The eurozone needs more than discipline from Germany
By Martin Wolf
Published: December 21 2010 22:22
Germany rules. It will determine how well the eurozone prospers, maybe even whether it survives. It is the central European power – geographically, politically and economically. France knows this. The question is how Germany will use its power. The answer will depend not just on how it sees its interests but on how it understands events. I am much more concerned about the latter than the former.
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My colleague, Wolfgang Münchau, has defined the objectives of the German government as “limited liability” – do enough to keep the eurozone afloat, while minimising the exposure of German taxpayers. This stance is not uncontroversial, even in Germany. The article by Frank-Walter Steinmeier and Peer Steinbrück, the German foreign minister and minister of finance between 2005 and 2009, in the FT of December 15 demonstrates that. It proposes a combination of a “haircut” for debt holders, debt guarantees for stable countries and limited introduction of Europe-wide bonds, accompanied by better-aligned fiscal policies. But Angela Merkel, Germany’s iron chancellor, rejects guarantees or European bonds. Her proposal is tougher fiscal discipline, along with limited emergency financing, at high interest rates, with deficit countries forced to make rapid and brutal adjustment.
My colleague, Wolfgang Münchau, has defined the objectives of the German government as “limited liability” – do enough to keep the eurozone afloat, while minimising the exposure of German taxpayers. This stance is not uncontroversial, even in Germany. The article by Frank-Walter Steinmeier and Peer Steinbrück, the German foreign minister and minister of finance between 2005 and 2009, in the FT of December 15 demonstrates that. It proposes a combination of a “haircut” for debt holders, debt guarantees for stable countries and limited introduction of Europe-wide bonds, accompanied by better-aligned fiscal policies. But Angela Merkel, Germany’s iron chancellor, rejects guarantees or European bonds. Her proposal is tougher fiscal discipline, along with limited emergency financing, at high interest rates, with deficit countries forced to make rapid and brutal adjustment.
Germany’s dominant position is not just the result of its economic size. It is more because it is the largest creditor nation with the best sovereign credit.
When countries with external deficits run out of foreign providers of private credit, they become dependent on foreign sovereigns. That is happening in the eurozone. The power of the creditors is simple: in the absence of their support, deficit countries will be driven into default. The consequent collapse of credit will, in turn, impose rapid cutbacks in spending and a huge recession. This recession, in turn, will make the public finances yet more unmanageable. The downwards spiral will also impose costs on surplus nations, since they must write down their assets and lose export markets. But their surplus position allows them to expand domestic demand, instead. In crises, the mercantilists rule. So it is now in the eurozone.
In deciding what to do, Germany first has to determine its own interests. These are more than narrowly financial. The embrace of its neighbours, inside the European Union, has been a pillar of German postwar policy for excellent reasons: isolated, Germany proved a calamity for its neighbours and itself. Moreover, a recreated D-Mark would soar in value, with devastating impact on the competitiveness of Germany’s exports. For both reasons, maintaining the eurozone is in the enlightened self-interest of Germany, so long as the euro remains a stable currency, in terms of domestic purchasing power, as it surely will.
The issue, then, is not whether to preserve the eurozone, but how. The crucial requirement is understanding rightly what has gone wrong. It has not, as conventional wisdom now goes, been a fiscal failure, except in Greece. It’s the private sector, stupid!
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An excellent new report from the Organisation for Economic Co-operation and Development makes this point very powerfully. Countries with weak domestic demand and competitive external sectors generated surplus savings, in Germany’s case mainly among households, which flowed into their banks. As the eurozone integrated, the excess of deposits over loans in surplus countries flowed to deficit countries, where banking sectors were short of deposits. This, one might argue, was meant to happen.
Unfortunately, given low eurozone nominal interest rates and their buoyant economies, deficit countries had very low real rates of interest. The consequent asset price bubbles were fuelled by foreign borrowing: by 2007, Ireland’s net liabilities to foreign banks were 204 per cent of gross domestic product (see charts).
Ireland and Spain had strong fiscal positions throughout: it was private borrowing that ran amok. True, when the crisis broke, the fiscal picture worsened dramatically.
But it was only at this late stage that fiscal discipline bit as private creditors fled. Thus fiscal disciplines have tended to be disastrously pro-cyclical.
What are the implications for the future of the eurozone? It faces two challenges: dealing with the present mess and longer-term reform.
On the former, the needs are to finance the fiscal contraction of those that can still cope, implement debt restructuring by those who cannot cope and refuse to push sovereigns into bankruptcy to make creditors of their failed banks whole.
Meanwhile, if they are to thrive inside the eurozone, the deficit countries will have to engineer a painful reduction in nominal costs. That means deep labour market reforms. It would help if demand took off in the eurozone core, too.
On longer-term reform, there is a big debate over whether a fiscal union is needed. It depends on what one means by such a union. Among the necessary conditions for successful operation of the union are fiscal financing of adjustment, to avoid unnecessary sovereign defaults, and financial sector reform. On the latter, it is evident that if one wants the financial system to be reasonably crisis-proof, it needs to be diversified across the eurozone. Banks that lend only in one country, particularly a small one such as Ireland, are very vulnerable. Provided it is possible to ensure that shareholders and creditors bear financial losses, that need not be an issue. Alas, this seems inconceivable. The conclusion is that there must either be adequate eurozone fiscal capacity to bail out big and diversified banks, wherever domiciled, or that these institutions must be based in large countries with solvent governments.
Alongside a more integrated financial system, the eurozone will also need effective macro-prudential controls on lending. The key to all this is to recognise that private, not public, finance, has been the Achilles heel of the system.
The German government surely does intend to do what is needed to keep the eurozone together. But the eurozone it has in mind will be desperately uncomfortable for many members. This is largely because the failings of the eurozone have not been fiscal irresponsibility, but macroeconomic divergence, financial irresponsibility, asset price bubbles, and huge shifts in competitiveness. If the eurozone is to work better, it must manage these disorders. The challenge is to design a system that will do this.
Germany has to play the leading role. Should it fail, it may wake up to find it has lost the eurozone, in a fit of absence of mind.
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