Update: Read Gavyn’s comment on the likely outcome of the emergency summit in Brussels.
Ever since Italy was sucked in to the European debt crisis a couple of weeks ago, commentators have warned that there has been a profound transformation in the nature of the crisis, which requires an equally profound change in the political response from Europe’s leaders. Ahead of tomorrow’s European summit, no such response appears to be forthcoming.
By all accounts, the summit will focus primarily on Greece. In addition to new loans, we should see some genuine debt relief for Greece, finally attacking the solvency issue, and not just the liquidity problem. With luck that might remove Greece from the limelight for some time. Eventually, similar programmes will become inevitable for both Ireland and Portugal. But it is still far from clear whether any of these countries will be able to implement the fiscal tightening they are promising. And the wider systemic issues which are now plaguing the eurozone will be left completely unresolved.
Helmut Kohl and Francois Mitterand in 1994. Image by Getty.
It would be a gross understatement to say that European leaders are finding it difficult to craft an adequate response to the problems they face. The current generation of leaders certainly suffers by comparison with their fabled predecessors. Can the Merkel/Sarkozy combination really be compared with Schuman/Monet, Adenauer/de Gaulle, Schmidt/Giscard, and Kohl/Mitterrand? I think not.
But it is also true that some of today’s problems are beset by genuinely intractable elements which any generation of Europe’s leaders might have struggled to resolve. These all come down to one central fact: the eurozone is not a single nation state, yet it has some of the elements and institutions of a nation state. It is a halfway house, and therein lies the problem.
Imagine what would happen if the eurozone were a genuine single nation. The debt issued by that nation would of course be backed by the taxpayers of the entire union, and sitting behind them would be a mighty central bank, the ECB. Viewed as a single nation, the public accounts of the eurozone (EZ) would look very good. The EZ public debt ratio would be 88 per cent of gross domestic product, compared with 99 per cent for the US. The EZ budget deficit would be 4.4 per cent, compared to 10.8 per cent in the US. In other words, if the EZ were a nation state, sovereign default would be inconceivable, and bond yields would be around 3 per cent.
Surely, then, the solution to the European debt problem is fairly straightforward. Why not just create pan-European organisations which are backed by the entire EZ, and have them absorb all of the debt issued by the weaker sovereigns such as Greece? Many economic commentators have proposed mechanisms which would do precisely that.
The only problem is that those countries, such as Germany, which would have to foot the bill for a budget sharing plan (or a fiscal transfer union, or a eurozone bond issue, which are all variations on the same theme) show no appetite for sanctioning such action on the scale needed to solve the problem. There has been a tendency for economists to portray the attitude of these countries as short-sighted and obstructionist. But there are in fact some very good reasons for their intransigence.
One is the cost of the measures required. In a fiscal union, the bond yields of the most indebted countries would fall sharply, while the yields paid by the least indebted (notably Germany) would certainly rise. I have seen estimates which indicate that this would involve a cost to Germany of 1.8 per cent of GDP per annum. Even if the cost could be brought down to much less than this, by restricting the pan-European portion of the bond market to well below 100 per cent, it would still be substantial.
Inside a nation state, transfers of this scale, and more, routinely occur between rich and poor regions. In fact, this is one of the key reasons for having a national budget in the first place. But such transfers have never seemed remotely possible inside the European Union, because there is insufficient “community spirit” to make them politically feasible. Americans from all 50 states of the union feel part of a much bigger entity. Europeans from the member countries in general do not, or at least not to the same extent.
And there is another big stumbling block to fiscal union: moral hazard. How do you impose budgetary discipline on countries such as Greece, after they have benefited from a German guarantee on their debt?
The central budgets of most nations, like the US, are very large relative to the local budgets of states, cities or regions. The majority of taxation, and the majority of government spending, is conducted by the centre, not by the regions. Therefore, as John Kay argues today in the FT, it is possible in the US to allow the states to go bust without creating havoc at the federal level. But in Europe, the relative size of the central budget, and the budgets of the member countries, are precisely the other way around.
Inside the eurozone, the EU has only a tiny budget, while many member countries are too big to fail. The markets would know that if there were a budgetary union. Consequently, such a union would need a watertight mechanism to ensure that some countries were constrained from borrowing too much, on the back of the fiscal credibility of others. These mechanisms have failed in the past. In the end, the only way of eliminating moral hazard would be to shift much more of the tax and spending decisions to a central EU budget – a genuine national budget for a genuine nation state.
The eurozone is a very long way from that state of affairs. It is not a nation state. And that explains why it is having so much trouble fixing what many economists think should be a relatively straightforward problem.
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