Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 6 July 2012

The balance of power in the Eurozone, and the independence of the ECB

                Just over a month ago, I wrote a post entitled ‘Why I can still believe the euro will survive, just’. This was not based on any forecast of the Greek elections, but rather a judgement about the balance of power within the Eurozone. (It is also based, as Paul Krugman points out, on the optimistic belief that the actors concerned recognise this shifting balance.) The talk at the time was all about how Greece would 'have to' leave if they tried to renegotiate their loans. I thought this was not a credible threat, because other Eurozone countries (including but not just Germany) had at least as much to lose as Greece if such an outcome came to pass. Satyajit Das describes the potential losses for Germany here.
                I think the outcome of the recent summit is consistent with that view. Charles Wyplosz is right that it does not represent a sea-change, but the hard line position that Germany had taken has begun to crumble. In part this is because other major countries (Italy, France) have, perhaps for the first time, aggressively argued against that line, but I also think that Germany is beginning to realise how weak its position is. Change will be slow, if only because German public opinion has also to recognise its objective position, rather than staying comfortable on some imagined moral high ground. (For German attitudes on Greece, see here, and for hard line attitudes to banking union, here:HT MT). The problem, as Paul Seabright eloquently points out, is in seeing this as a one sided moral issue, which is why I wrote my – admittedly also one sided – alternative moral tale. For a much more reasonable and interesting discussion between a German (Kantoos) and Greek (Yanis Varoufakis) economist, follow this link.
                Here is just one aspect that contributes to the weakening position of creditor countries like Germany within the Eurozone.

Underlying Primary Budget Balance, OECD Economic Outlook June 2012

2009 
2010 
2011 
2012 
2013 
France
-4.3
-3.4
-1.5
-0.5
1.3
Italy
0.3
1.4
1.6
4.5
6.2
Germany
0.8
-0.1
1.0
0.9
1.1
Greece
-10.1
-4.2
0.4
3.2
5.5
Ireland
-7.1
-4.7
-2.7
-0.8
0.9
Portugal
-5.9
-5.1
-2.3
1.4
2.9
Spain
-7.7
-4.9
-3.3
0.5
3.7

These are the OECD’s estimates and forecasts for the cyclically adjusted primary budget balance (i.e. the budget balance excluding interest payments on debt). Now these figures look much better in 2013 than actual deficits, because all countries are expected to have negative output gaps. But these cyclically adjusted numbers are more meaningful in perhaps two respects.
                First, they show just how much fiscal adjustment has been done by Greece, Ireland, Portugal and Spain, and is expected to be done by Italy. (Sebastian Dullien contrasts this with what Germany has done here.) Too much, too fast, from an economic point of view, but the line that these countries have not done enough is simply absurd. If there is a problem, it is that austerity has been so severe that it has substantially reduced output, masking the true extent of fiscal adjustment. Menzie Chinn analyses how much this has already reduced output. Now an interesting question is why the markets have so far been unimpressed by these national efforts. That brings us to the threat of default.
                It is generally argued that once the actual primary balance moves into surplus, the incentive for a country to default increases because it only needs to borrow to pay interest on its debt. One could make a case that the cyclically adjusted primary deficit, and not just the actual primary deficit, is relevant here. If default was accompanied by a suspension of plans for additional austerity, this would help the economy recover more quickly. In addition, if default was accompanied by Euro exit, after initial chaos devaluation would again support activity.
                Anyhow, the direction of travel is clear. As deficits fall, the options of debtors increase, and the position of creditors gets weaker. For exactly this reason, the chances of default may actually rise (at least as seen by the markets), and so interest rates on this debt may stay high. Only when governments have both achieved primary surplus, and show a clear desire not to default, will the risk premium on debt begin to fall. (Of course you could believe that high risk premiums are all down to critical comments from non-Eurozone economists! I guess we all knew in our hearts that it was Krugman's fault.)  
If nothing else, this analysis shows the folly of using the risk premium as an indicator of fiscal responsibility. (You could put this down as a mistake due to Ordoliberalism.) The combination of a sound fiscal position in terms of flows, but a weak position in terms of a debt burden, may be just the time in which default risk is highest. What the Eurozone has so far failed to do is recognise the nature of this problem, let alone do something effective about it. As Paul DeGrauwe and many others have pointed out, the only institution that can effectively tackle this is the ECB. The means by which it could happen are various, but an ESM bank backed by the ECB would be one of them, and Karl Whelan laments that the ECB seems to have ruled this out.
Unfortunately my balance of power argument has much less force with the ECB, because it is designed to be independent of such influences. Tim Duy is incredulous that the ECB has not come to the aid of Italy and Spain with bond purchases. To quote “Only the most irresponsible policy body would take such a risk.” The problem here may be a deep seated fear of fiscal dominance, which is why I wrote this post. If Eurozone leaders do collectively move on issues like banking union, austerity and growth (albeit much too late and much too slowly to prevent a serious recession), but their efforts are frustrated by the ECB, then John Quiggin may be right that the ECB will go down in history as the central bank where the idea of independence was pushed too far.     

5 comments:

  1. Sea change isn't it? Apart from that, good article. I'm coming round to the idea that the Euro could survive by taking a series of small steps, each at the last minute and thus get from A to B eventually, despite laughing in the face of anyone who suggested B when they were at A.

    ReplyDelete
    Replies
    1. Yep - how did that get past spell check? Thanks.

      Delete
  2. what you and Mr. Dullien are missing:

    a) Dullien
    Germany started the more agressive turnaround Agenda 2010 in 2003 after 10 years of "soft" cost cutting, brutal marginal tax rates of 60% in the 90ties. Underlying changes, like pension adjustments, reigning in private debt, keeping a very tight leash on public salaries already started around 1998.

    Germany had a public debt of just a little over 60 % GDP, and violated the 3% deficit rule just a little bit, end of 2002. The prior rule was, that the European Commission REALLY gets serious after 3 violations, Germany did it 4 times, but at the fourth time (End of 2006) it was very clear, that it is on a very good path. And it became also clear, that 3 years is a little too short in reality. But you aim for 2.5 -3 years and reality then makes it 4 years. If you target 4 years, it becomes 6 -8 years, eeerm, when the next crisis hits already : - )

    Typical example: the recent adjustments in Spain and Italy, and Portugal will need some slight adjustment /extension this fall, too.
    If we take this for the moment and for simplicity as a rule of thumb, with n=4, debt + n * deficit =max debt at turnaround, and debt beyond 90 % critical, beyond 120% very critical, you get an idea, how much short term pain is needed, to avoid long term injury (danger of bankruptcy).

    (Data from CIA world fact book: Spain 68.5 % + 4 x 6.5% = 94.5 %, Germany 81.5% + 4 x -1.7% = 88.3%, but we have to put in growth as well, Germany deficit shrank last year 83.4 -> 81.5%)
    There was no point in restraining public wages in Germany further, in fact, in hindsight we now know that even the 5 x 0.7% cuts, Dullien deplores as too meager, where a little more than needed, making Germany “too competitive”. Well, a 4 % raise this year, another one probably next year, and restraint in the GIPSIs brings everybody closer together.

    b) Your missing
    We have all agreed on the glide path rules of the stability pact:
    demanded surplus = (debt – 60 %) / 20 years
    with a ton of comments needed what “surplus” exactly is : -)
    Germany 81 % debt -> surplus = 1%, resulting in a 2.5 – 3% debt / deficit reduction, well, before, cough, ca 1 -1.5% likely transfers to our lovely neighbors : - (

    What do you want from Germany ? To trot out the posterboy of financial savings, generate 3% surplus, at the cost of reducing demand for GIPSI goods, services, vacations etc. ?

    Or that Germany runs the maximum expansionary politics allowed WITHIN the rules, to compensate for the demand cuts in the other places? The last time Germany scratched the deficits buoys, this is now used endlessly to argue for brutal and endless violations of the 3% rule.
    From my perspective the current path of Germany, expansionary, rising wages WITHIN the agreed limits, is the best for all.

    ReplyDelete
  3. Is the option of default for the debtor countries not limited by the fact that their banking sector holds most of their sovereign debt?

    ReplyDelete
  4. Great article! As a non-economist, but an educated reader otherwise, this is just what I need. I might not fully appreciate the finer points, but I know and understand sooo much more since I started reading the blog.

    ReplyDelete

Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time.