News Analysis

Thursday 18 September 2014

Colm McCarthy: Let's write off monetary union and start afresh

Many of the expected benefits of Eurozone membership are not being delivered.

Published 04/11/2012 | 05:00

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Last week saw further announcements of job losses in Ireland, with An Post and Eircom set to shed 3,500 jobs between them. Output is falling in all seven of the most financially distressed Eurozone countries.

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There could be zero growth for Europe as a whole next year, in which case there will be no export-led recovery in Ireland. Unless prospects of economic recovery can be restored, the five-year-old crisis could limp on for many more years.

The Irish Government's efforts to secure relief from bank-related debt brought German Finance Minister Wolfgang Schauble to Dublin last Monday, while Taoiseach Enda Kenny visited Berlin on Friday. Mr Schauble confined his on-the-record remarks to a reiteration of support for Ireland's adjustment programme, citing Chancellor Angela Merkel's acceptance, which she repeated again on Friday, that Ireland is, in some undefined sense, a "special case". The Irish Independent summarised the outcome of Mr Schauble's visit, quoting an Irish Government source, in these terms: "He is basically saying, 'Come to us, find a unique way that distinguishes you from everyone else'. He's very cautious about opening up any opportunities for other countries."

If this is an accurate description of the German government's position, it could turn out to be a dangerous course, heralding a divisive competition between debtor countries to distinguish themselves from one another in pursuit of one-off debt relief. There are indeed unique features to the Irish case, but every goose is a swan in the eyes of its owner, and every one of the distressed Eurozone countries can point to special features that make it especially deserving of generous treatment. If last week's quotes reflect accurately the position of the German government, it has embarked on a most unpromising route to resolving the Eurozone crisis. Here, briefly, are the arguments that could be marshalled to establish the uniqueness of five of the distressed Eurozone countries. These are Greece, Ireland and Portugal -- already in rescue programmes, plus Cyprus, which has had to apply for a programme, and Spain, which may shortly need to do so.

Greece: Only one Eurozone country has thus far secured relief from unsustainable sovereign debt. Greece defaulted on private holders of government debt to the tune of €100bn, the largest sovereign default in history. Another restructuring of Greek debt is inevitable. The debt/GDP ratio, even after the huge write-off of privately-held sovereign debt, is headed for 190 per cent and the economy continues to contract. Greece is unique.

Ireland: Through the summer and autumn of 2010, efforts by the Irish Government to avoid repayments to unguaranteed and unsecured holders of bonds issued by two bust banks, Anglo Irish and Irish Nationwide, already in the process of closure, were frustrated by the European Central Bank, headed at the time by Jean-Claude Trichet. The Central Bank forced a reluctant Government to risk national solvency in order to pay bondholders to whom no guarantees had been given. This action has no precedent in the history of central banking. Ireland is unique.

Portugal: Despite valiant efforts to stick with the terms of the EU/ IMF rescue programme, Portugal is likely to join Greece in defaulting on its sovereign debt, according to bond market prices. The 10-year bond yield is at 8.57 per cent, implying the highest default risk of any country that has not yet restructured its debt. A second defaulting Eurozone member would be a major setback and would spur contagion to other vulnerable sovereigns. The threat from Portugal is unique.

Cyprus: Cyprus has been forced to apply for a rescue programme from the EU and IMF. Exposure to Greek debt has crippled the Cypriot banking system, making Cyprus, uniquely, a victim of contagion.

Spain: The crisis in Spain precipitated the measures announced at the Brussels summit last July 29, promising to "break the vicious circle" between banks and sovereigns. Spain is a TBTF country, Too Big To Fail without bringing down the Eurozone project. Spain's uniqueness has already been demonstrated.

Any other Eurozone country in financial distress and facing ejection from the bond market will be able to point to unique features which entitle it to favourable treatment. Italy is also a TBTF country, while Slovenia, which faces short-term problems, can point to the peculiarities of its banking crisis.

An ad hoc approach based on the ability of the financially distressed countries to argue a case for debt relief will see Ireland joined by everyone else. A case by case approach will also see extraneous matters dragged into the negotiations. On Friday the media reported several German politicians rattling on about Ireland's corporate tax regime, a concern already voiced by some of their French counterparts.

The broken Eurozone project needs two sets of policy actions. The first, for the long term, is a re-engineered monetary union designed to survive, which means a banking union and a more centralised system of macroeconomic management. The second, and more contentious, is a clean-up operation to restore prospects of economic recovery, especially in the growing list of financially distressed members.

To date, the performance of the Eurozone political leadership has been dismal, inviting unfavourable comparisons to the more decisive actions of the US Treasury and Federal Reserve.

The clean-up operation needs a coherent macroeconomic strategy at European level as well as an acceptance that the debt burdens remaining on several Eurozone members need to be relieved. The macroeconomic strategy should see a relaxation of fiscal consolidation in those countries which retain good access to bond markets, as well as a deliberately expansionary monetary policy from the European Central Bank. Some weakening in the external value of the euro should be seen as a minor concern. If the current growth standstill continues it may ultimately weaken anyway.

It is fashionable in Germany to argue that Europe needs greater political union, permitting a more centralised fiscal policy. If the Eurozone were already a single country, with a normal central bank and a counter-cyclical macroeconomic strategy, it would already be seeking to bolster aggregate demand as the US has been doing. The zone as a whole does not face an imminent inflation threat, does not have a balance of payments deficit and has public debt and deficit ratios no worse than those in the US, the United Kingdom or Japan. But it remains committed to a policy stance that is exacerbating the downturn, particularly in the regions of the Eurozone facing financial distress.

In addition to a relaxation of policy at Eurozone level, a pragmatic approach needs to be taken to the debt-encumbered member states. Greece will have to undertake another debt restructuring, perhaps fairly soon. Several other countries may be unable to carry the burden of debt which has been accumulated. A partial mutualisation of excess debt burdens is the other essential component in the clean-up operation, preferably on a no-fault basis. This will likely happen in a messy and politicised manner anyway. Better to accept that debt burdens in excess of some agreed threshold be addressed, through further haircuts for private creditors in some cases, some monetisation by the ECB and some mutualisation by Eurozone rescue vehicles. Peripheral states in trouble could expect to see a reversal of capital outflows, with a consequent reduction in borrowing costs. If this kind of clean-up operation requires treaty changes, so be it. The Irish Government is understandably wary of changes given the mixed record on getting EU-related referenda passed, but if treaty change is the price of a durable solution it should be considered on its merits.

When Ireland was considering whether to abolish the punt and join the euro in the mid-90s, one of the clinching arguments deployed by the proponents of entry was the reduction in borrowing costs which would result. Borrowing costs did reduce, but the monetary disintegration which has since occurred has left the periphery facing far higher borrowing costs, and constrained access to credit, relative to the core. Thus one of the key benefits of monetary union, the promised equalisation of credit market conditions across the zone, is not being delivered. On that score alone the monetary union project has failed, and it is time to face the task of writing off the botched experiment and getting it right next time.

Sunday Independent

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