Monday, 17 November 2014

Where to draw the line (2)

This article was published in The Malta Independent on Sunday - 16.11.2014
Where do you draw the line between the arguments of core and periphery eurozone countries about how best to restore the economy to normal growth and avoid the dangers of a lost decade and a perilous slip into deflationary debt trap?
Before presenting both sides of the argument, I should mention that between the core and the periphery there are countries referred to as ‘coriphery’, including France, who have never asked for an EU bailout and never (so far) suffered any loss of access to financing their sovereign borrowing requirements on the capital markets at normal interest rates, and yet whose economy is plagued with structural problems and is seriously in breach of Euro Maastricht Treaty conditions landing them under the watch of the Commission through Excessive Deficit Procedures.
According to the German (core euro) economic doctrine, growth can only come through hard, economic restructuring, irrespective of the pain and social consequences involved, to restore the competitiveness that periphery euro countries have lost through excessive spending and high borrowing without comparable efficiency gains. According to this doctrine, competitiveness cannot be regained through demand-stimulating measures, whether fiscal or monetary, but should be addressed at source through internal devaluation. Internal devaluation means the rollback of government expenditure involving painful wage and entitlement cuts, accompanied by new tax measures to raise more government revenue as well as measures to enforce taxation and fight evasion so enhancing public revenue flows. This doctrine preaches that excessive deficit problems cannot be resolved by undertaking further deficits to stimulate the economy, even if such additional borrowing were possible.
In arguing the way they do, Germany and core euro allies point to the sacrifices they had to make post-2003, when they were the first to infringe the Maastricht rules, and how such sacrifices have helped to restore their competitiveness so they now have a budget in balance and a Balance of Payments surplus of seven per cent of GDP.
When criticised that their approach lacks any dose of the solidarity that is required to keep any union together, not least a monetary union, the Germans point to the risks of moral hazard that such solidarity would generate. Moral hazard means that were Germany to get generous through solidarity measures, the periphery problem countries would go soft on the need to restore their economies to competitiveness and would just persist in their old ways, knowing that big daddy will ultimately have to pay their bills.
The other side of the argument – made by the euro periphery countries, especially Italy, Greece and Spain, as well as coriphery France – is that economic restructuring cannot be carried out in a recessionary or even deflationary environment and that stimulation of demand across the whole eurozone is a pre-condition for successful economic restructuring. They point out that Germany’s restructuring in the noughties was largely facilitated by the bright international economic environment and by the deficits that periphery euro countries were running at the time to buy their BMWs and Mercs from Germany. By analogy, unless Germany uses its ample fiscal space, while periphery countries are addressing their deficits, the periphery countries – for all their sacrifices – will continue running on the spot or, worse, slip into deflation.
They argue that unless Germany reflates its economy by stimulating demand and raising its inflation to three per cent or more, the ECB target two per cent average inflation for the whole eurozone can never be reached. If Germany continues to justify a balanced budget with a strong balance of payments surplus and an inflation rate of less than one per cent, then in order to restore competitiveness, periphery euro countries will need to have a three per cent inflation differential, which would put them into a deflation, negative two per cent inflation, basically a debt trap that blocks any economic growth.
Periphery countries point out that there is a limit to how much pain they can load on their electorates without risking the very workings of democracy that underpins the Union. The electorates will accept restructuring if it happens in the context of economic growth so that those who lose their job through waste-cutting and expenditure retrenchment will have a fair chance of finding alternative productive employment. However, restructuring in the context of a recession or even depression flies in the face of all Keynesian teachings which delivered so much prosperity in the post-war period. This will ultimately lead to democracy mandating demagogue extremists, irresponsible enough to take nationalistic unilateral action that will lead to the dissolution of the euro system and the EU itself and will undo the great post-war political achievements in Europe. Front National in France,Syriza in Greece, Cinque Stelle and Lega Nord in Italy, all in different measures, profess either more German solidarity or departure from the euro (and by consequence from the EU) if they are ever elected to power.
Where should the line be drawn to enable a compromise between these two extreme positions and to work collaboratively on a programme to re-set euro countries collectively on a route to prosperity?
To my mind there are three conditions required to form a compromise that will be politically acceptable and economically effective:
Firstly, Germany and other core countries have to accept the high level advice being rained upon them by the US, the IMF and other international sources that they must use their fiscal space to stimulate internal demand and therefore create better prospects for the euro periphery restructuring. Germany has just announced a balanced budget for 2015 ignoring all US and IMF pressure to do the opposite. US Finance Secretary Jack Law says this will mean a lost decade for Europe. Germany insists that it must be an example of fiscal discipline for the rest to follow.
Secondly, a massive infrastructure investment programme has to be undertaken in Europe to create demand and increase the economic capacity of the region. This investment has to be financed outside mainstream budgets through funding by the European Investment Bank (EIB) and private sector involvement. The EIB will have to bolster its resources for this purpose by issuing low coupon subordinated capital and debt instruments which may be bought by the ECB through its asset purchase programmes (a European style of quantitative easing) and, if necessary, by demanding more capital from member states. New Commission President Juncker has pledged such an initiative to the value of €300 billion.
Thirdly, the ECB must engage in more aggressive loosening of its monetary policy, expanding its balance sheet by buying EIB debt and, if available, corporate and bank debt (sovereign debt purchases remain highly contentious and should therefore be avoided). In addition, the ECB should fund the European Stability Mechanism (ESM) to force-feed European banks with additional capital, even beyond the shortfall identified in the stress tests, to ensure that European banks are strong and capable of funding European growth and investment opportunities. Such capital funding should be reversible, in the form of redeemable preference shares, in order to maintain investors’ confidence to invest in bank equity so that, once confidence is restored, the preference shares will be redeemed and dilution of equity investors avoided.
Surely, a compromise with these elements is possible if Germany and its core allies accept that it is not in their interests, or in the interests of sustainability of the great advantages they drew from the EU, to remain so rigid about arguing that the adjustment has to come from the deficit side only.  
Either a compromise is reached, now that a new Commission with fresh energy and vision is in place, or it will have to be reached at 10 seconds to midnight somewhere down the line, when crisis is about to blow the euro and the EU apart.

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