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Anyone tempted to take the Maastricht treaty at face value as a guide to what might happen to bond markets in Euroland is being extremely gullible. The treaty was not written by people possessing a great deal of understanding or sympathy for financial markets. Many ends were left untied. Some of those omissions will be put right in secondary legislation, perhaps to be drafted in consultation with financial market participants. More on the working of Euroland debt markets will be gleaned from the monetary management blueprints that the European Monetary Institute (EMI) will offer before the end of this year. But the future is fraught with uncertainty.
The system created by Maastricht is a one-off. Maastricht sets up a monetary system by fiat but leaves it far from clear who, if anyone, is supposed to say "fiat"!
In the financial field, the essence of sovereignty is the ability to create money. A government that can get its own money used needs neither tax revenues nor the proceeds of debt sales to cover its expenditures. Instead it can be argued (with many historical examples, such as that of the Southern Confederacy) that the reason for taxation is to create an incentive for the subject to use the sovereign's money. In the absence of money-creating power, taxes have to be levied to fund both current spending and the interest on government debt. So, unsurprisingly, public entities without the power to issue money typically have tight limits on spending more than they tax. In the US, for instance, 48 states (or 49, depending on interpretation) are bound by balanced budget laws: their issue of new debt is subject to very strict limits. Quite literally, they are not sovereign borrowers.
Non-sovereign public borrowers are, like corporate borrowers, subject to insolvency risk. When Orange County found itself faced with a sudden drop in tax revenues, it also faced bond market exclusion. Draconian fiscal austerity had to be imposed. But at least the starting debt position of Orange County was manageable. The same is true of US states: none of them has a debt-to-income ratio of more than 20%. The position of the European governments which are planning to deprive themselves of sovereign borrower status is very different. Luxembourg apart (and Luxembourg is already part of a monetary union), all of these countries will have a deficit close to, or perhaps significantly above, 3% of GDP when they enter European monetary union (Emu). The best of them (again, excluding Luxembourg) will have a debt ratio close to 60%, and the worst of them will have a ratio of almost 140% and debt service costs of close to 10% of GDP. Only the experience of Israel during the period of dollarization appears to offer anything close to an historical comparison with this foolhardy experiment.
Financial traps
The implications for European bond markets are potentially so serious that the Maastricht framework cannot possibly survive as designed. A degree of stumbling and confused recognition that there is some sort of problem are seen in the efforts of German finance minister Theo Waigel to rewrite the treaty without rewriting it. His proposed stability pact is intended to address the so-called "free-rider" problem in Emu. With a single monetary policy, the interest-rate implications of an irresponsible fiscal policy in an individual member state would be diffused over the whole area. To deal with these perverse incentives, tight rules have to be imposed on fiscal behaviour.
Unfortunately, the stability pact idea comes a generation too late for Emu. The 1% limit on budget deficits favoured by Waigel is politically over-ambitious, but financially it isn't ambitious enough. Existing debt burdens mean that a 1% limit on the overall deficit implies a substantial primary surplus over a very long period. There are no historical examples of democracies being able to sustain such surpluses. In Belgium, which has run a large primary surplus for several years (yet still has an overall deficit clearly above the proposed Waigel limit), parliamentary democracy in financial affairs has already been suspended. Yet Belgium is the only OECD country (apart from Norway, which is in a much happier fiscal situation) in which the structural deficit is planned to rise this year.
This degree of fiscal austerity has been forced down the Belgians' throats by arguing: "We need it to get into Emu, but once we're in, all our problems will be over." The imposition of the Waigel stability pact on Belgium after 1999 would, without compensation, create huge political and popular disillusionment. Belgian citizens would gag. The strain would rip the two halves of the country apart: would Flemish bond-holders or Walloon welfare-recipients have priority?
Yet even the immediate imposition of the Waigel pact would not rescue Belgium's government bond market from the impact of Emu. A non-sovereign borrower with a debt ratio of close to 130% would be likely to see a dramatic downgrading of its debt. So Emu could mean financial collapse and political disintegration in Belgium, with other Emu members suffering problems that differed only in degree. If a stability pact had been in operation a generation ago, Europe's public debt problems would not have existed and the loss of sovereign-borrower status through Emu could have been contemplated with some equanimity. But a generation ago there was no need for a stability pact: because governments apparently expected to remain sovereign borrowers, the issue of debt was a monetary policy operation, a reserve drain not a fiscal operation, financing the deficit.
Are European politicians just kamikaze pilots? Or will they find an Emu structure that works?
One way for governments to get out of the financial trap might be to shift their borrowing to the short end of the curve. The German government has already beaten down Bundesbank opposition to the introduction of short-term instruments (the official line is that this is to help Frankfurt as a financial centre, but the steepness of the German yield curve and Bonn's budgetary difficulties are other compelling reasons). Such tactics on a massive scale are one possibility for Emu. At present, banks tend to regard short-term government debt as almost as good as cash, because it is repo-able. But a general switch to short-term borrowing would vastly increase the stock of cash-like assets in the economy. The European Central Bank (ECB), if it guaranteed to maintain the interchangeability of cash and short-term government paper, would be presiding over an extremely inflationary situation.
You could argue that this is nothing new: governments can issue long bonds more cheaply than the private sector, because markets know that in extremis the government can sell short-term paper to the commercial banks which the central bank will convert into cash. That will still be true in Emu. Or will it?
There are two important differences. In a national monetary system, the issue of short-term debt by a government is effectively interest-free if it is taken up, via repos or whatever other means, by the central bank: it's like printing money. The government has to pay interest to banks on the short-term debt it sells, but if the banks offer that paper in repos the central bank expands the size of its balance sheet. Its (interest-free) monetary liabilities increase, as do its (interest-earning) claims. The central bank's profits, and its profit-transfer to the government, increase the government is robbing Peter to pay Paul. In Germany, the Bundesbank's profit-transfer to the government has always been treated by the central bank as monetary financing of the government deficit. But the same degree of openness is not evident in the Bundesbank's accounting treatment of repos; when the repo system was first instituted the bank showed repos against government paper as credit to the government; as the stock of repos expanded this became the sin that dare not speak its name, and the bank drew a veil over the question by reclassifying the whole stock of repos as credit to the banking sector.
In Emu, the right of money creation will no longer be the privilege of the central bank (and ultimately the government) of the country issuing short-term debt. Instead, the total money creation in the Emu system will be shared out among national governments according to a weighting scheme based on GDP and population. A government issuing short-term debt will still have to pay Paul (the banks) but will get very little from Peter (the ECB) in return. Governments would have to agree among themselves that they would all issue short-term debt and divvy out the ill-gotten gains. In other words, they would have to behave, in this respect, as though they were a single government. In the absence of collusion, the bigger countries would have an advantage relative to the smaller ones. One can see this intuitively: if Ireland formed a Maastricht monetary union with Germany, the latter country's debt status would hardly be affected at all, while the former's would be radically altered for the worse, even if the Irish and German representatives on the ECB followed national instructions and had equally-weighted votes.
Credit downgrade
It is not the independence of the ECB that will be so financially damaging (many countries with independent central banks have triple-A rated government debt). The danger comes instead from the fact that no individual government owns the central bank. Maastricht tries to separate absolutely the fiscal function from the monetary function something that is doomed to failure.
The Bundesbank has apparently already been telling certain hedge funds that it er, sorry, the ECB will impose its own debt-management rules on Emu governments by refusing to repo the paper of all governments on equal terms. This is perfectly consistent with Maastricht philosophy, according to which the public sector is treated, in financial terms, exactly as if it were the private sector. A government which was not behaving financially in the way the Bundesbank er, sorry, the ECB thought appropriate would not get its short-term paper repo'd any more than a financially wobbly private company would. This may be consistent with Maastricht, but it is politically explosive, perhaps most of all for France. It amounts to a takeover-bid by the ECB or Bundesbank for fiscal control in Emu. It is one that cannot possibly succeed.
The credit-standing of governments must deteriorate in Emu: that of big Germany and thrifty Luxembourg least; that of small high-deficit countries most. The position of Belgium would rapidly become extremely precarious.
Yet Belgian politicians are desperate for Emu. The only plausible explanation for this is one readily accepted by most Belgians: Emu is seen as inevitably leading to a takeover of the country's debt by the Emu area as a whole. Former European Commission president Jacques Delors was very blunt about this once he had left office. He told a committee of the European parliament: "Emu means, for instance, that the [European] Union acknowledges the debts of all those countries that are in Emu." Bundesbank president Helmut Schlesinger implicitly expressed the same view when he told a Brussels audience in January 1993 that the Maastricht debt criterion did not matter, for Belgium at least.
What would be the practicalities of a takeover? One can imagine a post-Emu financial crisis coming to a head in Belgium. The Belgian government would tell its partners the game was up there's no way it could do an Orange County.
The way out through money creation is not feasible: Emu money supply would have to expand massively for Belgium's share of the additional seignorage to make any difference to its problems (and there would be fatal delays in the process). Instead, the ECB would have to go out and buy Belgian bonds at prices the market was unwilling to pay. If it wanted to sterilize the monetary impact of these purchases it would have to issue its own paper. It would become the sovereign borrower in the system, acting as a sort of European Monetary Fund or Euro-treasury. And it would, like the IMF, issue instructions about future government behaviour in fiscal and no doubt other areas, insisting on the strict application of a Waigel 1% limit on deficits as a bare minimum.
The ECB is, of course, completely unaccountable. The politicians would then seize this opportunity to ram through an emergency amendment to the treaty that would supposedly eliminate the democratic deficit by setting up a single Euroland economic government.
A European economic government
The central bankers, the Bundesbank in particular, congratulated themselves that in the Maastricht treaty they had fragmented the opposition (governments). But they overplayed their hand. The risk of financial collapse inherent in the treaty will lead either to the collapse of Emu or the creation of the French-designed "European economic government" of which the Bundesbank, for all its calls for political and economic parallelism in European integration, has always lived in dread.
Emu implies a communal debt takeover. That may or may not prove politically acceptable if the only real debt outlier is Belgium. Belgium's debt, though huge relative to its GDP, is small relative to the GDP of the country's likely Emu partners.
Taking on the Belgian debt might be viewed as a price worth paying by Germany, which has always seen Belgium as part of its natural economic and political zone. It might be similarly viewed by France if it led to the sort of inter-governmental control over European economic and monetary policies that French politicians and bureaucrats have always wanted.
These arguments definitely do not apply to Italy. No-one in "hard core" Europe, with the possible and admittedly weighty exception of German chancellor Helmut Kohl is likely to view sharing the burden of Italy's mountainous debt as a price worth paying. That need not be a disaster for Italy, even in purely financial terms. Outside Emu, it would retain its monetary sovereignty. There would be no need for the further fiscal austerity that participation in Emu would imply. Italy could, in all financial respectability and with no more risk of inflation than it bears at present, cock a snook at the stability pact.
It is ironic that the long-awaited installation of a government in Rome which the markets, at least, are prepared to view as stable might encourage the addition of Italy to a European political and economic system that will exhibit, in aggravated form, all the structural faults of the old Italy. But no-one has ever claimed that politics especially Europolitics is easy to understand.
Bernard Connolly lives in Brussels and is a senior adviser to AIG Trading Group Inc. His book The Rotten Heart of Europe is published by Faber & Faber |