Emergency repairs
May 13th 2010
From The Economist print edition
A promised huge rescue fund and central-bank help for indebted governments have eased the euro area’s crisis. The respite must be used wisely
FOR weeks, Europe’s policymakers have stood accused of doing too little, too late as the sovereign-debt crisis that engulfed Greece threatened to spread to Portugal, Spain, Ireland and perhaps elsewhere. By May 7th, as yields on vulnerable euro-area countries’ government bonds rose sharply, there seemed to be a real threat that foreign financing for these countries would stop. That in turn raised fears about the exposure of banks to European governments and private borrowers. Europe’s Lehman moment, it seemed, might be at hand.
The European Union’s policymakers were forced to act with unaccustomed speed and unprecedented force. In the early hours of May 10th finance ministers, meeting in Brussels, agreed on an extensive scheme of repairs for the euro zone. The biggest stack of financial scaffolding is a “stabilisation fund”, worth up to €500 billion ($635 billion). This includes €60 billion to be financed by EU bonds that can be sold fairly quickly—as much as can be raised over three years without breaching the union’s budget ceiling. This element had to be approved by EU members, such as Britain, which do not use the euro, because their taxpayers would also be on the hook were the money not repaid in full. (It is an extension of a similar €50 billion fund for non-euro countries with balance-of-payments problems.) The stabilisation fund would be supplemented by up to €250 billion more from the IMF.
In addition, the European Central Bank (ECB) said it would purchase government bonds to restore calm to “dysfunctional” markets. It will offer banks unlimited cash at a fixed interest rate at its next two scheduled three-month financing operations on May 26th and June 30th. The ECB also reopened credit lines that had been put in place in the autumn of 2008, in post-Lehman days, with the Federal Reserve, the Bank of England, the Bank of Canada and the Swiss National Bank, so that it will be able to lend European banks dollars and other currencies.
Financial markets’ initial response was euphoric. Germany’s stockmarket closed more than 5% higher on May 10th. France’s main index went up by almost 10%: big French banks are heavily exposed to Greece, so they stand to benefit from a guarantee of rescue. The yield on ten-year Greek government bonds plunged from more than 12% to less than 8%. Yields on comparable Irish, Italian, Portuguese and Spanish bonds also fell sharply—mostly, it seems, because of purchases by the ECB (see chart 1).
However, this giddy joy soon gave way to a more sober view, for three main reasons. First, the rescue plan has a patched-together feel. Many of the details are still missing. Second, the fact that the ECB is buying the debt of euro-area governments raises questions about the central bank’s much-trumpeted independence of politicians—and hence about its credibility as an inflation-fighter. And third, the package, impressive though its scale and speed may be, only buys time for troubled governments to cut their budget deficits and put in place structural reforms needed to improve their lost export competitiveness. If that time is wasted, even worse trouble may lie ahead for the euro zone’s policymakers and their fellow citizens.
International rescue
Start with the rescue plan. Its mainstay is the promise of up to €440 billion over three years from a “special-purpose vehicle” to be set up by the 16 euro-zone countries, which will control the disbursement of money and guarantee the vehicle’s financing. The scheme is open to EU countries that do not use the euro: Poland and Sweden say they will sign up to it; Britain says it will not. At Germany’s insistence the money will be raised and overseen by governments. The Germans do not want Eurocrats raising and handing out too much money without close monitoring from national capitals.
That much is plain. Further details of the scheme’s workings, however, remain sketchy. It is not clear, for instance, whether the pool will raise money in anticipation of a funding emergency or only when it is needed, which is how the balance-of-payments fund operates. The interest rate to be charged for access to funds has not been decided—a detail that delayed the Greek rescue package for weeks.
The IMF has not yet spelled out the precise size and nature of its promised contribution, although it seems that some finance ministers were in contact with fund officials during the late-night talks. The ministers expect the IMF to chip in “at least half as much” as European countries, just as it did for the rescue of Greece and, before that, for Latvia.
These elements of the rescue plan would take a while to become fully operational—too long, perhaps, for jittery financial markets to wait. That is what made the ECB’s participation necessary: it is the only institution that could react rapidly enough. However, the role of the central bank raises a second set of concerns.
Some of these are easier to assuage than others. By buying government bonds, the ECB is pumping money into the economy. This is potentially inflationary. However, the central bank says it will soak up the cash, for instance by selling instruments of its own, so that monetary policy will not in fact be loosened.
More niggling is the suspicion that the ECB has caved in to political pressure to help out spendthrift governments. As recently as May 6th, Jean-Claude Trichet, the central bank’s president, said that the ECB’s 22-strong governing council had not even discussed buying bonds at its regular monetary-policy meeting. Four days later the bank was doing just that. Not every member of the council was happy with the change of heart, even though Mr Trichet insisted it was backed by an “overwhelming majority”. Axel Weber, the head of the Bundesbank, Germany’s central bank, and a leading candidate to succeed Mr Trichet when he steps down next year, voiced his criticism to Börsen-Zeitung, a German financial newspaper.
Mr Trichet has denied that the ECB was pressured into buying bonds, saying that the central bank was “fiercely and totally independent”. Yet the ECB looks a different animal from what it was when the fiscal crisis began. Last year it balked at buying government bonds when other central banks were doing so as an emergency extension of monetary policy—ie, to hold down the interest rates at which firms and households could borrow and to get money flowing through the banking system. Now it finds itself providing explicit support for European governments’ fiscal policies, which is a far bigger threat to its reputation for independence. It is influencing the borrowing costs of euro-zone governments directly, without much of a guide to what the rates on their bonds should be.
This is not the only sharp U-turn Mr Trichet has had to perform recently. He opposed the IMF’s involvement in the Greek rescue, then welcomed it. And he said the central bank’s rules on what constituted acceptable collateral should not be altered to suit one country, only to change them to ensure that Greek bonds could be exchanged by banks for ECB cash. The central bank’s credibility relies in part on a reputation for living up to its pledges and partly on its disdain for political expediency. On both counts, it has lost something.
The loss need not be fatal. As one senior policymaker puts it, it is one thing to be independent of politicians but quite another to have discussions with them in a crisis. It was the flaws in the construction of the euro that forced Mr Trichet’s hand, not a lack of fortitude under political pressure. The ECB had to step in to head off the threat of a run on Irish, Portuguese and Spanish bonds (and maybe some banks) because no other euro-zone institution could do so. Equally, the ECB could scarcely refuse Greek government bonds as collateral for central-bank money even if they were junk. To do so would be to deny Greece one of the privileges of membership. It might even have been illegal.
Gouvernement économique
The third cause for concern is what the euro area’s governments will do with the time the rescue package buys them. Already, countries that have been dilatory in cutting their deficits have pledged to be more resolute. Portugal’s government, which clocked up a deficit of 9.4% of GDP last year, has said it will delay plans to build a new airport, to follow a recent promise of cuts in unemployment insurance. On May 12th the Spanish prime minister, José Luis RodrÃguez Zapatero, announced that civil servants’ pay would be cut by 5% from June and frozen next year. Ministers’ pay will be slashed by 15%. It is hoped that this and other measures, including a €6 billion reduction in public investment, will cut Spain’s budget deficit from 11.2% of GDP last year to just over 6% in 2011. “The situation is difficult and it would be nonsense to hide it,” said Mr Zapatero.
However, keeping up the pressure on countries with big deficits may prove difficult with a safety net in place. After all, the rescue package is, in effect, an attempt by policymakers to convince investors that euro-zone sovereign debts are collectively insured: the debts of one are guaranteed by all. The idea that the €440 billion scheme will be retired after three years is hard to believe: it is difficult to withdraw a guarantee once it has been given. All governments, even that of reluctant Germany, understand that they have taken a step towards a kind of fiscal federalism. Indeed euro-zone policymakers are now scrambling to claim the plan as their own so that they can set the terms for the economic co-ordination and surveillance that it entails.
For many, the fallout from the Greek crisis has proved what they had suspected all along: that the euro zone needs more fiscal co-ordination in order to work. If its members are to underwrite each other’s debts, they will demand more say in each other’s budget plans. The stability and growth pact, the scheme that was meant to limit euro-area countries’ budget deficits to 3% of GDP and public debt to 60% of GDP, has clearly failed.
That still leaves Europe’s policymakers grappling with the problem of how to impose fiscal discipline. On May 12th the European Commission set out proposals for strengthening the EU’s “economic governance”. The commission said budget plans and economic reforms should be subject to peer review before they reach national parliaments. Breaches of budgetary rules should be punished faster—by withholding funds from the EU budget or by fines, placed in an interest-bearing account pending remedial action. It is easy to think of other possible sanctions but harder to work out how they could be imposed.
Lax countries could be threatened with harsher terms on borrowing from pooled funds. Sinners could lose access to ECB support. The trouble is, these sorts of threats are empty as long as they impose costs on those who would dole out punishment. Fiscal surveillance in the euro area has failed because the punishers fret that one day they might be the punished, or because the strong financial links between euro-area countries mean that any punishment would undermine the currency zone’s stability.
Budgetary discipline will be only one part of euro-zone surveillance—and perhaps not the most important part. The commission also wants to monitor trade imbalances and the build-up of foreign debts. Greece, Ireland, Portugal and Spain have become heavily reliant on foreign capital, racking up big current-account deficits year after year (see chart 2) and hence accumulating ever larger foreign debts. Portugal is deepest in hock: its net international debt (what it owes, less its foreign assets) rose to 112% of GDP last year. Roughly half of that total was public debt. Spain, Greece and Ireland are also heavily in debt.
What makes this problem so acute is that very little of the foreign capital in these countries is greenfield direct investments, like new factories, or purchases of shares in big firms listed on stockmarkets—the kind of money that tends to stick around and can bear losses. The bulk of it is either government bonds or short-term money that has been funnelled through the banking system to fund mortgages and loans to small firms, and is more likely to disappear in a crisis. Portuguese banks’ net foreign debts were around 46% of GDP last year. These credit lines need to be rolled over regularly and their price and availability depend on the creditworthiness of the government. In the fallout from the Greek crisis, the market’s confidence about Ireland, Portugal and Spain was draining away. As the yields on their government bonds rose at the end of last week, there seemed to be a real threat that foreign financing would come to a sudden halt.
Dependence on foreign capital in these countries is both symptom and cause of a deeper problem: a lack of export competitiveness. Cheap foreign credit fuelled the booms in domestic demand in Greece, Spain and Ireland in the years after the euro’s launch in 1999. That pushed up unit-wage costs relative to those in the rest of the euro area (notably super-competitive Germany) and cost competitiveness declined steadily (see chart 3). Consumer booms also skewed industrial structures away from firms that export to those that serve the domestic market and are more sheltered from foreign competition.
Reversing those trends will be hard, but essential if countries are to service their foreign debts from export earnings. Devaluation, the usual route to rebalancing, is not open to countries in the euro area. They must find ways of cutting labour costs and boosting productivity. Ireland has already reduced wages; Spain made a start this week. Granted, lower wages will make mortgage debts harder to service. But the choice is between lower wages and higher unemployment, which is already in double digits in Portugal and Ireland and close to 20% in Spain. It will not be easy to dismantle Portugal’s and Spain’s complex wage-setting agreements, which set a floor to industry pay. But firms, especially small ones, should be allowed to opt out of such arrangements so that they can better match labour costs to productivity.
Export or die
Policy should also be directed at shifting resources to exporters. One complaint in Portugal is that the monopolistic state of some service industries serves only to reinforce existing imbalances. The best graduates want to work for telephone and energy companies because they pay well, thanks to the profitability that comes from market power. The lack of competition imposes costs on firms, including exporters, which are forced to use their services; and weak competition reduces productivity more generally. That makes measures to boost competition in services all the more vital. A report on strengthening the single market by Mario Monti, a former EU commissioner, was issued on May 10th.
Tax policy can also help, where fiscal consolidation allows it. Increasing levies on spending, such as value-added taxes, while reducing taxes on jobs would shift economies away from domestic demand, mimicking a devaluation. Countries that habitually run a trade surplus (Germany, Belgium, the Netherlands and Finland) need to mirror the reforms in deficit changes with policies to promote stronger domestic demand and a shift away from an emphasis on exporting industries.
The transition to a more competitive economy will be painful. Politicians have not prepared electorates for difficult times. Running up debts is fun; paying them off is not. In an ideal world, the pain of a structural-reform programme would be cushioned by an expansionary fiscal policy. That is a luxury that Spain, Portugal and the rest can no longer afford.
The fall in the euro will help. It cannot help high-wage countries compete with Germany, but it gives their firms a chance against imports from outside the euro zone. Economic logic as well as market sentiment points to further euro weakness. Business cycles favour it: America’s recovery is more advanced than Europe’s. Figures released on May 12th showed that the euro-area economy grew by 0.2% in the first quarter: America’s economy expanded four times as quickly.
Monetary conditions should also hold the euro down. The pressure to tighten fiscal policy in some parts of the euro area will make it hard for the ECB even to consider raising interest rates. That will weigh on the euro and will also help indebted households in Spain, Portugal and Ireland, where mortgage rates tend to track the ECB’s benchmark interest rate. The euro is still dear against the dollar on gauges such as purchasing-power parity, notwithstanding its recent slide.
The measures announced this week offer countries a chance, perhaps their last one, to put things right. There are some hopeful signs. Portugal started to introduce some modest reforms to jobs and product markets after 2005. Its economy grew by an impressive 1.7% in the year to the first quarter—about as fast as Germany’s—which suggests that its efforts to reorient itself may be paying off.
It would be wrong to conclude that, in trying to get ahead of the crisis, the euro zone’s policymakers have already gone too far. The threat that Portugal and Spain might be cut off from credit markets, triggering a meltdown in Europe’s financial system, was all too real. The rescue effort will dent the ECB’s reputation as a single-minded inflation-slayer. There is still a risk that the insurance provided by the rescue scheme may leave countries that benefit from it a bit less minded to cut deficits and reform their economies. But those faults, real as they are, must be set against the potential costs of doing nothing.
Copyright © 2010 The Economist Newspaper and The Economist Group. All rights reserved.
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