen, in replacement of financing from the international bond markets which are demanding too high a price for lending to such deficit countries as the risk of default gets priced in, motivated not least by Germany’s double talk about bailing out countries in distress or cutting them loose.  Governments in Greece and Ireland have had no option but to accept the bitter medicine whereas Portugal and Spain may have to follow before long even though they have started their own austerity programmes in an attempt to manage their way out of the crisis rather than be overwhelmed by it.

The unsustainability of this approach is rendered evident by the fact that Germany is a great beneficiary of the distress of peripheral countries as the weakness of the Euro adds further stimulus to Germany’s export oriented economy.   As a result, whilst the peripheral countries in distress are experiencing austerity-induced contraction,  the German economy is rumbling on at growth rates higher than those experienced before the crisis. 

Can this dichotomy exist in a monetary union?   What if distress countries find it impossible to stay the course?   What if democracy elects governments with a mandate to switch off the austerity sausage machine?

Germany would then have some hard choices to make from one or a combinations of the following:

·         Letting deficit countries to default  on their debts to ease the burden of adjustment without continuing a prolonged austerity programme

·         Organising a temporary and well –planned break-up of the EMU into a hard and soft areas allowing the hard Euro to revalue substantially against the soft Euro and engineer a re-integration into a Euro V.2  at rates of exchange that would rebalance external competitiveness across the whole EMU area.

·         Accept a disorderly dismantling of the EMU with members returning back to their old currencies, inevitably leading to capital controls, sovereign defaults and probably the disintegration of the EU project.

All these three alternatives are unthinkable doomsday scenarios which will bring extreme pain not just to the deficit countries but also to the surplus countries whose banking systems are gravely exposed to the fortunes of peripheral EMU countries.  There will be no winners in such scenario, all would be losers and none would be spared the pain.   The very foundation of 65 years of peace in Europe will be brought to an abrupt end with consequences that could be too terrible to contemplate.

Germany and allied surplus countries would therefore be well advised to desist from playing Russian roulette with periphery countries in distress.    Forcing successive rounds of unbearable austerity could backfire with grave consequences.   I am not arguing for any bail-out to deficit countries through fiscal transfers as if the EU were a single state.    This is not politically possible as the EU is not yet ready for a fiscal union.   Even if it were possible, fiscal transfers would create moral hazard and remove the discipline on errant countries to mend their ways.   What I am arguing is for austerity programmes to be spread over a much longer period of time and to make economic growth an indispensable ingredient in the adjustment process.  

For this to happen the central EU financial mechanism which distress countries can access when bond markets shut their windows will have to be much better resourced and with funding costs not higher than 1% over what the strongest EMU country pays for its own sovereign funding.   Access to such funding will continue to be subject to IMF style of conditionality to ensure that aid and adjustment move hand in hand.

Suggestions for deficit countries to borrow through a  Euro bond on the collective responsibility of the  EMU members are dangerous and surely unacceptable both politically and economically to the surplus states whose reluctance to put their own balance sheet to back up weak states without having levers on the discipline for continued macro-economic re-structuring is understandable.

The Euro-zone needs German discipline but it equally needs German leadership, understanding and generosity to keep the EMU intact and remove gradually the internal tensions built by Germany’s obsession with export led growth rather than balanced growth with a strong component of  domestic demand.

It is in Germany’s interest to do all that needs to be done to ensure that the Euro survives.  The loss of competitiveness Germany will suffer if it is forced to go back to an appreciating Deutsche Mark, to say nothing of the stress that will be suffered by German banks with exposure to Euro sovereign claims on peripheral distress countries, will deal a big blow to the German economy and to the EU’s stature in the world.  What needs to be done must be done in a programmed manner now and urgently.   Otherwise it will have to be done in crisis mode on the strike of midnight when financial panic threatens to blow away the door on which it is already knocking

Alfred Mifsud