Tuesday 17 September 2019

Euro stuck in danger zone without an escape plan

Timid leadership and restrictive policy means we are unlikely to have a sustainable recovery, writes Colm McCarthy

Colm McCarthy

Colm McCarthy

Rosy assessments of economic prospects in Europe keep running up against a few inconvenient truths: the economies in most countries are showing no signs of recovery, the banking system is still broken and there is no political willingness to fix it. The overall stance of macroeconomic policy at eurozone level remains restrictive, despite the evidence of widespread stagnation. The policy stance is to issue upbeat forecasts while doing nothing to make them a reality.

The eurozone is entering the sixth year of the banking crisis with no evidence that the critical lessons have been learnt or that serious safeguards against a repetition have been put in place. There is no sign of political commitment to a proper banking union and the financial system still looks fragile. This overshadows prospects for sustainable recovery in Europe generally and particularly in Ireland, one of the principal casualties of the eurozone debacle.

Countries without their own currency or central bank can face persistent liquidity crises, with both governments and banks struggling to finance themselves, and these crises can last for very long periods. A poorly designed common currency area which lacks the architecture of a full monetary union is particularly vulnerable to these liquidity crises. To a greater or lesser degree, they have brought down Cyprus, Greece, Ireland and Portugal, all four requiring official lender support, with Italy, Slovenia and Spain also encountering severe financial pressures. Seven of the eurozone's 17 members are in serious trouble. Where the fate of governments and banking systems are intertwined, banking problems can infect government credit-worthiness as happened in Ireland, while the insolvency of the government, as in Greece, can bring down the banks. It is quite remarkable that the IMF, a lender of last resort for 187 governments, now sees most of its worldwide balance sheet deployed in the eurozone, in the form of emergency loans to countries which are members of a rich country club.

The negotiations on banking union continued their tortuous and inconclusive course in the week before Christmas in Brussels. A proper monetary union requires centralised bank supervision, a system for resolving failed banks without bankrupting their host government, and a system of centralised deposit insurance to prevent destructive capital outflows.

The United States is a full monetary union in this sense, with 50 constituent states. The eurozone is just a common currency area of 17 without the centralised institutions necessary to ensure financial stability. At the Brussels meeting of finance ministers, the German government declined yet again to acknowledge the need for a comprehensive reform, agreeing only to a partial centralisation of bank supervision and a limited scheme for bank resolution which would leave overborrowed treasuries exposed to further liabilities for bust banks. There has been no progress at all towards a centralised system of deposit insurance.

The European Parliament wishes to go further towards banking union, as do the European Commission and some council members at the European Central Bank. At this stage it appears that only an inadequate form of banking union will be agreed, which will leave the eurozone saddled with continuing risks to financial stability. These risks are perceived to be non-uniform and unlikely to create problems in Germany.

In the Irish bailout, the IMF and other official lenders financed the Government to meet its own needs but also to pay off departing unsecured creditors of bust banks. If the finance ministers' most recent effort is to be the blueprint and a distressed government needs to find national funds for a bank creditor rescue, the IMF could be called upon to repeat the Irish manoeuvre and will quite likely decline. The IMF is a credit union for governments. Why precisely should taxpayers in Asia, the Middle East and the Americas fund the IMF to rescue unwise lenders to bust banks in the eurozone? Would European countries increase their IMF subscriptions to rescue creditors of bust banks in Florida, the US federal government having omitted to design the dollar zone properly?

The coming year will see 130 major European banks, including the three surviving Irish domestic banks, subjected to stress tests with oversight from the ECB. At this stage it would appear that any bank shown to have inadequate capital will either be expected to raise equity in the markets or will turn to the host government, yet again. That is to say, some of the financially distressed eurozone governments could face new demands for bank recapitalisation. There is a consequent risk the ECB will duck the issue and succumb to the temptation to soften the bank stress tests in a further extension of the extend-and-pretend policy. This would sacrifice another opportunity to draw a line under the eurozone banking crisis. The failure to agree a credible system of bank resolution in time for the stress tests could result once again in tests lacking credibility, since the ECB can hardly declare banks to be undercapitalised without a clear path to resolution. This would be the worst possible outcome, worse than having no stress tests at all.

The ECB will have to face another challenge early in the new year and that is the risk of very low, or even zero, inflation in the eurozone. Zero inflation is not normally seen as terrible news, but in a deep recession when official interest rates have already been cut close to the minimum, zero inflation is a headache. The reason is because bank lending rates in the distressed countries, if credit is available at all, are already well ahead of the ECB's policy rate, which in turn is so low that it cannot be significantly reduced. For a business facing borrowing costs at 5 or 6 per cent, it hurts if the inflation rate is close to zero. The real cost of funds is high, working capital and investment finance is expensive. The low rates created by the ECB's interest rate policy are not available in the financially distressed countries, and are not much of a stimulus to business even in Germany if inflation is zero.

When the monetary authority has cut the policy interest rate as far as it can (and the ECB has pretty much done so, as have the UK and US central banks), too low an inflation rate offsets some of the benefit. The rate of eurozone inflation is supposed to be about 2 per cent but has actually been zero since March last. The ECB economists are forecasting just 1.1 per cent inflation next year and 1.3 per cent in 2015, both well below the 2 per cent target and likely to result in continuing high real interest costs for businesses in the periphery. Since the ECB cannot cut its policy rate much further (it is almost zero already) it is necessary to get the inflation rate up a little, in order to cut the real cost of funds and encourage business recovery. But there seems to be resistance to the ECB taking the measures needed to get inflation back up to even its own stated target. The means to do this are well understood and the ECB needs to get on with it.

The central banks in Britain and the US have embarked on a policy of 'quantitative easing', which means the creation of liquidity through the purchase of financial assets. This expands the availability of money and credit, giving a nudge upwards to the inflation rate. In Japan, the new government has declared publicly that zero inflation and the threat of actual price declines was inhibiting economic expansion, and has set a policy target of getting inflation back up towards 2 per cent and has begun to take the measures necessary to bring this about.

The eurozone's macroeconomic position needs lower real interest rates. With the policy rate already as low as it can get, this means that zero inflation is a threat to recovery. The ECB faces two challenges: interest costs to business have diverged, with excessive rates in the countries suffering most from the downturn, and an overall rate of inflation below target, which exacerbates the deflationary pressures. The construction of a proper banking union would help eliminate the excess interest rate faced by businesses in the distressed countries, while the pursuit of the ECB's target inflation rate of 2 per cent would bring down real interest costs for all.

The evident unwillingness to conduct policy in a manner favourable to recovery threatens the sustainability of the common currency.

Irish Independent

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