Sunday, 1 December 2013

The lines are drawn

This article was published in The Malta Independent on Sunday - 01 . 12. 2013
This last week, the lines have been drawn on several political and economic battlegrounds.
In Italy, the ousting of Berlusconi from the Senate, and the splitting of his party into hardliners who have joined the Opposition and middle-of-the-roaders who have opted to continue as members of the governing coalition has more clearly defined the political landscape. At last Italy has a government that need not continuously look over its shoulders to guard itself from the enemy within.
Prime Minister Letta has greatly enhanced his political credentials and now has the strength to look Merkel in the eye when negotiating how best to restore growth in the European economy and address the atrocious chronic unemployment levels. Italy now has the levers to force pragmatism over economic Talibanism fighting inflation that does not exist and ignoring unemployment that is all too real, especially among young people, leading to a lost generation.
The Italian government has a short-term mandate. It plans to stabilise the economy and change the electoral law during 2014 and then hold fresh polls in 2015. Unless the EU helps Prime Minister Letta to continue with restructuring in the context of growth rather than counter-productive austerity, there is a grave risk that the Italian electorate will send Europe a protest vote that puts back into power populists like Berlusconi and Grillo. That disaster came close enough in last February’s elections and could well be realised if the Italians are forced to vote with emotion rather than logic. That would practically mean the end of Italy in the eurozone and, by implication, the end of all that the EU and the euro stand for.
Lines were also drawn in the German political landscape. Dynamics in Germany are moving in the opposite direction to Italy. While the dynamics in Italy have now clearly made a distinction between the centre/left in government and the extreme right and protest vote in Opposition, in Germany the dynamics have led to a grand coalition of the right and left. I view this positively. The concessions that Merkel’s conservative CDU/CSU had to make to get the socialist SPD on board mean that Germany will have to loosen up and restore purchasing power to consumers and stimulate a shift from investment to consumption. The minimum wage and the lowering of the pension age could well force German industry to move to other lower cost locations within the EU, helping to rebalance growth across the region. Addressing the surplus built by Germany will make correcting the deficits in problem countries somewhat more manageable.
What still has to be seen is how the important ministries will be shared among the coalition partners, in particular who will occupy the Foreign and the Finance Ministries. Especially in the Finance Ministry and in the Bundesbank (the German Central Bank), there is an acute need for a fresh approach to resolving the euro’s problems.
In fact, battle lines have also been drawn on the turf occupied by the European Central Bank (ECB) and German finance authorities, in both government and the central bank. A major point of principle is being fought over: will the ECB be a replica of the Bundesbank dressed in European clothes, or will it truly be a central bank operating in the interests of the whole euro area? That is the question that needs to be resolved, and the earlier the better.
The lines were drawn when, at the last meeting of the ECB on 7 November, the Council decided by a large majority to cut interest rates by a quarter of a point to 0.25 per cent. Faced with a situation where the inflation rate is rapidly falling below the target of two per cent, and coming dangerously close to the zero level, the ECB’s hands were practically forced to loosen monetary policy further.
But the ECB council members from Germany and other allied North European countries voted against the rate reduction, arguing that it was too low for their domestic economic realities. ECB president Mario Draghi – and the majority – argued that the rate decision had to take account of the realities in the whole euro area and not just in the northern countries. And they carried the day, much to the dismay of the German group, who then decided to leak their dissent outside the Council.
Whilst Draghi made sincere efforts to play down the differences, arguing it concerned more the timing than the principle of the rate cut, the German reps externalised their dissent and their disappointment that they could not sufficiently ‘Germanise’ the ECB.
But the battles have not ended with the decision to cut the interest rate. There is an evident conceptual clash round the ECB table, and the matter needs to be settled without further delay, as the risk of a relapse into recession and deflation in Europe is getting ever more real. While the US economy seems to have entered a solid recovery trajectory to which it was guided by ultra-loose monetary policy including aggressive quantitative easing (QE – monetisation of purchases of long-term bonds to also bring down long-term interest rates) and by the forced recapitalisation of banks to remove any doubt about their ability to extend credit and act as an efficient transmission mechanism for monetary policy instruments, Europe is still staring at the abyss of deflation without its Central Bank having as yet embarked on QE.
Deflation is far more treacherous territory than inflation. If consumers slip into a frame of mind that tomorrow one can buy more cheaply than today, deflation will be a spiral building on itself as consumption stalls and investment is postponed. Recovering from deflation would be like trying to run uphill while skidding down to the bottom. The last deflation of the 1930s needed the catharsis of a global world war to address it.
The ECB has a choice to make if the situation continues to deteriorate: either introduce the US and UK (and now Japan, too) style of QE or continue reducing interest rates to zero and below, introducing negative interest rates. Negative interest rates mean banks charge depositors when accepting their deposits rather than paying them interest, in an effort to persuade investors to spend rather than save.
Negative interest rates are within the mandate of the ECB as they are a pure monetary instrument, but they represent uncharted territory with huge potential for unintended consequences. QE is an unorthodox monetary measure that impinges on fiscal policy. The Germans argue that QE is outside the mandate of the ECB, as it is only tasked to make stable prices as its objective with no brief for economic growth and employment levels. But QE is charted territory and is easier to implement and fold back with far fewer unintended consequences than negative interest rates.
Should the ECB force Germany’s hand to lift objections to potentially outside mandate QE with the threat that the alternative of negative interest rates would be more risky even if within the mandate? Some argue that QE is not outside the mandate of the ECB, even though it is not specifically allowed. If QE is adopted to repair the transmission mechanism for monetary policy decisions, then it falls within the mandate as the ECB cannot tolerate a situation where its monetary policy decisions are sterilised by a broken transmission mechanism.
And we seem to be inching towards drawing some political battle grounds in Malta too. Following 25 years during which the Labour Opposition gave the PN government a consensus for building the financial services industry to where it is today, the signs are that the PN have not yet adjusted to their role in Opposition. They expect the view of the minority to prevail over the view of the majority. Their understanding of consensus seems to be ‘my way or the highway’. That is the only thing I could conclude when I heard the Leader of the Opposition denigrating Malta’s image in the foreign media, giving the impression that Malta is about to sell citizenship wholesale to the most undesirable characters, and announcing that he is participating in further rounds of negotiations with the government about the citizenship scheme but would only give his consensus if his conditions are met.
The Leader of the Opposition has threatened to unconstitutionally revoke the Labour government’s contractual commitments if he is ever elected to power, has declared that he is prepared to sit on the governing board of the Scheme only to externalise its details, and has now agreed to attempt consensus negotiations with prior declarations of ‘my way or the highway’. In the event of no agreement, he has indicated that he may consider an abrogative referendum.
Here, too, the Opposition is on treacherous ground – both legally and morally. Legally, because the scheme can be interpreted as fiscal legislation, given that the government has included €15million of revenue from the scheme in the 2014 Budget and fiscal legislation is specifically excluded from the Referenda Act and morally because if the abrogative referendum mechanism is used so liberally just because a person cannot accept that the executive power has been passed on, then the PN needs some lessons in accepting that they are no longer in government. I know that after 25 years this does not come easily, but come it must.

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