Investors are increasingly loath to trust the debt of many euro zone sovereigns. That is the most important lesson of recent events. Many European politicians wish to declare war on the markets. They need to remember that they want people to buy their debt.
As of Monday, spreads over German bunds were more than 60 basis points (0.6 percentage points) in Finland and the Netherlands, 152 points in Austria, 155 points in France, 292 points in Belgium, 466 points in Spain, 480 points in Italy, 650 points in Ireland, 945 points in Portugal and 2,554 in Greece. For most members, such spreads are manageable. Even Italy and Spain could live with current yields for a while, albeit not indefinitely. What is worrying is that stresses in euro zone public debt markets are rising: Ireland is the only member to have had a significant decline in spreads, though to what is still a penal level.
There are three explanations.
The first is that investors realize that a number of euro zone countries are at a far greater risk of insolvency than previously thought.
The second is that euro zone sovereigns lack a true lender of last resort. They are what Charles Goodhart of the London School of Economics calls “subsidiary sovereigns”. Their debt bears a risk of outright default rather than mere monetization. Fearing default, investors create illiquidity, which turns into insolvency. The greater the proportion of foreign creditors, the more plausible default becomes: investors know that politicians are more unwilling to default to their own citizens than foreigners. But, as a result of the currency union, foreigners hold a higher proportion of sovereign debt than before: half of Italian public debt is held abroad.
The third explanation is that there is break-up risk. No currency union is irrevocable. Even countries do not survive forever. But a currency union among discordant states is far more fragile than a country.
The first explanation does not work. Spain’s debt and deficit position is not obviously worse than the UK’s. Yet the UK is paying just 2.2 per cent on 10-year bonds, against Spain’s 6.6 per cent. The explanation for this gulf must be the risks of illiquidity and break-up. These risks are also related: if illiquidity were to cause default, countries might well exit. That is not inevitable. But it is conceivable, given the massive shock a default by a significant sovereign would cause.
So what is to be done? Last week, I moderated a discussion of this topic at a conference in honor of Paul de Grauwe of Leuven University in Belgium. I concluded that the euro zone confronts three interwoven challenges. The first is to manage the illiquidity in markets for public debt markets. The second is to reverse the divergence in competitiveness since its launch. The third is to create a regime capable of ensuring less unstable economic relationships among its members. Behind this list is a simple point: people have to believe that members will fare better in than out if they are to trust in the euro’s future.
Take each of these points in turn.
First, vulnerable countries simply cannot eliminate illiquidity or break-up risk, on their own. Promises of austerity that are bound to make the economy weaker undermine credibility rather than strengthen it. Interest rates have to be capped at manageable levels. How this is done is a second order question. Some combination of the European Financial Stability Fund with the European Central Bank seems a logical route, as Peter Bofinger of Würzburg University and George Soros suggest. Unfortunately, potent interventions are unlikely, because of a misguided ideological resistance. Vulnerable sovereigns will be left to dangle. Yet, if spreads were capped, but not eliminated, countries would still retain a strong incentive to curb their deficits and lower their debts.
Second, a great part of the loss of competitiveness of peripheral countries must be reversed. But, as Germany should know from its experience in the last decade, this would be far easier if inflation were relatively high in partner countries. The ECB should seek to ensure enough demand in the years ahead to facilitate the improvement in competitiveness now needed in peripheral countries. By this standard, the ECB has been unsuccessful. Growth of broad money has collapsed and nominal and real gross domestic product have been far too weak (see chart).
Now that fiscal austerity is the rule, the ECB ought to be delivering a strongly expansionary policy, instead of the most restrictive policy of any of the big central banks of advanced countries. In current circumstances, the ECB’s mantra about price stability in the medium-term risks becoming lethal. As one official in Brussels remarked to me quite recently, the ECB risks being remembered by historians as the magnificently orthodox central bank of a failed currency union. Is that how the members of its council want to be remembered? I suspect not.
Unfortunately, adjustment may, in some cases, still fail. In that event, the euro zone would face one of three dire alternatives: a permanently depressed member; a member on permanent external life support; or an exited member. I know of no way to make these choices palatable.
Finally, consider the euro zone's future regime, political and economic. It seems to me that three lessons shine out from the crisis. First, as André Sapir, of the Université Libre de Bruxelles pointed out at last week’s conference, the euro zone's financial sector must be regulated by a common regulator and backed by a common fiscal authority. Second, the euro zone would, at the least, benefit enormously from a unified bond market that covered a big portion of member country debt. Finally, there needs to be more effective discipline over the structural and fiscal policies of the member states. But none of the above would (or should) be acceptable to democracies without a substantial move towards a political union. Yet everything we have recently seen and heard suggests that this development, ruled out in the 1990s, would be even harder now.
The euro zone, in sum, has to advance or risk disintegration. In a pamphlet I wrote some 15 years ago, I argued that “not only is the absence of shared political culture and a common political process an obstacle to enduring success; the European Union also lacks the constitutional structures to make the centralized exercise of politically sensitive powers legitimate”. The euro zone must now prove me wrong.