The Allure of Growth for the Euro Zone

A currency union requires strong political leadership, and complete integration of monetary institutions within a single state, to be able to survive. Yet there still seems to be a collective reluctance to acknowledge the scale of the requirements for full monetary and fiscal union in the euro zone.

Euro coin in front of the giant symbol of the Euro outside the headquarters of the European Central Bank.
Thomas Lohnes | AFP | Getty Images
Euro coin in front of the giant symbol of the Euro outside the headquarters of the European Central Bank.

It would mean the surrender of national sovereignty on economic management, and a pooling of debt. The terms "debt pooling" or "monetary union" are used in an abstract way; in reality it would mean taxes sent from all individuals and organizations in all euro zone statesto the center, to be distributed to all others, covering debt repayments as well as hospitals for example. It would mean a single central Exchequer responsible for taxation and budget spending across the euro zone. Are the countries of the euro zone ready for this?

While the official line is that the euro is here to stay, the yield on five-year government bonds is just 0.3 percent in Germany, over 5 percent in Italy and 6.5 percent in Spain. Thus the markets are already assuming a break-up, at the very least into two blocs.

There is a silent bank run across Europe, while capital movements are still unrestricted. Wealthier individuals in peripheral countries are buying property in, or sending money to, other countries seen as being safer. Deposits are down 8 percent in Italy and over 17 percent in Portugal.

Given that many of these imbalances and pressures have been evident for at least two years, since the European Financial Stability Facility (EFSF) was established, why haven’t we experienced a break-up yet? The answer lies in a mechanism known as Target2, which has operated a degree of cross-continental fiscal transfers.

Target stands for Trans-European Automated Real-time Gross Settlement Express Transfer System.

After the 2008 credit crisis, European banks began to stop trusting one another, and over time inter-bank lending began deteriorating and eventually totally seized up. The European Central Bankstepped in and took the place of interbank lending via the Target2 system. Target2 has led to monetary transfers within the euro zone via credits and debits at national central banks

Given the diverging fortunes of Northern and Southern Europe, the Target2 imbalances simply will increase over time on the current course. Therefore, as time goes by, Germany and the rest of the euro zone have to confront the inescapable truth that in a monetary union either trade flows or capital flows need to balance. Capital flows currently do the balancing. This is not occurring via fiscal transfers or Eurobonds, but nonetheless Germany finds itself going reluctantly ‘all-in’ monetarily, via its exposure to the ECB.

While Target2 has prevented a collapse of bank funding, it does nothing to resolve the underlying trading imbalances.

The German central bank wrote to the ECB to complain at the rising exposure of Germany, after it emerged that its credit with the ECB through the Target2 system grew 65 percent in 2011, to reach nearly 500 billion euro ($613 billion). Just four euro zone central banks — Germany, the Netherlands, Luxembourg and Finland — have positive balances. The sum has been rising by an average of 33 billion euros ($41 billion) a month since July last year. Meanwhile, all the peripheral countries have big liabilities.

The so-called “growth pact” or mini Marshall plan amounting to 1 percent of European Union GDP is too small to change anything, and is unlikely to be increased.

When people criticize the German government for insisting on austerity, and resisting the formal pooling of debt, they appear not to be aware of these mounting bills, which seem to have no upper limit if Target2 imbalances continue on their present trajectory.

There is no guarantee that such permanent effective fiscal transfers would be affordable for Germany, even if German voters accepted that burden. The only sustainable way to prevent these imbalances growing is for the periphery to become as competitive as Germany. There is no real prospect of this occurring at anything like the rate necessary – which needs to be months rather than years. The other way is for the periphery to have a deep economic recession, hence a collapse in imports and a halt the exposure accumulating via Target2. This is the current policy path – but it is unsustainable in the long run.

Any meaningful growth pact would defeat the purpose of reaching competiveness balance, which is why it will not increase substantially in size.

Germany is technically a surplus state, but a large and growing proportion of its profits may not be ever realized, as Target2 imbalances begin to resemble a giant sub-prime bubble. Critics who state that if Germany leaves the euro its exports will collapse (which is true) miss the point that the profits they make on these exports are fictitious, or recognized but not received. For this precise reason, Germany is obsessed with the fiscal pact and needs and even wants a recession in the periphery.

Greece, by not conforming to the austerity measures, is creating a huge headache for Germany. If one deficit country does not comply, then why should Spain or Italy? And an absence of austerity measures means continued balance of payments deficits and ever-increasing German exposure via the ECB. The longer this goes on the more invested Germany becomes in the outcome, and the bigger her potential losses.

If Target2 imbalances were to be unwound, the path for an orderly exit of the euro may become possible. This is why creditor countries have not yet left. Faced with the enormous implications of complete monetary union, alternatives are being explored.

Markets view a Greek exitas inevitable, but they have lost confidence in Europe’s firewall and its existential issues dominate the agenda. Is the “Troika” ready to pull the plug on Greece? Within three months we know for certain, as all sides attempt to back-pedal and cover massive ground.

Jason Manolopoulos is the author of "Greece's Odious Debt" and Co-Founder of Dromeus Capital