Sunday 25 February 2018

Europe is in denial but will have to confront reality

EUROZONE leaders dropped the ball again and will not be popular at today's gathering of the G20. Last week's rescue package was far too small and is already unravelling.

Politically, it was not enough to rescue Greece -- a casualty of the first stage of the crisis that is now apparent.

Financially, the EFSF (European Financial Stability Facility) rescue fund needed to be a multiple of what was agreed, but Germany insisted that the European Central Bank (ECB) could not be tapped.

It is not even clear where all of the insufficient funds will come from -- Europe is already accused of "hijacking" the International Monetary Fund (IMF) and China is not keen to invest in a mess.

In fact, there is a touch of financial blackmail in the eurozone's presentation of an insufficient and incomplete package to the G20 and this will prompt some interesting exchanges.

It is certainly true that the world will suffer if the eurozone implodes, but outside assistance is probably at its limit. This is especially true when the eurozone refuses to resort to its central bank as the US and UK did.

So the eurozone will be asked to face the simple, if unpleasant, truth that the problem is far too big to be resolved without the ECB.

Professor Thomas Sargent, who recently shared the Nobel Prize in economics, co-authored an article in 1981 that explained how debt dynamics lead to 'Some Unpleasant Monetarist Arithmetic'.

His lesson was that when fiscal problems get out of control, they will eventually undermine any monetary restrictions or promises that are in place and will have to be resolved by expanding the money supply.

Central banks will eventually have to bail out delinquent and hamstrung governments. At its simplest, when the interest rate on government debt is larger than the growth rate of the economy, debt grows faster than the ability of the economy to service it.

Unless this is addressed by corrective fiscal policy, the debt level can quickly become unsustainable.

Policymakers are then left with a stark choice; either the government defaults or the monetary authority buys up the debt.

In Europe, interest rates on government debt in Spain, Italy and France are dangerously high and are on the rise again. Meanwhile, forecasts for growth have been slashed across the continent and the room for fiscal correction has been exhausted in many countries.

This arithmetic is treacherous and leads to anomalies like France contributing to a fund that may have to support its own borrowing.

Italian borrowing costs are stuck above 6pc while the economy is likely to grow at barely half that rate (including inflation) over the next few years. Debt is already at 120pc of GDP.

The ECB says default is not an option -- and Greek restructuring will not become a model for others. It argues that further default would undermine the financial institutions holding the debt and shake confidence in all government bonds, driving interest rates higher. But rates are rising anyway.

As an alternative to default, the ECB tried to get the stronger economies to bail out the weaker. But delays have seen the burden grow larger, as witnessed by the migration of more and more countries from the ranks of the reliable.

The tax base in the eurozone is shrinking fast and the likelihood of a monetary solution has soared. To deny this possibility only serves to further undermine confidence in financial institutions and government debt -- the outcome the ECB wants to avoid.

So, forget about the details of the rescue packages -- it is best to follow this crisis in stages.

During the first stage, the smaller programme countries might have recovered if the assistance given to them had been sufficiently generous.

Eventually, the support increased and the financial terms were improved, but only in time to put Ireland on a firmer footing. Portugal stagnated and Greece went off a cliff. At the next stage, a significant restructuring of debt became inevitable.

Greece finally got a partial default but the significance of this is not clear to a population that can see no future beyond austerity -- debt relief should have been made more tangible through a relaxation in policies.

Meanwhile, a crisis of confidence has spread to other countries and a second recession is looming. The EFSF is still not big enough to allay fears of contagion.

So now Europe must prepare to use the ECB to absorb its debt. The longer it delays, the more inevitable, significant and disorderly will the necessary action become.

There are essentially two routes that could force the ECB to intervene -- a large country like Italy comes to the verge of default or there is a serious run on banks holding bad sovereign debt.

It is simply not credible that the ECB would allow either of these events to occur and it is time for it to say so.

Unfortunately, this task was left to the new Italian head of the ECB and he cannot yet lead. Germany will resist until the last minute.

Europeans still cannot speak the truth to one another; but expect some very plain talking from our friends in Cannes.

Gary O'Callaghan is Professor of Economics at Dubrovnik International University. He was a member of the staff of the IMF and has advised numerous governments on macroeconomic policies

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