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Thursday 28 August 2014

Colm McCarthy: 'Clean exit' bets on no more crises

The Troika's gone, but the real story is the continuing lack of eurozone reform, writes Colm McCarthy

Colm McCarthy

Published 17/11/2013 | 01:00

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GLACIAL PROGRESS: ECB President Mario Draghi, left, Irish Finance Minister Michael Noonan, French Finance Minister Pierre Moscovici and EU Economic and Monetary Affairs Commissioner Olli Rehn, right, at an EU summit in Brussels last week.

THE Government's decision not to seek a precautionary credit line on exit from the Troika programme looks like a gamble. The advice from virtually all quarters was to make an application – the initiative has to come from the country concerned. The Government decided not to do so and thus the conditions that might have been attached are unknown.

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However, the signs were unpromising. An extension of a credit line from the ESM bailout fund would have to be unanimous, so every country could have a go at setting conditions. Two appeared to be doing so: Finland, which produced mutterings about collateral, that is, the pledging of specific state assets against any new loan, and Germany. There, the Social Democrat (SPD) party, currently in negotiations about a new coalition, wants changes to Ireland's corporate tax rate and support for a controversial financial transactions tax, to which the Irish Government is opposed.

Both positions are ridiculous for different reasons. Lending to sovereigns cannot be collateralised without weakening the position of all other creditors, including future sovereign bond buyers. The Finns tried this curious and impractical line before in connection with the rescue programme for Greece.

As to the tax issues which concern the SPD, there is no provision in the EU treaties for harmonising corporation tax rates, and any new financial transactions tax, to which there are various and serious technical objections, should be freely negotiated in the normal way. Elements in the SPD appear to envisage that the financially distressed countries could be deprived of a voice in these decisions, something for which there is no legal basis and no precedent.

Finance Minister Michael Noonan must have concluded that applying for a precautionary credit line would open a can of worms, inviting politicians in the northern European countries to dream up shopping lists of arbitrary demands on Irish policymakers. The unanimity requirement in the ESM treaty invites this outcome. It would have been far better to delegate the conditionality on precautionary credit lines to some independent agency, such as the IMF or a unit of the EU Commission.

The Government explanation for the 'clean exit' without a credit line does not rely on these arguments. Instead, ministers have been pushing the line that Ireland will not need the backstop, the State is already funded through 2014 (sounds familiar) and sole reliance on volunteer market lenders will suffice.

This is indeed a possible outcome if things go well. There are essentially two ways in which things could go badly. The first, to which the Government has drawn attention, is another eurozone sovereign debt crisis, for which read a screw-up in Italy or Spain, both likely to miss their fiscal targets for 2014. This is not a problem for Ireland to worry about to the extent that Italy and Spain are 'TBTF' countries: too-big-to-fail. If the crisis of summer 2012 is repeated, there will be another fix at eurozone level, perhaps an across-the-board activation of bond purchases by the European Central Bank (ECB). As happened on that occasion, Ireland would be an unintended beneficiary of whatever fix had to be conceded.

A more serious risk is a screw-up affecting Ireland only. This could happen in a number of ways, including the discovery of further holes in bank balance sheets, a failure to deliver on budget deficit reduction or a government break-up. Ireland is not bidding farewell to external surveillance on December 15, it is replacing surveillance by the Troika with surveillance by a sovereign debt market whose capacity to lose faith rapidly has already been demonstrated. This is the specific risk that would have been covered by a precautionary credit line. If this scenario materialises, Ireland would have to seek renewed access to bailout lending in unfavourable circumstances. Therein lies the real gamble.

The political response to the eurozone crisis plays out at glacial speed. Finance ministers met in Brussels last Thursday to consider how to deal with bust banks. They failed yet again to reach agreement. Some European banks may have inadequate capital, or none, when their balance sheets are scrutinised in the latest round of stress tests due to be completed next autumn.

If the capital deficiency cannot be met from market investors and falls to be filled by governments, as is the stated desire of the ECB the doom-loop linking bust banks to bust governments will be strengthened. Breaking this 'vicious circle', you may recall, was the key decision of a celebrated EU summit in July of last year. Through exposing governments to ongoing liabilities for banks, and through stuffing the balance sheets of periphery banks with more domestic government debt, the doom-loop has if anything been reinforced since the vicious circle was supposedly addressed last July. This is a dangerous game.

The decision to cut the ECB's main interest rate 10 days ago was not unanimous. The governing council, unlike decision-making bodies in many other central banks, does not publish its minutes, so nobody is meant to know who voted for or against any proposition. This code of omerta is breaking down and it has now emerged that, of the 23 members, six appear to have voted against the rate reduction. These included the central bank governors of Austria, Germany and the Netherlands plus a second German, executive board member Jorg Asmussen.

The ECB council members are supposed to be independent of their national governments and, perhaps more importantly, of their national interests. The reason Mario Draghi chose to cut the main ECB policy rate again is that inflation in the eurozone is too low, 0.7 per cent at the last count and well below the two per cent target. The feted output recovery is uneven and anaemic. This is evidence that the overall stance of monetary policy is too tight, given the budget corrections under way. Should the general price level begin to fall, Europe could be caught in a new set of economic policy problems. When price deflation threatens and output is faltering, an interest rate cut is the conventional policy response.

The trouble is that no single interest rate will ever suit each individual eurozone member, unless their economic cycles could be magically aligned. Back in 2003 and 2004, when interest rates were far too low for the bubble economies in Spain and Ireland, France and Germany needed lower rates since their economies were sluggish. The ECB delivered what they wanted – it is not known if the central bank governors of Spain and Ireland voted against rate reductions at that time, since minutes have ever surfaced. They should certainly have done so from a national interest perspective. The roles have now been reversed. It suits the weaker countries to have lower interest rates, while there are worries in Germany that easy and cheap credit could fuel a housing bubble there.

The negative reaction in the German press to Mario Draghi's leadership at the ECB is becoming a political issue in itself. Even though two per cent inflation is the official eurozone target, German attitudes are not symmetric. It is anathema to exceed this figure but acceptable, it would appear, to undershoot. Draghi has been accused of pursuing Italian interests, Italy being one of the countries deemed likely to benefit from lower interest rates. One German newspaper fulminated last week against the "Banca d'Italia" which it believes is now residing in Frankfurt.

The row between Germany and Mario Draghi may in due course be seen as a ball of smoke. Cutting the already low ECB interest rate will make little difference to those countries, including Ireland, which cannot benefit from the low ECB rate anyhow. The reason is something called financial fragmentation. The eurozone is supposed to be a full monetary union but it is really just a common currency area. Credit conditions and interest rates are not the same throughout the zone and the monetary policy transmission mechanism, the pass-through of easier money from the ECB to the periphery, is broken. The latest interest rate cut could fail to do any good in the distressed member states for this reason.

The media focus these last couple of weeks on Ireland's Troika exit, without a parachute, is understandable.

The bigger story, though, is the continuing evidence that durable reforms of the eurozone architecture will not be contemplated until the next crisis forces the pace of change.

Sunday Independent

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