The eurozone is confronted with a crisis of not just labour costs and prices – but culture. The burden is primarily on southern Europe, where sovereign bond credit spreads (relative to the German Bund) range from 370 basis points (Italy) to 1,960 basis points (Greece). The northern eurozone countries have tight spreads against Germany – a narrow 40 to 80 basis points for the Netherlands, Austria, Finland and France. There are thus two distinctly defined eurozone areas: in the north and in the south.
The ranking of credit risk spreads by size across the eurozone in 2010 was almost identical to the ranking of the level of unit labour costs (relative to that of Germany), suggesting that the higher labour costs and prices have rendered “euro-south” less competitive and so more subject to credit risk. The more competitively priced net exports of the northern eurozone participants, in effect, more than covered the rising level of net imports of the south. In short, between 1999 and the first quarter of 2011, there has been a continuous net transfer of goods and services shipped from the north to the south. Northern Europe in effect has been subsidising southern European consumption from the onset of the euro on January 1 1999. It is not a recent phenomenon.
I recall that in the early years of the eurozone there was a general notion in the markets that the Greeks were behaving like the Germans. But there is scant evidence that on embracing the euro southern members significantly altered their behaviour – behaviour that precipitated chronically depreciating exchange rates against the D-Mark. From 1990 through to the end of 1998, euro-south unit labour costs and prices rose faster than in the north. In the years following the onset of a single currency, that pace barely slowed. In fact, the underlying trend was stopped only by the financial crisis of 2008. Since then there have been signs of price level stabilisation in the north and the south.
The ability for the south to sustain its pre-euro financial excess after 1999 was facilitated by borrowings subsidised by the credit ratings of euro-north members. Before 1999, borrowing in the legacy currencies of the south was far more expensive than in the north. But, anticipating the euro, drachma-denominated 10-year sovereign bonds fell more than 450 basis points relative to German Bund rates in the three years leading up to Greece’s adoption of the euro in 2001. Likewise, Portugal’s escudo yields fell almost 375 basis points and Italy’s lira yields fell by nearly 500 basis points in the three years preceding the formation of the eurozone on January 1 1999. Changes in pre-euro entry bond rates for France, Austria, the Netherlands, Finland and Belgium were negligible.
Subsidised borrowing may have accounted for much of the acceleration in the ratio of euro-south consumption relative to that of Germany. It rose between 1995 and 1998 at a 1.26 per cent annual rate. Presumably as a consequence of subsidised euro credit, that ratio accelerated to a 1.63 per cent annual rate of increase between 1998 and 2007.
Euro-north has historically been characterised by high saving rates and low inflation, the metrics of a culture that emphasises longer-term investments rather than immediate consumption. In contrast, negative saving rates – excess consumption – have been a common feature of Greece and Portugal since 2003.
There remains the question of whether most, or all, of the south would ever voluntarily adopt northern prudence. The future of the euro beyond a select group of northern countries with a similar culture will depend on the ability of all eurozone nations to follow suit.
Failing that, the eurozone will not have the ability to address the key concern of currency-pooling arrangements: that the value created by a pooling arrangement tends to be distributed disproportionately in favour of the financially less collegial and less prudent members of the pool. We observed this tendency as growth of the south relative to Germany accelerated following the creation of the euro. Thus, unless restrained, the less collegial members of the pool will try and often succeed in exploiting their advantage, as Greece so brazenly did recently.
If the euro is to remain a viable currency across the eurozone, members must behave in the responsible manner contemplated in the Maastricht treaty. But it is not clear that culture, so integral to a nation’s personality, can be easily altered. As Kieran Kelly noted last week: “ . . . if I lived in a country like this [Greece], I would find it hard to stir myself into a Germanic taxpaying life of capital accumulation and arduous labour. The surrounds just aren’t conducive.”
It seems inevitable that for the euro to prevail, something more formidable than the failed stability and growth pact is needed to constrain aberrant behaviour. It may be that nothing short of a politically united eurozone, or Europe, will, in the end, be seen as the only way to embrace the valued single currency.
The writer is former chairman of the US Federal Reserve
The focus must be on solving the immediate crisis of confidence
Alan Greenspan correctly identifies the north-south divide between the surplus countries in northern Europe and the deficit countries in the south as the main force that drives the eurozone apart. Its leaders recognise this and have agreed to a ‘pact for the euro’ that will tighten the fiscal discipline needed for a common currency area to survive. The pact, agreed at the European Union Summit on March 25, seeks to impose much closer economic and financial surveillance through balanced-budget amendments and by monitoring unit labour costs to ensure they are in line with productivity growth.
This is all fine, but the immediate problem facing the eurozone now is a loss of confidence. It has driven credit spreads to all-time highs. Countries such as Italy and Spain, which are illiquid but solvent, must pay a high risk premium to roll over their debts. This premium raises debt service costs and will eventually undermine their solvency, triggering a further increase in credit spreads. European policymakers fully understand that it is essential to break this vicious circle by making it possible for these countries to borrow at lower interest rates. Indeed, the eurozone parliaments are in the process of revising the European financial stability facility’s charter to permit the bail out fund to make loans to countries such as Spain and Italy that have not lost access to the markets, to enable them to fund their deficits more cheaply and to recapitalise their banks.
Will this be enough? With contagion risking to spread even beyond Spain and Italy to France and Belgium, the answer is almost certainly no. Given the size of these countries’ gross borrowing needs, the €250bn the EFSF will have available – after allowing for prospective commitments to Greece, Ireland and Portugal – will not be enough to “wow” markets. European policymakers are said to be looking into ways of leveraging EFSF resources, possibly with the help of the European Central Bank, to increase its firepower.
The problem is not just dealing with the flow of debt service payments falling due, but also with the debt overhang of countries such as Greece, which is insolvent. Markets know that attempts to restore fiscal sustainability via austerity in the midst of a deep recession are bound to fail. What is needed is debt reduction. The agreement reached in the Eurogroup summit meeting on July 21 to “bail in” private creditors through a 21 per cent haircut on the Greek government bonds they hold is insufficient to restore Greek debt sustainability. Hopefully the haircut will be revised to something closer to 50 per cent to reassure markets that there will not be a re-restructuring of the Greek debt down the road. If so, new stress tests will be needed to assess bank recapitalisation needs.
Mr Greenspan is correct that greater political union is needed in Europe. The groundwork already has been laid with the ‘pact for the euro’ and the constitutional amendments to a balanced budget that will be required of all eurozone members. But first, the immediate confidence crisis and the debt overhang need to be addressed.
The writer is senior strategist at IJPartners, a wealth management company based in Geneva.