Wednesday 29 March 2017

Colm McCarthy: Those who control the fate of the euro have opted for a sticking-plaster approach

Instead of a durable solution, those who control the fate of the euro have opted for a sticking-plaster approach, says Colm McCarthy

Greek Finance Minister Yanis Varoufakis
Greek Finance Minister Yanis Varoufakis
Colm McCarthy

Colm McCarthy

When a piece of equipment fails the options are to fix it decisively, scrap it, or patch it up with half measures. The eurozone architecture is a piece of economic policy equipment, it is clearly not working and the strategy is to devise one temporary fix after another.

Europe's political leaders have spent 10 weeks wrestling with the latest instalment of the Greek crisis, five years after it erupted in the early months of 2010. There is no sign of a resolution and the period since Syriza's election victory on January 25 has been wasted on a dialogue of the deaf, interspersed with leaks and counter-leaks, veiled and unveiled threats. No clear path to a viable recovery for Greece has been set, and both the EU and Greek leaders appear content with blame-games designed for domestic political consumption. There remains a serious risk that Greece could end up outside the single currency, by accident or design.

The eurozone was meant to be forever, and for every country which joined, not just a permanent monetary union but the decisive catalyst for the political dream of 'ever greater union'. It has instead been revealed as premature, poorly designed, poorly managed, a burden on economic recovery, a fruitful source of new divisions in Europe and a distraction from grave geopolitical challenges at Europe's borders.

There is revealing evidence of this dysfunction in the eurozone's airy self-description - 'Economic and Monetary Union'. Bits do not fall off in a proper monetary union. Europe has indeed achieved a substantial degree of economic integration. There is free trade amounting to a single market and free movement of labour. Until the euro crisis came along, there was also free movement of capital. This has been suspended for two years now in Cyprus and capital controls are being touted (ironically by officials of the European Central Bank) as a part of the 'solution' for Greece.

The notion that the fruits of monetary union include the suspension of capital mobility would be funny if the stakes were not so high.

The eurozone is not a monetary union. It is just a common currency area. To see why this distinction matters, consider what shape a Greek exit from the euro would actually take. Deposits in Greek banks account for most of the money supply in that country. If convertibility is suspended - prohibiting payments abroad, as was done in Cyprus - a euro in a Greek bank ceases to be equivalent to a euro anywhere outside Greece. The ECB can suspend the convertibility of Greek bank deposits without the agreement of the Greek authorities, either by collapsing the Greek banks or by denying them access to the so-called 'Target' settlement system which it controls. All payments between eurozone banks go through Target.

Thus Greece could end up with a new currency (the Greek 'euro') in advance of the government actually printing new banknotes. Some commentators expect that this is precisely the way a Greek exit is most likely to happen. The public think so too: there have been large outflows from Greek banks, with funds transferred to safety abroad or converted to cash, which would be unaffected. If you hold deposits in a Greek bank, you should be nervous, even if you believe the bank to be entirely solvent.

This is a key distinction between a proper monetary union and a mere common currency area. In a full monetary union, such as the United States, the geographical location of solvent banks does not matter. Nobody fears that California will be leaving the dollar zone, putting the value of deposits in California banks at risk, even if the state of California has made a mess of its budget policies (which it has, by the way). The address of the headquarters of a bank does not matter in the USA and nobody talks of California leaving the dollar, or being ejected from the dollar zone.

Creating a common currency for Europe in advance of closer political union, including a banking union, was a gamble and the gamble has failed. The Greek government could run out of cash in a matter of days or weeks, barring another temporary fix. Even if a deal is done, Greece's place in the eurozone will be uncertain into the indefinite future. Eurozone leaders have been dropping hints that there are 'firewalls' in place to prevent spillover problems in other countries if Greece is ejected. In effect, they are saying that the impermanence of the zone's membership is seen as a valuable new design feature.

Official interest rates in the eurozone are at all-time lows and the ECB has commenced large-scale purchases of government debt. This makes it feasible for heavily indebted governments, including the Irish Government, to fund their deficits and to re-finance maturing debts at low cost. But nobody thinks that this sticking plaster solution will work forever. A natural development would be for interest rates to move back to a margin above the rate of inflation, which is supposed to be 2pc. The current interest rate regime (some lucky governments can borrow five-year money at negative cost) is another temporary fix and cannot last.

The preferred policy is to pretend that the inherent weaknesses in the Eurozone design have been addressed and to muddle through, with or without Greece. This policy could work, at least for a while, in the sense of keeping the show on the road. But the weaker members will be at permanent risk of low growth, high unemployment and persistent budget deficits. There will be more rows over adherence to budget rules. If the next country to elect a non-cooperative government is a large state (it could be France, Italy or Spain) the experiment could come to a catastrophic end. Ditching Greece might be survivable but the euro will not last long if the adherence of a large country comes into question.

That risk is magnified if Greece is thrown to the wolves. The imposition of exchange controls in Cyprus was the first acknowledgement that this is not really a proper monetary union. If Greece goes, then membership itself, and not just the terms of membership, ceases to be guaranteed. If one of the 17 surviving members gets into trouble the outflows from the banking system will be enormous and immediate (remember Greece!). The Greek 'rescue' in May 2010 was botched and the Greeks are deserving of more sympathy than is being shown. But the problem is not Greece, it is the attempt to have a monetary union without making the necessary political decisions.

A less accident-prone system with a full banking union could have been designed and implemented in 1999 when the euro was introduced. The on-the-hoof reforms introduced since the crisis broke do not add up to a durable re-design. It could still be done but necessary reforms have been resisted, principally by Germany, and the political will to pool sovereignty has diminished as the squabbling and expulsion threats proceed apace. The polar alternative is to admit that a proper monetary union cannot now be constructed and to plot a return to national currencies. But this would be disruptive and would require even more political courage. Muddle through it is then.

Sunday Independent

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