Friday, 11 November 2011

Saving the Euro – Flood it or Leave it!

11th November 2011
The Malta Independent

Not many choices are left to save the euro. It has brought down the Prime Ministers of all troubled countries, in Ireland, Portugal and probably Spain through fresh elections and in Greece and Italy (work-in-progress) through bond market pressure for the formation of a wide-based national government that can be trusted to take the tough measures needed for proper economic restructuring without the interference of re-election prospects coming into the equation

Yet the fate of the euro is hanging on a thread. It takes one missed debt auction by a government like Italy or France to set the euro house on fire. It takes depositors loss of confidence in Italian banks, just as the Greeks have lost confidence in their own banks, to damage the system beyond repair.

That we have a grave problem on our hands is best exhibited by the likely booting out of Berlusconi from the Prime Ministerial seat in Italy. The bond market will succeed where sex scandals, financials impropriety, tax evasion and unbecoming behaviour failed. But when yields on 10-year Italian government bonds exceeded 6.77% and the margin between Italian bonds and German bonds widened to more than 5% that was it! Even his closest allies could not avoid reading the writing on the wall that no one, not even a political survivor like Berlusconi, can challenge the bond market.

The grave problems plaguing the euro system have to be sorted out in one of three ways. And none of these three possible solutions needs to come from any meeting of the 17 EU member states or Ecofin meetings of the respective finance ministers. Such meetings have become an utter waste of time producing complicated and half-backed decisions concocted by the Merkozy tandem to address last year’s problems. EU governments remain hopelessly behind the curve and have lost all market confidence they have or can get things under control.

The most obvious solution is for the ECB to take the lead and do what central banks are meant to do when facing a financial crisis of this magnitude. I have been repeating this ad nauseum in my recent writings. In a monetary union that is not under-pinned by a common fiscal policy and a common treasury, monetary policy has to be much more forceful and flexible. Forceful in setting and implementing discipline during the good times, by taking the punchbowl away before the party gets too hot; by using its moral suasion powers over governments of countries that find the common euro interest rate unsuitable for their particular requirements, to take supplementary local measures, both fiscal and direct, which make up for the inadequacy of the common interest rate policy. Flexible during times of crisis to take measures that procure financial stability that only a Central Bank operating autonomously, without need to get the complicated approval of 17 national parliaments can do.

The ECB is doing nothing of the sort. Probably it feels that this goes beyond its mandate but in such case it should seek a change of its mandate rather than preside over the euro disintegration. After all it is the ECB President’s signature that goes on the euro notes and not the signature of Merkel or Sarkozy.

When the going was good, the ECB was blind to the asset price inflation happening in Ireland and Spain as real estate prices soared, fuelled by inappropriately low interest for their domestic conditions. These low interest rates were tailored to suit Germany’s economic fatigue of integrating the East with the West. The ECB could and should have used its moral suasion authority to calm down such asset price inflation in Ireland and Spain through direct controls over private credit growth. Asset price increases move hand in hand with private credit growth and control of credit growth would have avoided the speculative boom that blew up the Irish and Spanish economies.

Now that we are in crisis the ECB is not being bold enough to put out the fire ignited by the politicians’ mishandling of the situation. The ECB is reluctantly supporting sovereign bond markets of Italy and Spain when it should be really making it clear that it has no limits how much bonds it would buy to keep yield spreads sustainable provided governments of countries in distress do what needs to be done to render their fiscal position sustainable in the long term.

The ECB is the only institution that can match the power of bond markets. It has unlimited resources as it can monetise its bond purchases and can provide whatever funding is needed by the EFSF without raising taxes anywhere, without forcing countries to take on undue leverage risks and without humiliating Europe having to go cap in hand to seek financial support from China and the like.

To be fair the change of leadership at the ECB effective 1 November, 2011 bodes well. Since Draghi has assumed the role of President there are all his fingerprints over the manoeuvre to force Berlusconi out of his position. When the ECB slowed supporting Italian spreads by slowing its bond purchases, Berlusconi had to come to terms with the force of the Bond market that had lost all confidence in his ability to re-invigorate the Italian economy.

Some might validly argue that it is undemocratic for the ECB to have such powers over sovereign elected governments. Democracy is never perfect and checks and balances are needed when democratically elected politicians start putting their personal and narrow self-preservation interest before the interest of the country and the people they were elected to serve. Pressure by other countries could be perceived as imperialism and foreign interference. Consequently, subtle action by a technocrat board of 22 central bankers from all euro area countries is the least democratically offensive solution for the greater good of the nation and the Union.

Failure by the ECB to do what needs to be done will mean the break-up of the euro in the not too distant future. And this comes in two choices. Either the weak links have to leave permanently, or the strong links have to exit at least temporarily.

The biggest disaster for the soul of Europe is if the weak are forced to leave. If Greece is forced to leave the euro, the rapacious oligarchs that through their corruption have broken the Greek economy, will have the biggest laugh at the expense of the decent Greeks who earn relatively little, but unlike the corrupt super rich, actually pay their taxes. These oligarchs control large parts of the Greek business, the financial sector, the media and indeed politicians. These oligarchs have been exporting cash from undeclared profits out of the Greek economy so much so that the London property market is reported to have received a boost from Greek buyers. If Greece is forced out of the EU and revert to the Drachma which will have to be grossly devalued, these oligarchs would make huge gains from their foreign assets and will be able to buy on the cheap public assets priced in devalued drachma that will have to be privatised under duress to enable the Greek government to find the funds that will no longer be available from bailout EU sources.

On the contrary if the strong countries exit the euro the domestic currencies they will temporarily revert to will strengthen and will make imports from Greece and other countries that stay in the euro cheaper and more attractive. It will also stimulate direct investment flows from north to south so that the Greek restructuring is based on a dimension of growth not solely on austerity. In the process Greece will be helped to sharpen its institutional arrangements to bring the tax evasion and corruption under control and offenders to the book.

Germany has a choice! Let the ECB act as a true Central Bank, or bring misery and total disorder to the southern flank of Europe, or temporarily exit the euro to permit an orderly recovery of competitiveness across the whole euro area and eventual re-merge into a single euro under new rules and at realistic conversion rates reflecting current realities. Search for other solutions is a waste of precious time and resources.

Alfred Mifsud

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