Groucho Marx once quipped that he would refuse to join a club that would have him as a member. It is safe to assume that the European Commission did not have Duck Soup in mind last month when it warned France, Greece, Ireland, Latvia, Malta and Spain to bring their budget deficits back into line. But a club in which nearly half of the members are flouting the rules and are in danger of being blackballed might be to Groucho’s anarchic taste. What it says about the workings of the European Union is less than funny.
The timing of the warning from the rules committee was not exactly gentlemanly. The spread of Spanish, Greek and Portuguese debt over Bunds had just hit fresh records, as had the cost of insuring against Irish default in the CDS market. This has prompted more excited talk about the demise of the single currency. This is wrongheaded. The spreads that countries such as Italy and Greece would have to pay outside the euro would be much higher. Given that, there is little immediate incentive to leave.
The current crisis does, however, expose policy and structural flaws at the very core of Europe’s political and economic architecture. Unless they are corrected the whole project could yet be undermined. The first problem is fiscal policy. The Stability and Growth pact adopted in 1997 is in many ways admirable. Restricting budget deficits to 3% of GDP and national debt to 60% is a sensible goal and achievable in typical cyclical downturns.
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The July 2008 ECB rate rise vies with the US decision to let Lehman fail as the worst |
However, these are far from normal times. Ireland is projected to run a budget deficit of 10% this year. Does the EC propose to fine Ireland for non-compliance? What would be the point? Few, of course, foresaw the severity of the present crisis. But that simply serves to illustrate why a fiscal straitjacket is a bad idea. Like much economic policy in the EU it is the result of political compromise. Germany was reluctant to give up the Deutschemark and the Bundesbank for a currency that could be undermined by profligate ‘southern comfort’ countries. The Stability and Growth pact should probably be suspended but it won’t be. Another problem that besets the EU is that blocking votes make changing the rules all but impossible. There is little chance the Dutch and the Germans would ever sign up for something that lets Spain and Ireland off the hook. European Central Bank council member Jürgen Stark (the clue is in the name) says he sees no need for reform.
He is wrong. However, if the implosion in eastern Europe and the collateral damage it is wreaking on EU banks gets much worse, Germany could be forced to change its tune. Finance minister Peer Steinbrück has conceded that intra-EU bailouts might soon be on the agenda. How they will be funded within the existing fiscal rules remains to be seen.
Monetary policy is also problematic. The ECB has a single mandate – price stability. It has pursued it with excessive zeal. The July 2008 rate rise vies with the US decision to let Lehman fail as the worst mis-step of the crisis to date. It was poor politics and execrable economics. It set the ECB adrift from the US Federal Reserve when a united front might have helped calm investors.
To target headline inflation in the midst of a credit crunch is to fight yesterday’s war. A seizure in the banking system is always deflationary. Raising interest rates as this undertow sucks economies into the abyss just makes the inevitable slump worse. The eurozone economies are paying the price now. The US looks set to record a fourth-quarter 2008 annualized decline in GDP of 4%. German growth fell at an 8.4% annual rate and Italy at 7.2%.
Far too late, the ECB has joined the rate-slashing party. Reluctantly they are heading towards zero. Once rates get there another weakness of the EU will be exposed. In the US, UK and Japan quantitative easing is about to start. The central banks will buy long-dated bonds to push down yields, easing monetary conditions further.
This is not an option for the ECB. Which bonds would the ECB step in and purchase? Would it buy Italian and Spanish government debt because they are suffering from higher spreads? That would reward fiscal irresponsibility. Buying Bunds would be futile. In any case it is hard to see how agreement on the best policy course could be wrung out of 16 member states each pursuing its own interests.
There are many more problems with the EU that have not helped through the current economic crisis – banking regulation, budget mismanagement and sclerotic decision-making processes spring to mind. However, the fiscal straitjacket of the Growth and Stability pact and the adamantine monetary stance of the ECB are the most damaging. Worse still, they are self-inflicted. The euro will probably survive, but the rules of the club need to change.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own
