By Martin Wolf
Published: November 23 2010 22:27
If any good can come out of the Irish disaster it is via the realisation that the classic German perspective on the problems of the eurozone is mistaken. Any currency union among diverse economies is bound to be a risky venture. But, with mistaken ideas about how it should work, it may prove calamitous.
What, then, is this canonical perspective? It is that the core problems of the eurozone are those of fiscal incontinence and economic inflexibility and so the right solutions are fiscal discipline, structural reform and debt restructuring. Ireland, however, is not in difficulty because of fiscal failings, but because of financial excesses; Ireland has needed rescue, notwithstanding its astonishingly flexible economy; and an emphasis on restructuring of debt has, predictably, triggered a crisis. These realities should make Germany rethink. Will it? I doubt it.
Ireland is nothing like Greece. Back in 2007, Ireland’s net public debt was just 12 per cent of gross domestic product. This compares with 50 per cent in Germany and 80 per cent in Greece. Spain, too, had net public debt in 2007 at just 27 per cent of GDP. If the fiscal rules had been applied as ruthlessly as German policymakers say they now want (though their predecessors resisted their application to themselves in the early 2000s), they would have affected France and Germany more than twice as often as Ireland or Spain between inception of the eurozone and the current wave of crises.
It was not the public but the private sector that went haywire in Ireland and in Spain. In the low interest rate environment caused principally by chronically weak demand in core European countries – Germany’s real domestic demand was a mere 5 per cent higher in 2008 than in 1999 – asset prices and credit exploded in several peripheral countries, particularly Ireland. An expansionary monetary policy has to work in much this way, somewhere. Moreover, until November 2007, spreads of Irish and Spanish public debt over German levels were next to zero. Nor is it surprising that private suppliers of credit failed to discipline the boom: they caused it.
Then came the “Minsky moment”. Financial markets changed state, asset prices collapsed, all the dreadful lending emerged into view and the Irish government rushed to guarantee its banks. The combination of the guarantees with huge fiscal deficits caused by private sector retrenchment – the Irish private sector will run a financial surplus of 15 per cent of GDP this year, according to the International Monetary Fund – has caused an explosion of public indebtedness. But this calamity is the consequence of the crisis, not its cause. Moreover, the notion that Ireland might have run a fiscal surplus big enough to offset the destabilising impact of the private sector boom is ludicrous. This was also not required by the treaties, which take no account of private sector misbehaviour.
So much for the causes. Now consider the solutions. Ireland is certainly not lacking in flexibility. On the contrary, its unit labour costs have collapsed, relative to Germany’s. This gives the country a good chance of growing out of its difficulties, in the long run. But, in the short run, the fall in wages and prices worsens the overhang of euro-denominated indebtedness. Under pressure, Ireland has also imposed fiscal retrenchment. But deflating an economy suffering from the collapse of an asset price bubble often fails to work, though Ireland, as a small open economy, has a better chance of exporting its way out than other vulnerable eurozone members.
Unfortunately, while Ireland was trying to achieve just that, the members of the eurozone agreed to introduce a sovereign debt restructuring mechanism, at the behest of Germany. In fact, the agreement on October 18 between Angela Merkel, Germany’s chancellor, and Nicolas Sarkozy, France’s president, to seek a treaty revision to introduce such a mechanism triggered bond sell-offs in Greece, Ireland and Portugal (see chart). This, in turn, helped cause the renewed bout of panic.
As Leuven University’s Paul de Grauwe, a fierce critic of these ideas, notes in a paper for the Centre for European Policy Studies, legitimation of sovereign debt restructuring is sure to create speculative runs. Instead, he recommends the creation of a large European monetary fund, to fund needed adjustment. The case for this is that the private sector creates self-sustaining excesses on the upside and the downside. By assuming the worst, it makes dire outcomes almost inevitable. This provides the case for such a crisis lender. This does not preclude debt restructuring, but that should happen only when adjustment is infeasible. Without liquidity support, however, retrenchment alone will too often fail to turn adverse sentiment round, because investors find the promise of ever harsher austerity unbelievable. Default may then be unavoidable, even if it would be unnecessary with less onerous terms on borrowing.
Evidently, the German view of how to proceed reflects more than the convictions of its elite. The hostility of the public to “bail-outs”, even if they were to get their money back, plus the role of its constitutional court, make its demands inevitable. The big question, however, is whether a monetary union run on German lines can work.
At best, reliance on fiscal disciplines and sovereign debt restructuring is sure to generate massively pro-cyclical policy. At worst, it will generate serial depression and default among member countries. Moreover, this is also a global problem: the emphasis on deflationary adjustment in weaker countries risks turning the eurozone as a whole into a gigantic Germany, dependent on importing demand from the rest of the world. As Philip White has noted in a paper for the pro-European Centre for European Reform, the eurozone is far too large to play such a role in the world economy. Thus, the question of imbalances within the eurozone is inescapable, however much Germany may wish to resist such a discussion.
The crisis is a huge challenge for Ireland, which should surely convert unsecured bank debt into equity rather than force its citizens to bail out all the improvident lenders. But the Irish case also shows that the German view of how the eurozone should work is mistaken: fiscal sloppiness is not the main problem and fiscal retrenchment and debt restructuring are not the sole solutions. One cannot learn from history if one does not understand it.
Copyright The Financial Times Limited 2010.
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