Northern Ireland Assembly and Business Trust
Debating Europe: Challenges and Opportunities Over the Next Decade
The Implications for the UK of the Sovereign Debt Crisis and Euro Zone Economic Governance
Thursday 7 February 2013
Dr Lee McGowan (Queen’s University Belfast): Good afternoon, everyone. I work in the School of Politics, International Studies and Philosophy at Queen’s University. It is a pleasure to welcome you here to this particular seminar and the series on Debating Europe in general. This is the first of the six themes that we have had the honour of hosting here, and, hopefully, you will enjoy this.
The series has been jointly organised and put together by the School of Politics and the Northern Ireland Business Trust and has been supported by the European Commission representation office in the UK. Our aim for the duration of this seminar series is to address six very salient themes that really go to the heart of contemporary European issues, issues of governance and key themes that will be debated over the next 10 years. It will address straight political issues, economic issues and social issues, and some of the themes still to come deal with competitiveness, the whole idea of social inclusion and exclusion and Euro-scepticism.
The series has been designed to go way beyond the academic remit and to bring in policymakers, politicians, people from the business world, the public sector and the voluntary sector, students and wider civil society to come and hear more about the European Union and to get engaged with what is going on and the structure and themes as we begin to hear more about them or should do in the press as we move, maybe, towards a referendum in about four or five years’ time.
Today’s theme is, without doubt, one of the most salient. It deals with the whole issue of the euro and the euro zone and what the implications of being or not being in the euro zone might be. Our guest speaker today is my colleague Dr Andrew Baker. This is his field. He specialises and teaches in international political economy, globalisation and, in particular, the politics of the G8. He is very interested in how the international management of money and finance relates to politics, power and wealth distribution. His research has examined how global financial orders are created and sustained, and much of his research has focused on the political and social dynamics that influence and drive the evolution of the institutions and practices for governing global finance. We will begin to tease out some of those issues after the presentation.
I have two small points to make at the beginning. This session will be recorded, and I say that because, if people want to look at a transcript of the session afterwards or know people who might want to see it, we will direct you to the website where you can find that. One of our ideas is that we want to try to engage with as wide an audience as possible, so we are putting all of these up as podcasts. I will be very grateful if, at the end of the session, you can fill out the evaluation sheet in your packs. Let us know what you thought of the event. Was it the right theme? Would you like a different theme? Was it too long or too short? Please fill those in and hand them back to us at the end. I will introduce Andrew in a few seconds’ time, and, at the end, there will be a Q and A session. Feel free to ask as many questions as you want of Andrew. I am sure that he will be delighted to answer them. I think that it will be a very topical debate and that it might be quite a controversial little theme. Let us see how it all begins and takes shape. Without further ado, I pass you over to my colleague Dr Andrew Baker.
Dr Andrew Baker (Queen’s University Belfast): Thank you, Lee, for your kind introduction. Thank you all for coming and listening today. As you will see, I have tweaked the initially circulated title slightly. I will talk more about that later.
I will begin by taking the liberty — it is a bit of a liberty — of reading you a letter from a senior incumbent European politician:
We have been telling you for the past three years that the reason we have rising employment is because states have spent too much. This is why we need to return to sustainable public finances. However, the explosion of sovereign debt is a symptom, not a cause, of the crisis we find ourselves in today. The biggest banks in the core countries of Europe bought considerable sovereign and private debt from their neighbours. This flooded these countries with cheap money to buy products from core countries, hence the current account imbalances in the euro zone that we hear so much about and the consequent loss of competitiveness in some parts of Europe. Following bond market contagion, triggered by the threat of default on Greek debt, it became clear that the institutions we designed to run the euro zone were not well equipped. Liquidity dried up, and our bond repayments dramatically increased.
The problem is that we have given up our right to print our currency and set independent exchange rates — our economic shock absorbers — so that we could join the euro. Meanwhile, the European Central Bank, the institution that was supposed to stabilise the system, is not equipped. It exercises no lender-of-last-resort function. It exists to fight inflation, regardless of actual economic conditions. Whereas the Federal Reserve and the Bank of England can accept whatever assets they want in exchange for however much money they inject into the system, the ECB is both constitutionally and intellectually limited in what it can accept. It cannot monetise unneutralised debt. It cannot bail out countries. It cannot lend directly to banks in sufficient quantity. It is very good at fighting inflation, but, when there is a banking crisis, it has few weapons or instruments.
The European banking system as a whole is three times the size and nearly twice as levered as the United States banking system. It is filled with bad assets that the ECB cannot take off their books. You can see we have a problem. We have had over 20 summits, countless more meetings, promised fiscal treaties and bailout mechanisms to each other and even replaced a democratically elected Government or two to solve the crisis and not managed to do so. It is time to come clean. The banks we bailed in 2008 increased sovereign debt to pay for their losses and ensure their solvency, but the banks did not recover, and, in 2010 and 2011, they began to run out of money, so the ECB had to act against all of its instincts and flood the banks with billions of euro in very long-term refinancing operations. The money the ECB gave to the banks was used to buy some short-term government debt to get our bond yields down a little, but most of it stayed at the ECB, earning interest, rather than circulating into the real economy and helping you back to work. The entire economy is in recession, people are paying back debts and no one is spending or investing. This causes prices to fall, thus making the banks ever more impaired and the economy ever more sclerotic.
However, we need to keep the banks solvent or they collapse, and they are so big and interconnected that even one of them going down could blow the whole system. Awful as austerity is, it is nothing compared with a general collapse of the financial system. We cannot inflate and pass the cost onto savers. We cannot devalue and pass the cost onto foreigners, and we cannot default without killing ourselves, so we need to deflate for as long as it takes to get the balance sheets of these banks into some kind of sustainable shape. The only tool we have to stabilise the system is for everyone to deflate against Germany. It is horrible, but there it is. Your unemployment will save the banks, and, in the process, save the sovereigns, who cannot save the banks themselves and thus save the euro. We, the political classes of Europe, would like to thank you for your sacrifice.”
Obviously, that is a dreadful, second-rate piece of literary fiction that I have concocted to demonstrate a point, but, in about two minutes, that is the nub of where we are. If we were to miraculously invent a truth serum and run around injecting leading European politicians with it, that is more or less what we might get from them.
My title today is “What is Wrong with the Euro Zone and What To Do About It”, and I have given you a very brief synopsis of where I stand on that. The original title, of course, was “The Implications for the UK of the Euro Sovereign Debt Crisis”. That is not my title, and the answer to that as a question is very simple. The UK’s main export partners are Germany, at 11·6%; the United States, at 10·6%; the Netherlands, at 8·4%; France, at 7·8%; Ireland at 6·4%; and Belgium, at 5·6%. The UK’s destinations for exports are euro zone-centric; five of the top six destinations are in the euro zone. So, if demand is low in those places and uncertainty spreads due to fear of contagion and/or break-up of the euro zone, it is very bad for the UK. The UK, of course, is part of the world’s largest single market — the EU — and, if unemployment in some countries in that market hits 25% and political unrest, violence and instability result, UK exports will be hit, and a long period of stagnation will result. So, the main point here is that the UK needs the euro zone to get its act together.
The question that I will focus on today is this: precisely what is the problem with the euro zone? I will do it in four parts. I will begin by saying something about the macroeconomic design of the euro zone; then speak to the history and politics of monetary union; talk about the financial crash of 2008 and the response; and then say some things about how to design the current macroeconomic framework.
The point about monetary union in Europe and the euro is that it exists. They are concrete realities, and trying to dismantle the euro zone would cause not only huge uncertainty and fear but unpredictable capital flight, potential currency wars, competitive depreciations and exactly the kind of beggar-my-neighbour policies and spiralling recession and economic hardship that led to the rise of political extremism in interwar Europe, eventually culminating in the Second World War. So the economic and political chaos and tensions potentially triggered by the break-up of the euro zone are unthinkable and best avoided.
It is important to recognise and acknowledge that it is difficult to have a sensible debate about Europe because things quickly become polarised between europhobes and sceptics who see the travails of the euro zone as confirmation of everything they have ever thought about the problems of the European project and the europhiles, who are so enthusiastic about the European project that it is difficult for them to take a detached, critical perspective. The latter is needed, if we are to progress this. My basic starting position is that breaking up the euro zone is not a good idea, but we do need a better designed and better functioning euro zone, and that means new ideas and a new approach.
My main point about the euro zone is that, from a macroeconomic perspective, its design is dysfunctional and even pathological. For europhiles, that is a hard thing to say because it entails conceding ground to europhobes, but it is precisely such a recognition that is required if we are to have a sensible, considered debate about the euro zone and reflect on what the real problems are. So I will try to express my basic point as simply as possible and pose this question: what does it mean to join a monetary union in macroeconomic policy terms? What does that actually entail, and what, in essence, is a monetary union? The simple answer is that states that have joined the euro have given up two things and retained one. They have centralised interest rate policy, previously set by national central banks, creating a new institution, the European Central Bank headquartered in Frankfurt. The ECB has a staff, but its governing council — the equivalent of the Bank of England’s monetary policy committee (MPC) — is made up of national central bank governors who reach a decision on euro zone interest rates, the central lending rates at which qualified banks can borrow from the central bank.
Unlike MPC members, the individual figures on the governing council do not have a vote. They are supposed to reach decisions by consensus, and that is to facilitate collective decision-making and ensure that decisions are reached on the basis of a review of conditions across the euro zone as a whole, rather than for individual countries. That institutional design reflects an implicit admission that, given the centralisation of interest rate policy, individual European countries will have quite different interest rate requirements at different parts of the cycle and, therefore, might want, for entirely self-interested reasons, different interest rate policy positions. The decision-making procedure of consensus is designed to prevent national central bank governors from bargaining with one another over interest rate decisions, and, for a similar reason, there is no voting record of decision-making at governing council meetings and no publication of that record. Voting records, it is believed, might make national central bank governors prone to pressure from vested national interests seeking to pressurise national governors who are, of course, supposed to be independent and above politics. So the strong peer pressure and norm therefore inside the governing council is for governors to reach decisions on what is best for the euro zone as a whole on the basis of assessments and interpretations of the relevant data from across the euro zone, rather than their national territory.
The important thing here is to emphasise that, at any point in time, interest rates set by the ECB may be higher or lower than the needs and requirements of a particular national economy. For example, when Ireland first joined the euro zone, when the so-called Celtic tiger was booming, the interest rates set by the ECB in the early 2000s were, in all probability, too low for the needs of the Irish economy, given Irish rates of growth. That also probably played a role in stoking inflationary pressures and allowing a financial bubble — notably, of course, in property — to inflate. The main point is that Governments no longer control interest rates and, therefore, have lost a crucial macroeconomic policy instrument for steering economic activity in their jurisdiction.
The second policy instrument that euro zone states have given up is the exchange rate. Countries in the euro zone no longer have their own currency, which means that they can no longer effectively pursue an independent exchange rate policy. Typically, at times of economic downturn, a country’s currency depreciates, which gives a boost to exports. That was a crucial economic adjustment mechanism that allowed countries to return to growth more easily following a period of recession. When a country joins a currency union and gives up its currency, that adjustment mechanism is no longer available. Therefore, the valuation of a supernational currency such as the euro, which results from aggregate transactions and demand for that currency in foreign exchange markets, can produce an outcome that is too high or too low as suggested by the underlying fundamentals and conditions in a particular national territory at any point in time. Currently, for example, due to strong German export performance — mainly machine parts being sold to China — and relatively low inflation across the euro zone as a whole, the euro remains stronger than the relatively poor-performing so-called PIIGS countries would ideally like. That impacts negatively on their export performance, because it is said that they are not as competitive and productive as the German economy and, therefore, need a lower exchange rate. Of course, all of that reduces the ability of those countries to recover through exports.
All of that means that euro zone states have only one macroeconomic policy lever open to them, which is, of course, fiscal policy — tax and spend — or budgetary policy. Euro zone states have given up control of two or their three macroeconomic policy levers: monetary policy and exchange rate policy. That means that fiscal policy becomes extra important in a monetary union. A good illustration of that is provided by the Irish experience in 2001. Ireland was growing, and the interest rates set by the ECB were, in all probability, lower than they would have been had the Central Bank of Ireland been setting them. Likewise, due to sluggish economic performance in France and Germany in the early 2000s, the euro did not appreciate at the level that would likely have occurred had it been based simply on Irish growth rates and fundamentals. All of that resulted in relatively localised inflationary pressures in the Irish economy. In June 2000, the Irish Finance Minister, Charlie McCreevy, participated in a review process through Ecofin, which was a form of peer review or multilateral surveillance that produced broad economic policy guidelines for Ireland, as it did for other countries. That review exercise concluded that Ireland needed to follow contractionary fiscal policy to prevent overheating in the Irish economy. McCreevy agreed to those loose guidelines.
The problem was that the Irish Government, in an effort to meet the Maastricht deficit criteria prior to euro entry, had negotiated a deal with their trade unions through Ireland’s peculiar form of social partnership, which is run through the Taoiseach’s office, that would enable Ireland to meet the annual budget deficit target of below 3% of GDP, which was one of the Maastricht criteria. The Government managed to persuade the trade unions to accept public sector wage restraint. Once membership of the euro had been secured, the deal was that the Government would deliver an income tax cut in return for support for public sector wage restraint. Tax reductions in the proposed 2001 Irish Budget effectively breached the broad economic policy guidelines that McCreevy had earlier signed up to because they produced an expansionary fiscal policy. On 24 January 2001, the European Commission asked Ecofin, under article 99(4) of the Treaty Establishing the European Community, to establish a critical recommendation to Ireland that was not formally legally binding but should be taken into account — a form of peer pressure. The Commission’s argument was that Ireland had breached the broad economic policy guidelines by following expansionary and — this is the key phrase — procyclical budgetary policy.
The crucial point here is that, in a monetary union, when Governments have given up their capacity to set interest rates or influence and steer the exchange rate, which, as a consequence, can be either too high or too low at any given time, fiscal policy has to pick up the macroeconomic slack and perform a countercyclical role. During periods of growth, fiscal policy should be contractionary and quite severely so. During slow periods, it should assume a more expansionary role, which is doubly, nay trebly, important in a monetary union because neither monetary policy nor exchange rate policy can perform its usual macroeconomic stabilisation role.
In this instance, the Commission appeared to acknowledge the importance of countercyclical fiscal policy and the dangers of procyclical fiscal policy in a monetary union, which can exacerbate the cycle. Most important of all, it makes good economic sense for national Governments to pursue countercyclical fiscal policy in a monetary union. Unfortunately, actual formal fiscal policy mechanisms in the euro zone entirely overlook that very basic but sensible insight. That was evident in the fiscal stability and growth pact. It has been reinvented and is now known as the European fiscal compact, which is essentially a stricter version of the stability and growth pact. The centrepiece of the stability and growth pact was a deficit-to-GDP ratio of 3% of GDP — the earlier Maastricht criteria that I referred to — which was to place a limit on annual budget deficits. Having a deficit-to-GDP ratio as a centrepiece for co-ordinated fiscal policy in a monetary union makes little sense. In the early 2000s, we saw that Germany was the first country to breach that deficit-to-GDP ratio. Unsurprisingly, that was entirely down to the path of the economic cycle that Germany found itself on, which meant that transfer payments increased while tax revenues decreased. Unsurprisingly, the German budget deficit got bigger. Later, together with France in 2005, the Germans negotiated a relaxing of the stability and growth pact. However, in 2012, following the financial crash, it reversed its course and pushed for a stricter fiscal compact to discipline countries and make them take their deficit reduction responsibilities seriously.
The real problem is that, when countries find themselves on the down part of the cycle, they almost inevitably breach the deficit-to-GDP target, as Germany discovered in the early years of the euro. Moreover, if and when banking systems blow up, producing vast amounts of lost output and demolishing the notional deficit-to-GDP ratio, the stability and growth pact and now the fiscal compact look completely ineffectual and lack any credibility. It was that, essentially, that happened following the financial crash of 2008.
The worst thing is that a deficit-to-GDP ratio is inherently procyclical and can add to and amplify the procyclicality caused by interest rate and exchange rate centralisation that means that neither the interest rate nor the exchange rate is available as a macroeconomic adjustment or stabilisation mechanism. So, when a deficit-to-GDP ratio is the centrepiece of the fiscal policy framework, fiscal policy can be procyclical. That is, it can be expansionary in a period of growth, as we saw in the Irish case, while the deficit-to-GDP ratio remains relatively unchanged or appears to improve.
Contractionary fiscal policy in an effort to meet the deficit target in a downturn can result in a deficit getting worse or leave it relatively unchanged because a lack of growth stops the deficit reducing and means that the economy remains mired in a phase of stagnation. In a monetary union, therefore, a deficit-to-GDP ratio is not a suitable policy target or anchor, and it completely overlooks the role that fiscal policy could or should play in a currency union. To put it at its most simple, it can result in fiscal policy being too tight at a time when monetary and exchange rate policy is also too tight, due to the fact that they have been centralised. Likewise, fiscal policy can be too loose, as in the Irish case, at a time when the exchange rate and monetary policy is also too loose at a time of growth. The result is a very undesirable and excessively procyclical macroeconomic policy mix.
So, all this poses a question: how did the euro zone end up with these dysfunctional macroeconomic governance mechanisms? To appreciate that, we need to understand that monetary union was a political project driven by particular political dynamics, and that requires going back deep into 20th-century European political history. Monetary union came out of a report by the Delors committee in 1988 at the instigation of the European Commission. Its basic message was a single money for a single market following the signing of the Single European Act in 1987.
In 1992, the Maastricht treaty was signed, which effectively created a timetable for the creation of monetary union and a set of qualifying conditions and criteria. The big political event at that time, of course, was German unification in 1990. Given that it was less than 50 years since a unified Germany had occupied France and the fact that a unified Germany had been the principal European aggressor in two world wars over the previous 80-year period, this was a move that was not without potential controversy. Of course, it was this that was also the primary public rationale for the allied powers dividing Germany after the Second World War. The German Chancellor at the time, Helmut Kohl, had a particularly personal political ambition to go down in history as the man who delivered a peaceful, unified Germany. For the Germans, therefore, French approval and endorsement of German unification was good politics and would bestow international legitimacy and acceptance on such a move.
France had a rather different priority. Throughout the 1980s, France had been a member of the European exchange rate mechanism — or the European monetary system — and, if you remember, the United Kingdom had an ill-fated experience with it in 1992 after it joined late in 1990. That is a story for another day, and it is one of my favourite stories that I like to tell my undergraduate students because it really is a telling tale of British elite incompetence. In the European monetary system, states sought to prevent fluctuations between their currencies that could disrupt trade and the workings of the internal market. There were a series of margins of fluctuation, which were 2·5% agreed around a mid-point that was, effectively, the Deutschmark, as Europe’s most stable and strongest currency in the post-war period. For France to maintain the franc in its margins of fluctuation, it effectively had to follow the monetary or interest rate policy of the German central bank, the Bundesbank. All that meant that Germany and the independent Bundesbank, with a strict price stability mandate, set monetary policy for all members of the European monetary system and, essentially, set monetary policy for the whole European Union. The French felt that that restricted their macroeconomic autonomy and calculated that tying Germany into a new unified Europe and a pan-European monetary institution would at least give France a seat at the table and enable it to shape EU monetary policy rather than simply being a policy taker, which was effectively the situation in the European monetary system. Furthermore, monetary union would consolidate a unified Europe in the context of German unification. So, the deal on the table at the start of the 1990s was unreserved French support for German unification in return for Germany giving up the Deutschmark and surrendering Bundesbank control of European monetary policy through the creation of single currency and a new European central bank in which the French would have a seat at the table.
Understandably, there was a perception in Germany at the time that the Germans were giving up a lot: a stable currency in the Deutschmark and the impeccable anti-inflationary credentials of the Bundesbank. At the Bundesbank in particular, there was limited enthusiasm for monetary union, and the quid pro quo was that Germany insisted on having the principal say in designing the institutional governance structures of the new monetary union. To understand this a bit further, we need to go back into German history and note the experience of Weimar Germany, when hyperinflation and huge currency depreciation followed the settlement at Versailles, which, of course, John Maynard Keynes fired off some interesting warning shots about. The reconstruction of the German economy after World War II saw the construction of a particular model, and it involved an independent Bundesbank taking a tough anti-inflationary line and targeting various measures of price stability; an expert growth model involving a manufacturing system prioritising high-end goods funded by cross shareholdings between major banks and companies; investment in research and development and training systems at a firm level; and finally, a form of social partnership involving wage councils and supervisory boards with an active role for trade unions that delivered competitive wage restraint and degrees of social consensus and co-operation. Those were at least the basic ideals.
A whole system of supportive institutional and social arrangements and relationships made Germany a successful export economy. There was, for example, little reliance on domestic demand for growth, personal savings levels remained high and fiscal policy was generally conservative. Germany’s macroeconomic frameworks worked in that context because of the wider supportive institutional and social structures in which they were embedded, which were built up over time creating certain social expectations and a basic level of trust and co-operation between stakeholders. However, when German macroeconomic frameworks projected outwards towards the rest of Europe in the design of monetary union, the supportive social and institutional context that made the German model work as a whole was not evident elsewhere.
The European Central Bank was given a price stability mandate to deliver inflation below 2% of GDP and little room for manoeuvre and few other policy instruments outside of that. The ECB’s institutional design was clearly modelled on the Bundesbank and was designed in a way that made the whole process far more acceptable to German central bankers. The really big concern for German elites was that other Governments would free ride off Germany monetary and anti-inflationary credibility by pursuing loose fiscal policy without the same fear of capital flight and exchange rate depreciation that might discipline them in a domestic context, and, for that reason, German delegations insisted on a stability and growth pact design that centred around deficit-to-GDP ratios as the key policy target so as to discipline those potential rogue free-riding Governments. The basic premise and perception of rogue profligate Governments following indisciplined fiscal policies persists to this day and has largely informed the fiscal compact of 2012. What that means, of course, is that the basic procyclical deficiencies of the stability and growth pact have not been addressed.
That brings us on to the financial crash of 2008. This is where I put my cards on the table a little more clearly. Let me be clear here: one of the reasons why I did not like the original title was that the sovereign debt crisis is nothing of the sort. It is a fundamental misrepresentation of what happened, and, if your diagnosis is wrong, you have no prospect of effectively treating and curing the disease. With the exception of Greece as an extreme outlier and possibly Italy as a less extreme example, Governments in the euro zone were not guilty of profligate spending. Spain and Ireland even ran pre-crash fiscal surpluses. In 2007, debt-to-GDP ratios were 27% of GDP as a total public debt in the case of Spain and 12% in the case of Ireland. Those two countries were best in class for low public debt. At that time in 2007, Germany’s public debt stood at 50% of GDP.
If you wanted to be really critical of Spain and Ireland, you could say that their fiscal policies were insufficiently countercyclical and they did not build up big enough surpluses during the good years, in a similar fashion to the Commission-inspired critique of Ireland back in 2001 that I mentioned earlier, but there is a problem with that. In Spain, loans to developers constituted 50% of GDP in 2007. In Ireland, house prices increased 160% between 1997 and 2007, and, in Spain, it was 116% during the same period. In 2007, the asset footprint of the three main Irish banks was over 400% of Irish GDP. As we know in the Irish case, once the state had to pick up or guarantee the liabilities produced by a giant housing bubble, inflated by financial sector lending, the fiscal deterioration was massive and rapid, and public sector debt shot up from 12% of GDP to 110%, which is an incredible increase.
The financial crash of 2008, therefore, was brought about by the combustion of unsustainable banking models and has globally cost between $4 trillion and $11 trillion, depending on how you calculate it. Bearing in mind that annual GDP in the UK is about $2·4 trillion, that is a big sum, and a very conservative estimate puts it at about the equivalent of one year’s lost output. As the Bank of England’s Andrew Haldane says, only world wars come with a heftier price tag. Europe’s so-called sovereign debt crisis is, in fact, a transmuted, elongated and camouflaged banking crisis. The simple version of what happened in Europe is that, over the decade of the introduction of the euro, big core European private banks bought lots of peripheral sovereign and private debt and levered up. They reduced their equity and increased their debt to make more profit levering up. Of course, the debt that they took on is now worth much less than it was when they bought it. They were searching for yield and profit. In the case of those banks, the leverage ratios were 40:1, so assets were forty times their equity. That means that a few percentage points against those assets can leave them insolvent, and it leaves them very vulnerable. When you add their liabilities together, the European banks are too big to bail, as opposed to too big to fail. In the United States, there is a lot of talk about being “Too big to fail”, but in Europe, the real problem is “Too big to bail”. As we will see, that is a phenomenon that the euro only exacerbates.
France’s three biggest banks have assets 2·5 times French GDP. The aggregate balance sheets of the UK’s three biggest banks are nearly four times UK GDP. The difference between the two countries, I think, is that France is trapped in a monetary union and does not have control over its own currency. Now the lesson we should draw from this is that French government bond rates come under pressure not because they cannot afford to pay for their welfare state, but because France’s bloated debt-ridden banks have become too big to bail and too big a liability for the state to take on. The same is true, really, of Ireland. Now, if one of those French behemoths fails, it can be bailed out by a Government carrying a government debt at 40% or 60% of GDP as a total, but, if public debt has risen to 90% of GDP, which it has done following the banking system’s induced contraction that has transpired since 2007-08, such a liability cannot be taken onto the balance sheet of the state. It is too big. So “Austerity Europe” is thus required, so that the state and its balance sheet can effectively act as a shock absorber for the entire system. That is the situation that we are looking at. So, in the words of Andrew Haldane of the Bank of England, banks have come to bank on the state. The crisis in the European sovereign debt markets — there has been one — is an effect, not a cause; it is a symptom, rather than the underlying cause of the condition.
I should say, by way of a qualifier in all this, that Greece is the outlying case, because it clearly lied about its public accounts and levels of public debt. Greece has to reduce its public debt because it is manifestly unsustainable, but it cannot do that effectively at a time of private sector deleveraging, when its main euro partners are doing exactly the same thing and all at the same time. The result is synchronised public/private international austerity. It is partly being perpetrated by the political and governance structures of European monetary union — the euro zone — and the continued political, financial and intellectual centrality of German policymakers. If we are all austere at once, all that does is shrink the Europe-wide economy for everyone. What might be good for one actor is bad for the economy as a whole if everyone tries it at the same time. That is commonly referred to as the “fallacy of composition”.
I will summarise. The Bank for International Settlements currently estimates that British, German and French banks have combined exposure of $1 trillion to vulnerable euro zone state debts in the so-called PIIGS countries: Portugal, Ireland, Italy, Greece and Spain. That debt was acquired because it was assumed that the creation of the euro had expunged risk from holding sovereign debt. Peripheral euro zone states, including Governments, were funded with cheapish money, as core euro zone state banks searched for yield and profits. When those assets began to decline in value, European banks began to find themselves dangerously imperilled, particularly in 2010-11 and, somewhat belatedly, the conservative European Central Bank responded with long-term refinancing operations in late 2011 and early 2012.
That brings me onto the final part of today’s lecture, which is how you redesign the euro zone’s macroeconomic governance. I will concentrate on macroeconomic governance because you can talk for a long time about financial resolution and crisis response mechanisms, and it gets very complicated.
The euro’s banking problem caused and is now compounding the sovereign debt problem, which in turn, via austerity, hurts growth in the name of fostering competitiveness, which is undermined by deflation. Encouraged by Germany and the ECB, as we know, Governments have sought to placate bond markets by making ruthless cuts in government spending. Those measures hinder growth without satisfying bond holders that their money is safe. Bond holders worry that the measures are not politically sustainable. So, as they begin to adopt Germany’s model of constitutionally enshrined debt breaks, other euro zone states will find it nearly impossible to use fiscal stimulus at times of crisis. With monetary policy already in the hands of the dogmatic anti-inflationary European Central Bank, their only means of adjusting to crisis will be to stand by as wages fall and unemployment soars. That goes back to the cheap work of poor literary fiction with which I began this lecture. If the EU is to survive, it will have to craft a solution to the euro zone crisis that is politically as well as economically sustainable. It will need to create long-term institutions that minimise the risk of future crises but refrain from adopting politically unsustainable forms of austerity when crises hit. They must offer the EU countries that are worst hit a viable path to economic stability, while reassuring Germany, the state currently driving economic debates in the union, that it will not be asked to bail out weaker states indefinitely.
The real thing is that the inherent procyclicality of macroeconomic policy frameworks in the euro zone is precisely one of the problems that needs to be overcome. What is required is a genuine countercyclical fiscal constitution and framework consisting of a system of automatic adjusters according to measurements of GDP growth, which will enable spending to be reduced when recovery is assured in a particular territory, increasing the possibility that fiscal policy could contribute to bringing down debt and the deficit in a sustainable fashion according to a clear set of criteria that could be communicated to the markets. This would enable fiscal policy to at least remain stimulatory or neutral until growth exceeds 1·5% of GDP, for example, for at least two quarters in a row. Some people would like to see it higher than that, but I am being deliberately conservative. The EU’s fiscal compact should frame and incentivise such an approach rather than being based on a simplistic — it is simplistic — ineffectual and unhelpful deficit-to-GDP ratio.
Let me be clear that that kind of proposal is not a soft solution. It means rules that prevent states running annual deficits during boom years, instead actually building surpluses. However, it also gives euro zone Governments more fiscal flexibility in lean years rather than forcing them into a procyclical fiscal straitjacket as the current arrangements do. If you were going to do this kind of thing, you would try to do it at the European level in some sort of currency union like this. It is far easier to police through supernational mechanisms and international mechanisms than it is through very soft national mechanisms that can be eroded away politically.
So, you could get a new supervisory institution that could be mandated to encourage such fiscal countercyclicality. That means taking a stern approach during the lean years with the power of sanctions. The Commission had the right idea with Ireland back in 2001 but could rely only on mild suasion. The European Court of Justice could be called upon to adjudicate between states pursuing unwarranted procyclical fiscal deficits during periods of growth, just as it does in the area of competition policy, while also adjudicating to give Governments fiscal flexibility when they really need it. There is also a case for moving towards a limited fiscal federation involving a relatively small pool of shared resources to allow for limited fiscal transfers between states at times of economic distress and a limited common bond mechanism that is carefully controlled to create more confidence in bond markets, so that imperilled states can meet their repayments and, therefore, reduce spreads. Finally, in monetary policy, the ECB may have a good track record in inflation, but it presided over asset price bubbles, which it needs to address in future. This requires much tighter control over financial innovation and a system of macro-prudential regulation that requires banks to build up countercyclical capital buffers based on credit-to-GDP ratio measurements. The EU is moving slowly and cautiously in that direction, but, significantly, it remains a good deal behind the UK in doing precisely that. Such measures should be sold to Germany as limiting the need for bailouts of other states because it would improve and enhance their own financial and fiscal stability.
The current procyclical macroeconomic policy mix in the euro zone is not working. If the EU fails to deal with the political fallout of its own institutional weaknesses — rising unemployment, economic stagnation and the imposition of permanent austerity from a combination of bond market pressure from core banks, the ECB and the German Government — it may collapse. Forcing voters to repeatedly shoulder the cost of adjustment on their own and expecting the EU and euro zone to remain legitimate is politically myopic in the extreme. We all know where early periods of shortsightedness lead us, and I have given some examples. What we are talking about is hard but flexible countercyclicality that offers the means to combine fiscal discipline with flexibility in order to cushion the political costs of adjustment in terms of economic stress. EU leaders need to institute that kind of framework in a hurry, but I am not particularly hopeful. Most importantly, this requires German leaders and German elites to realise that what has worked them is the result of their own unique institutional and social setting. It cannot act as an imposed universal model for the rest of the euro zone. Thank you.
Dr McGowan: There was certainly a lot of food for thought there. You may want to unpack, unravel and maybe even challenge some of that. I will now open up the session for questions. Who is eager to begin?
Mr David Mulholland (H&J Martin): It was a very interesting talk. You pointed to the banking crisis being the symptom rather than the cause. Obviously, the UK and the US economies had their own banking crises, so what was it that led to three different economies being exposed to a banking crisis? The UK and the US have, as you say, fiscal autonomy as opposed to the euro zone, but, as we see in Northern Ireland, fiscal policy for the UK is felt unevenly between the south-east of England and Northern Ireland. Is that an imperfect response as well?
Mr Ash Farah (Global Financial Services): I understand this morning that Allied Irish Bank is going into liquidation to ease the financial problem in the South. Will that be the way forward? What is your view on that?
Dr Baker: OK. First, I said that banking was the cause rather than the symptom. It was probably the sovereign debt crisis that was the symptom rather than the cause. Why did all three areas experience a banking crisis of sorts? They did not necessarily follow uniform patterns in every particular location. The obvious answer is that they are global institutions that engage in global markets and global transactions. They are not single-jurisdictional players, and they operate across the world.
The interesting thing, of course, is that we often think that financial innovation and financialisation is an Anglo liberal thing that was pioneered in the United States. However, the leverage ratios of European banks are far bigger than they are in the United States. The United States had some fairly modest leverage ratios imposed on some of its banks which were not evident either in the UK or in Europe. There is also a sense that one of the reasons why there are some rather nasty toxic assets on the books of European banks is that they were pretty late to the game of financial innovation and techniques such as securitisation and credit derivatives. A lot of that was pioneered in the City of London and in New York, on Wall Street. The British and American banks pretty much had a head start, and the Europeans were late to the game. They were chasing yield. There were a whole bunch of national circumstances that meant that the banking crisis in each jurisdiction had its own particular characteristics and form, but they are all, most certainly, linked.
I should say that I do not think that fiscal policy is the solution for the euro zone. I do not think that you can get out of the mess simply through fiscal policy. However, you can avoid making it a lot worse, and you can avoid doing silly things that are politically unsustainable and would get the whole European project into an awful lot of political trouble. That was the reason for talking about the notion of having some countercyclical fiscal policy and giving democratic Governments some breathing space as opposed to having, at least, the appearance of having policies imposed from the outside.
With regard to the AIB liquidation, obviously the problem is that Europe was less good at mopping up its bad assets. One of the reasons why that happened was that the ECB largely stayed inactive for a long time. I do not know the detail, and I have not looked into the fine detail of the AIB liquation. However, there almost certainly needs to be an attempt to sort out bad assets, and that means some serious haircuts for people holding assets.
The problem arises when too much of that liquidation process is handled by unelected, unaccounted institutions such as the ECB. If that then becomes imposed and there is a sense that technocratic governance outside the sovereign jurisdiction nation state is driving the entire process, then, again, you have a question of political legitimacy. If you are going to run that kind of process, you have to make sure that the sovereign Governments directly affected are seen to have genuine input into shaping the form of the liquidation process, otherwise it becomes very difficult to justify that to voters and electorates. Again, there is no doubt that that would damage the political legitimacy of the EU project.
Mr Gareth Brown: I am from the Queen’s MA programme in legislative studies and the Assembly bursary programme.
Is there any evidence to suggest that the euro is starting to replace the dollar as the status quo currency in global commodity pricing and what implications does that have for your analysis of the state of the euro zone at the moment?
Mr Stefan Andreasson: I am also from the School of Politics.
I was curious that so much of your diagnosis focused on macroeconomic governance, and I realise that that is primarily what you wanted to talk about. You also talked about the need for a move towards countercyclicality as your prescription for a solution. However, towards the end of your diagnosis, you inserted the absolute centrality of banks that are too big to bail, and we have come back to that in the questions. Can you be a bit more specific about the solutions for regulating the banks and resolving the banking part of the problem in the short term that you find interesting and how you see the future of the City of London in some sort of sustainable banking environment in Europe?
Dr Baker: What are the prospects of the euro as a reserve currency? Going back to 2007, because of dollar depreciation over more or less a decade, we see the Gulf countries that produce oil increasingly diversifying their resources, OPEC constantly having debates about whether we needed to replace the dollar as the principal currency for invoicing the international oil trade and the Chinese diversifying their resources. So, all those surplus countries — the emerging markets in the world economy — were clearly undergoing a big resource diversification process up to 2007. What did we see when the financial crash happened in 2008? One of the first things that happened was that the dollar rebounded and started to appreciate. The dollar remained a safe haven, so there was a flight to safety. I have not been following the more recent patterns of commodity pricing and so on so much over the past year, but, until that point, we definitely saw a slowing of the process of diversification into the euro. Therefore, the idea that the euro becomes a reserve currency to compete with the dollar remains a long way off. The most likely long-term scenario is Barry Eichengreen’s. He talks about moving eventually, over 20, 30 or 40 years, to a three-currency system involving the Chinese currency, the euro and the dollar, with the dollar probably remaining just about the biggest of the three. I guess that you might see that happen over a 40-year time horizon.
The thing to remember about reserve currencies is that they have sticky properties — you know, this feature that they have called “incumbency”. Investors are habitual. They do things out of habit, which is why you see the dollar immediately appreciate after the financial crash of 2008, even though the crash emanated from US financial markets in the first instance.
I deliberately wanted to stay out of the regulatory side of things today. This is a crisis of macroeconomic governance only in so far as global imbalances and the accumulation of large surpluses that were then reinvested into core countries made their financial systems very liquid. That is one of the macroeconomic explanations. I think that this is, primarily, a private banking crisis that has become a sovereign debt crisis, but it has become an issue of macroeconomics and Europe’s inability to come up with any macroeconomic response, which is why I focused today on the macroeconomic side of things.
I think that you have got to try to move towards some sort of system of macro-prudential regulation. It seems that the world leader in that at the moment — I mentioned it briefly — is the Bank of England and the financial policy committee. Making that system operational involves going to banks and saying, “You see all those assets and profits that you are accumulating? Well, you have to put this percentage aside in a kind of savings account — a countercyclical capital buffer”. That then gets moved according to measurements of the extent of credit flowing round the economy, according to GDP, and whether it is irregular and goes above trends that show that, once it goes about this level, historically it becomes difficult. So you require countercyclical capital buffers, but the only way to have that system is to move away from something called home country regulation and towards host country regulation. Although the ECB and the European institutions can supervise that, it means actually having regulation done at a national level. For financial regulation to be countercyclical, it has to be done at a national level because that is where the cycle can be measured from. For example, if a Swiss bank is inflating a property bubble in Hungary through its lending activities, the Swiss regulator does not care. The Swiss regulator who looks after that Swiss institution will consider whether that Swiss institution is safe. They do not care, so that goes on. On the other hand and for obvious reasons, a Hungarian regulator looking at the Swiss bank’s activities in Hungarian territory does care, so it will take action. One of the things that you have to have is a movement away from home country regulation, where regulators look after all the institutions headquartered in their territory, and move towards host country regulation. There are a host of reasons why banks do not like that, but we need a much safer financial world because you cannot afford to keep having financial explosions of the scale that we have had. Banks, as I have explained, have become too big to bail, and no modern political economy can indefinitely sustain banks banking on the state to the extent that has been going on.
Ms Shauna Mageean (European Project Manager, Northern Ireland Assembly): Do you see any conflict between regionalisation in Europe — for example, in relation to the Spanish regions or indeed here in Northern Ireland — and the need, as you put it, to redesign the macroeconomic environment in the euro zone?
Dr Baker: I do not really. Europe has always been that kind of multilevel governance project, and there is no reason why it cannot continue to move along those lines. Fiscal policy always has been a multilevel governance operation. It is different from monetary and exchange rate policies, which lend themselves to a certain degree of centralisation. A certain amount of fiscal devolution is probably a good thing, if we come away from the economic side of things, on a political level. If it empowers communities at a more local level, on a democratic level you would have to say that that is a positive thing. So I do not see that the two necessarily lead to conflict, but I have not necessarily thought it through.
Mr Michael Bell (Northern Ireland Food and Drink): I am interested in your thoughts on one of the other major global pieces of economic wiring that has changed in the last 10 years: biofuels. America is now diverting a third of its entire corn crop into bioethanol. Britain opened the largest bioethanol plant in western Europe last year. The effect of that that we are seeing is that you can superimpose the graphs showing the price of wheat and the price of oil. That is a new piece of economic wiring, if you like, that did not exist, say, two decades ago.
Dr Baker: I do not know anything about it. I take it that the price of wheat is shooting up as a consequence of the demand for wheat.
Mr Bell: What has changed is that, as soon as oil moves, food will now move, and they will track. Essentially, if you are a farmer you can either use your land to grow fuel or food, and that is a politically set policy. I am interested that it is not even on your radar, because we view it as becoming increasingly significant.
Dr Baker: I am sorry, I have a lot of things to do, and I have not been following the prices of commodities like wheat and fuel in that way. It is very interesting. There is an explanation. There was such volatility, for example, in food prices, and part of that was brought about by noise trading in various derivative products in the lead up to all of this. We saw immense volatility and increases in food prices, which, for developing countries, can be a double-edged sword, of course.
Mr Richard Stewart (Northern Ireland Assembly and Business Trust): I am the treasurer of the trust. You talked about automatic adjusters as part of the solution. How will the parameters of those adjusters be defined? It strikes me that the people who might define those parameters are probably the same people who might have defined the parameters of the ECB. How can you ensure that the same mistakes are not made?
Dr Baker: There are no hard-and-fast solutions. It is the same with macro-prudential regulation. If you are going to try new forms of economic governance to stop the economic system as a whole blowing up and to provide increased cushioning for Governments who are locked into a monetary union, you will have to experiment. If you go back to the history of the European monetary system, that is what happened. There is an ongoing process of experimentation in which you have adjustments and so on. I think that, inevitably, you would end up with the same kinds of figures and the same kinds of process as used by those who designed the stability and growth pact. By the way, I do not think that this will happen, because it requires individuals who have a particular way of looking at the world to unlearn some of the things that they think they know. We have just had a state-of-the-art experiment basically disprove most of what they believe in, and it has only cost $4 trillion to run it. I see no evidence of those lessons being unlearned. What you effectively have is a form of cognitive locking. You are not going to get that kind of countercyclicality. I think that you could build a political constituency for it, but I just do not see it happening. To end on a fairly pessimistic note, I do not see that it is likely to happen.
Robert Skidelsky came up with the notional figure that, once growth is at 2·5% of GDP, you have to crack down and start cutting public expenditure. I use the figure of 1·5% just to be slightly more conservative, with a small “c”. You pick a figure to represent the point at which you say, “We have growth at this level. Now we have a series of planned cuts that kick in once we hit that level” and you see how it goes. You experiment with it, and, eventually, through trial and error you find something that might work. However, you cannot sit by and do nothing. There has to be a better solution for reducing economic pain in the future.
My whole message is that, if the whole process breaks down, it will be very messy. We will have to try something different from what we have had for the past 10 years. All we have seen so far is, more or less, more of the same. The fiscal compact is, essentially, more of the same. It is a bolstered and stiffened stability and growth pact. I do not think that it provides any solution, nor does it address the real issue of the dysfunctionality that is evident in euro zone economic governance.
The answer is that you are probably right to raise those concerns. I do not have an answer.
Dr McGowan: You can probably talk to Andrew for a few minutes afterwards, if you want to, on a one-to-one basis. I will now pass over to John Rooney, the vice-chair of the Northern Ireland Assembly and Business Trust to make some concluding remarks.
Mr John Rooney (Northern Ireland Assembly and Business Trust): Ladies and gentlemen, as vice-chair of the Northern Ireland Assembly and Business Trust it gives me great pleasure to provide the closing remarks this afternoon. The trust is always keen to work with other organisations where there is a mutual benefit. This afternoon’s seminar has been arranged in partnership with the European Commission representatives in the UK and Queen’s University Belfast School of Politics, International Studies and Philosophy. I thank those organisations for putting together this excellent event. I thank today’s speaker, Dr Andrew Baker of Queen’s University, who has covered a highly interesting topic with great expertise. I hope that all he says does not come about, because a lot of us may be looking for a different job if that is the case.
Before I finish, I remind everyone to fill in the questionnaire before leaving today. I invite you to the third seminar in the series, which will take place on 14 March once again in Parliament Buildings. The topic will be “Reconnecting the public with the EU”. Thank you all for coming. I hope that we have more insight into the EU than we had before. Thanks very much.