By Martin Wolf
Published: November 30 2010 20:21
The fault lines in the currency union stand revealed. The promise was that the eurozone would deliver its members from currency crises. But, as I, and others, warned, be careful what you wish for: credit crises would replace currency crises – and these are likely to be even worse.
Why would a currency union lead to credit crises? One answer is that divergences in relative costs lead to structural trade imbalances – large external deficits when the less competitive economies are close to potential output. The private or public sectors must then spend more than their incomes to sustain full employment. Such excess spending must, in turn, be financed from abroad. In the end, such lending will vanish. If the lending goes via the banking sector, as in Ireland or Spain, there will first be a financial crisis. If the lending goes via the public sector, as in Greece, the crisis will first be in state finances.
A deeper answer is that the common interest rate will appear very low in some member countries. In the eurozone, the fact that global interest rates were low and demand in core economies weak, exacerbated this effect. These ultra-low interest rates triggered asset price bubbles and credit booms in peripheral economies. These, in turn, encouraged construction booms. In these circumstances, what the late John Kenneth Galbraith called the “bezzle” – the stock of financial crime – rises, to emerge in the crash. As the financial system implodes, the economy collapses and the public finances, seemingly strong in the boom, turn sharply for the worse.
The result is a huge credit crisis. Under a floating exchange rate, some of the pressure would be relieved by a rising exchange rate in the boom and a falling rate in the bust. With a pegged rate, the collapse in the currency would normally restore competitiveness and growth, as happened to the worst-hit Asian countries in the late 1990s. In a currency union, these safety valves are lost. Instead, we have a joint credit and competitiveness crisis. The solution for the loss of competitiveness is a sharp fall in prices. But that worsens the credit crisis: this, then, is debt deflation, as Ireland knows.
That is one respect in which a currency crisis is less bad than a credit crisis. But a sovereign default also shakes confidence in the state, which is the foundation of the legal and political order. A banking crisis is almost as harmful. A currency crisis, on its own, simply is not.
This is the context in which the eurozone crisis must be understood. In the old days of the European Monetary System, there would have been currency crises in peripheral countries, whereupon the Greek, Irish, Portuguese, Spanish, Italian and, maybe, other currencies would have collapsed against the old D-Mark. That has already happened to the pound sterling. If Ireland were still in the sterling area, the punt would have fallen with it.
Now the eurozone must tackle its credit crises, instead. It is not doing well. Despite heroic improvisations, indicators of risk on the sovereign debt of the less credible countries have reached exalted levels. Markets ignored risks in the boom and turned savagely against the weaker credits in the bust.
The underlying dynamic is, again, similar to those of currency crises. In the latter, governments feel forced to offer such high interest rates that they undermine credibility, rather than increase it. In credit crises, markets again impose unbearable rates. A credible country enjoys low interest rates that strengthen trust. A country lacking in such credibility faces interest rates that undermine trust. Expectations are self-fulfilling. This is what is now emerging in peripheral eurozone credit: slow-growing countries with large fiscal deficits cannot promise sufficient tightening, given the high interest rates, to strengthen their credibility. Austerity may fail to deliver the credibility it promises.
So what, against this background, needs to be done by individual countries and the eurozone? Not what was done in Ireland, is one answer. The Irish banking system is worse than too big to fail; it is too big to save. The first duty of the state is to save itself, not to load its taxpayers with obligations to rescue careless lenders. If the eurozone is not a “transfer union”, that has to work both ways: taxpayers of one state should not rescue those of others from having to save their banks from their follies.
The Irish state should have saved itself by drastic restructuring of bank liabilities. Bank debt simply cannot be public debt. If bank debt is to be such debt, bankers should be viewed as civil servants and banks as government departments. Surely, creditors must take the hit, instead.
That leaves the sovereigns. What is needed here, as eurozone leaders recognise, is a combination of generous funding with restructuring: the former is to reverse self-fulfilling panics; the latter is to recognise the realities of insolvency. Managing this combination would be very tricky.
Moreover, however helpful such expedients might be, membership of the currency union has transformed the financial position of members, which are deprived of a tame central bank and currency flexibility. As a result, they are far more likely to be driven to outright default than they used to be, as markets realise. The only ways out would be for the European Central Bank to buy the public debt or a fiscal union, with the capacity to bail out members in difficulty. Both are inconceivable. Germany would surely exit first.
So the big question now is not whether the eurozone can avoid a wave of fiscal cum financial crises. The question is whether the union will survive. The article this week by José-Ignacio Torreblanca of the European Council of Foreign Relations in Madrid, with its complaints about German attitudes, suggests the answer might be: no.
This is a political more than an economic issue. It is possible for a currency union to survive sovereign defaults. The question is, rather, whether members believe the arrangement remains beneficial. The difficulty for surplus countries is that they must finance those in deficit, accept external adjustment or push the eurozone into external surplus. The difficulty for deficit countries is that the cost of leaving the eurozone is to face debt crises. If those have happened already, the costs will seem smaller. If they think they have replaced currency crises with credit crises, which do not even restore competitiveness and growth, they may see the union as a bad deal. Political glue could melt. Such calamities do happen. It is now up to the members to see that they do not.
Copyright The Financial Times Limited 2010.
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