There is no sunlit future for the euro

Wednesday 19 October 2011

By Martin Wolf

Hurrah! The eurozone's crisis will be solved at the European Union's summit this Sunday. So participants at last Saturday's meeting of finance ministers of the group of 20 leading advanced and emerging economies have suggested . Will such hopes be vindicated? No. It is conceivable - if unlikely - that the eurozone will find ways to manage its emergency. It is inconceivable that it will cure the illness, partly because members are in denial about its nature and partly because it is a chronic condition.

Understandably, outsiders, terrified of another global financial shock, are putting fierce pressure on the eurozone's members to deal with its interlinked crises of sovereign and banking illiquidity and insolvency. Ministers called on the eurozone to act " decisively to restore confidence, financial stability and growth ".

Fix banks; fix Greece; and fix debt markets of other fragile eurozone sovereigns. These are the elements of the desired package . The main policy approach is also clear: pour buckets of money over everything.

First, what is to be done about the banks? The starting point is to be a credible stress test. But it is uncertain what a credible test would be. That depends on potential losses on sovereign debt, which is not only unknown but depends on policy decisions still to be taken. The question, then, is what capital ratios to aim at. Success will be judged by how easily banks can subsequently fund themselves. This is an exercise in market psychology, not science.

If, after the tests, banks were to shrink assets, rather than raise their capital, as they now threaten to do, the treatment could well be worse than the disease. The answer is to turn desired ratios into levels of capital that banks have to meet. The latter will scream. So be it. States underpin banks. They have the right - and the duty - to ensure that self-interested behaviour by state-supported banks does not cause a slump. The answer is for banks to be told to raise target levels of capital, underwritten by solvent states or the European financial stability facility (EFSF). If they cannot raise capital, it will come from governments.

Second, what is to be done about Greece? As my colleague, Chris Giles, has noted , the German government thinks Greek debt needs to be reduced to sustainable levels, while the French government, the European Central Bank and the banks believe that restructuring must be voluntary. Since voluntary reduction is unlikely to be sufficient, this cannot work. Germany is right. Greek debt service must be put on a sustainable basis. The International Monetary Fund knows that this has to be the starting point. What, after all, is the incentive for the Greeks to reform their government and economy if the benefits accrue to creditors indefinitely? Next to none.

Fools who lent money, without asking questions, deserve to share in the pain. They should not expect Greeks to rescue them from their folly, after the fact. The reduction in the debt burden can be achieved by cutting the stock, lowering interest rates or extending maturities. With net public debt forecast by the IMF at 175 per cent of gross domestic product in 2012 and no chance of borrowing in private markets, the case for radical cuts is powerful.

Third, how are other vulnerable members to be protected? A self-fulfilling panic in the sovereign debt markets of big countries, such as Italy and Spain, is the biggest danger confronting the eurozone and the world economy. Since Spain's net debt (forecast by the IMF at 59 per cent of GDP in 2012) and Italy's structural fiscal deficit (forecast at 1.1 per cent of GDP in 2012) are quite low, both countries have a good chance of regaining access to markets on more comfortable terms. The simplest solution would be for the European Central Bank to ensure liquidity in the market for these public debts. If this is rejected or deemed insufficient, the EFSF could provide partial guarantees on new borrowing, as recently suggested by Paul Achleitner of Allianz.

Suppose the immediate crisis were indeed overcome, in such ways. Would this promise a sunlit future for the euro? No. Nor, as so many suggest, is some sort of fiscal union the answer. True, if creditworthy members were to transfer resources to the uncreditworthy on a large enough scale, the eurozone might be kept together. But, even if such a policy could be sustained (which is unlikely), it would turn southern Europe into a greater Mezzogiorno. That would be a calamitous outcome of European monetary integration.

The fundamental challenge is not financing, but adjustment. Eurozone policymakers have long insisted that the balance of payments cannot matter inside a currency union. Indeed, it is a quasi-religious belief that only fiscal deficits matter: all other balances within the economy will equilibrate automatically. This is nonsense. By far the best predictor of subsequent difficulties were the pre-crisis external deficits, not the fiscal deficits (see charts).

Why do external deficits matter?

First, external deficits mean that residents are spending more than their income and financing the difference abroad. If creditors decide such borrowers are no longer creditworthy (be they private or public), they will cut them off, thereby causing a recession and a plunge into - or deepening of - fiscal deficits. Second, prolonged external deficits also shape the structure and competitiveness of an economy.

Third, sustained deficits lead to huge net external liabilities, often intermediated by banks. When the external lending halts, the banks are likely to implode, undermining both the economy and the fiscal position. As Goldman Sachs notes, the inability to devalue also rules out a way of adjusting net liability positions that has proved helpful to the US and UK. Worse, the only available mechanism - an "internal devaluation" (or falling domestic price level) - will make the burden of external debt even greater. The improvement in the current account balance must then be even bigger than it would otherwise need to be.

Most important of all, people care about what happens to their own country. The inhabitants of a depressed member country will hardly console themselves with the thought that others are booming.

Inside the eurozone, adjustment of imbalances remains essential. But it is also vastly difficult, because the exchange rate has gone. In its place, comes adjustment via depression and default. A currency union with structural mercantilists in the core now threatens a permanent slump in the periphery. Solving that is the true cure. Can it be done? I wonder.

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