That sinking feeling

Are we really talking about fiscal consolidation already?

Former German finance minister Wolfgang Schäuble is known for his adherence to monetary and fiscal rigour and a recent opinion piece in the Financial Times confirmed his reputation. He argued for a “return to monetary and fiscal normality [and that] the burden of public debt must be reduced.  Otherwise, there is a danger that the Covid-19 pandemic will be followed by a “debt pandemic”, with dire economic consequences for Europe … Thus, all eurozone members must engage in efforts to return to stricter budgetary discipline.” It is striking that following the biggest economic hit since WWII we are already hearing calls for fiscal tightening. Whilst acknowledging that there will come a point when fiscal support will have to be eased back, such calls require more nuanced thinking than Schäuble tends to apply to fiscal issues.

In what sounded suspiciously like a lecture to the finance ministers of euro zone member states, notably Italy, Schäuble noted that “the need to pay back the debt later is often overlooked. Many governments focus on the “easy” bit of Keynesianism – borrowing – and then postpone repayment of their debts.” This is, of course, not true. If bond investors were worried about not getting their money back they would cease purchases of euro zone debt. Aside from the obvious case of Greece (of which more later) that has not happened. Indeed, many EMU member states have agencies dedicated to managing the national debt which is an indication of how seriously they take the problem.

The article appeared to be based on a misunderstanding of how fiscal policy works, which is somewhat unfortunate from a former finance minister. For a start, he makes the amateur mistake of treating public finances in the same way as those of a household. In other words, he fails to account for the near-infinite lifespan of a government which allows debt to be repaid over multiple generations. And if he is worried about governments borrowing but not repaying debt, Schäuble might want to take a look at the level of German public debt which has doubled in the past 25 years at roughly the same pace as Italy (chart below).

Schäuble’s Italian concerns

That said, Germany’s performance in holding down its debt-to-GDP ratio is far better than that of Italy (chart below). Whilst the level of gross debt has increased at roughly the same pace since the mid-1990s, the fact that Italian GDP has grown more slowly than Germany means that there has been a significant divergence in the debt ratio performance. Italy has struggled to generate decent growth in the two decades since it joined the single currency. This can partly be ascribed to low productivity growth in a fixed exchange rate environment and there are many who believe that Italy’s days in the euro zone may be numbered.

The travails of the Italian economy can wait for another day but you can be sure that if Italy proves to be the catalyst for another euro zone debt crisis it will shake monetary union to its foundations. Precisely because it is in nobody’s interests to allow the euro zone to fall apart, the economy has to be managed in a way that accommodates the fiscal position of southern European countries. Whilst this is not what Germany signed up for, and Schäuble’s views are coloured by those of the people he serves – the electorate – politicians across the euro zone have to take some of the responsibility for allowing Italy into the single currency knowing that it failed the excessive debt criteria.

And he has form on Greece

For all Schäuble’s concerns about Italy, his role in the Greek crisis as German finance minister highlighted the perils of adherence to economic orthodoxy. After Greece was forced to put in place stringent austerity measures in 2010 in return for an emergency loan that was sufficient only to pay interest on existing debt and keep banks capitalized, his insistence on further measures in return for additional aid were more than savage. Former US Treasury Secretary Tim Geithner has recorded how Schäuble was willing to sanction Greece being kicked out of the euro zone, and he continued to hold Greek feet to the fire even in the face of IMF concerns that Greece would be crippled by its ultra-high debt.

The cost to Greece of the fiscal measures forced on them by other euro zone states has been high – even before the pandemic Greek real GDP was almost 30% below mid-2007 levels. In anyone’s book that has to go down as a depression. We can argue about how Greece found itself in such a predicament in 2010 and the extent to which it was the author of its own demise. But the actions of the German government, spearheaded by Schäuble as finance minister, illustrate that the costs of applying orthodox solutions at the wrong time can inflict huge damage. Anyone tempted to heed the siren calls for fiscal consolidation would do well to ponder the Greek case.

He ain’t no Keynesian

In his opinion piece Schäuble invoked the spirit of Keynes. Unfortunately he seems not to have understood Keynes’ prescriptions. He noted that “Keynesian economic experts like Larry Summers or Olivier Blanchard lament the crossing of red lines on public debt and point to the increased likelihood of runaway inflation.” But there is no clear link from high debt to inflation, other than that it is to the debtors advantage if the debt burden can be inflated away. High levels of debt do not, per se, result in high inflation – just ask the Japanese. The criticism levied by the likes of Summers and Blanchard is that a US economy with little spare capacity which receives a big fiscal boost may be prone to inflation, but it is not a question of the debt level itself.

In any case, the treatment of debt did not get a lot of attention in Keynes’ most famous work. In The General Theory of Employment, Interest and Money, I counted 22 uses of the word “debt” and one of them was to point out the perils of reducing it too quickly. As Keynes pointed out, “the desire to be clear of debt” may exacerbate existing economic problems by stimulating more saving than would otherwise occur, resulting in “a diminishing … propensity to consume” – the famous paradox of thrift argument. This is not merely a 1930s problem. IMF simulation analysis conducted in the wake of the GFC pointed out that when all countries are involved in fiscal consolidation with interest rates at the lower bound, the costs of lost output are twice as large as when one country performs fiscal contraction in isolation. If Keynesian analysis offers any insight, it is that there can simply be too much fiscal consolidation.

But we do agree on one thing

Despite the fact I disagree with most of his policy prescriptions Schäuble did make one argument that I found very appealing, suggesting that “a promising approach for Brussels to take would be a eurozone debt redemption pact, similar to the sinking funds devised by Robert Walpole and Alexander Hamilton.” Indeed, I made this very proposal some years ago (here). As I pointed out at the time “few investors will buy undated Greek consols, so the fund would have to be guaranteed by a body such as the ECB.” Last year’s joint borrowing plan suggests that maybe the European Commission itself might be an appropriate guarantor. There are many issues regarding how such a fund might work. Would all countries place debt in the fund or simply those with excessive debt (anything above an arbitrary limit such as 120% of GDP)? The issue of guarantor would almost certainly provoke a political storm.

However we are at the stage where the old pre-Covid orthodoxy no longer holds. As the last decade has demonstrated, unsophisticated consolidation is not guaranteed to produce good outcomes. If Europe is to emerge strongly from the pandemic it cannot afford to be encumbered by navel-gazing over appropriate debt levels. A sinking fund in which a large proportion of debt can be converted into undated consols might be one way to deal with the problem. If even someone as orthodox as Schäuble is talking about it, maybe this is an idea whose time has come.

More courtroom drama

As central banks and governments around the world battle to put in place measures to mitigate the worst of the Covid-19 economic fallout, the euro zone once again finds itself in an extremely difficult position. Whilst EU governments have done much to provide a range of packages to support workers who would otherwise lose their jobs, the only pan-Emu institution capable of looking at the regional picture is the ECB which is, to use the English cricketing parlance, batting on a sticky wicket.

Yesterday’s ruling by the German Constitutional Court (GCC) ordering the German government to ensure the ECB carries out a “proportionality assessment” of its debt purchases threatens to open a new front in the dispute between northern and southern members of Emu. The GCC is concerned that the “economic and fiscal policy effects” of the bond purchases should not impinge upon the ECB’s policy objectives and it has threatened to block Bundesbank purchases unless the ECB completes a review within three months. Having watched the UK Supreme Court intervene in Brexit-related issues, rightly in my view, it is difficult for me to say that the GCC is wrong. It is, after all, merely acting in what it perceives to be Germany’s national interest according to domestic law.

But this is not the first time that the GCC has become embroiled in the euro zone debate, having generally taken a dim view of Mario Draghi’s “whatever it takes” policy to keep the euro zone together. A case was first brought to the GCC in 2015 when a group of concerned citizens claimed that the ECB was engaged in monetary deficit financing which runs contrary to the Maastricht Treaty. This was subsequently referred to the European Court of Justice in 2018 which ruled in favour of the ECB. However, the GCC has now ruled that the ECJ’s earlier ruling is “untenable from a methodological perspective” which is a much stronger tone than anything it has delivered previously.

Had the ECB not recently ramped up asset purchases, the GCC would not have had to reopen the debate. But it did, and we could now be looking at a major constitutional problem. In effect the GCC has questioned the primacy of EU law, which takes precedence over national law and was such a bone of contention for Brexit supporters in the UK. Panos Koutrakos, professor of European law at City University in London is quoted in the FT as suggesting this represents “the first case where a German court says the European court has no jurisdiction.” One does not have to be a lawyer to realise that if the court has no jurisdiction, the legal basis of the single currency is under threat. It could get a lot worse for the EU if this encourages other governments to ignore ECJ rulings. For example, it has raised fears that the Polish government, which is engaged in a dispute with Brussels over the independence of the judiciary, could continue to defy the ECJ which would undermine the basis of the EU itself.

The GCC’s actions serve further to underscore the notion that there is one law for the prosperous north and another for the highly indebted southern Emu economies. If Germany is going to chafe at the actions of the ECB, the likes of Italy are less likely to accept lectures from other Emu members regarding fiscal policy. German politicians are likely to argue that both the actions of the ECB and the Italian government are in breach of the legal foundations of the euro zone. They may even be right. But that is not how the episode will be seen in Rome which is already disgruntled by the apparent lack of solidarity regarding support for those economies hardest hit by Covid-19.

As it happens, I find it hard to believe that the GCC really wants to cause the single currency project to unravel. Consequently I expect that the ECB will come back with a justification for its actions which satisfies all parties and the single currency will remain intact. But this is perhaps the most serious illustration yet of the flaws of the project. There are no instances of a single currency project holding together in the long run without some form of fiscal union. It is precisely because no such fiscal body exists within Emu that the ECB has to act as it does. History records that the Gold Standard lasted for almost a century whilst the Latin Monetary Union endured for 50 years. But the Bretton Woods System fell apart after 26 years. The common factor in the demise of each of these systems were the strains inherent in maintaining fixed exchange rate parities without any instruments other than monetary policy. Moreover, Bretton Woods fell apart because the US, as the biggest economy, was no longer prepared to subordinate its domestic policy to maintain the international order. The lesson from history is that the longer term future of the European single currency remains in doubt unless reforms are made to the institutional architecture.

But are the German critics right in their view that the buying of assets represents monetary deficit financing? The ECB has always been careful to emphasise that its balance sheet expansion has been driven by the need to raise inflation to meet the 2% target. If we accept this as true, then it is acting in accordance with its monetary mandate and not out of any fiscal concerns. Furthermore, the ECB buys in accordance with the capital key which means that it has bought more German Bunds than corresponding securities from other Emu members.

However, the lingering suspicion remains that there is a gulf between what the central bank says in public and the underlying motivation for its actions. But as Gertjan Vlieghe of the Bank of England pointed out recently, looking merely at the balance sheet transactions is not a good guide as to what a central bank is doing because “when a central bank issues reserves, the main counterpart asset on the central bank balance sheet is generally some form of government financing … in a strict sense some part of government spending is always financed with central bank money.”  The crucial determinant of the action is “who makes the decision and with what objective.” Given the separation of powers between Emu governments and the central bank, it is hard to make the case that the ECB is directly engaged in monetary financing. However much the judges sitting on the GCC may know about the law and however much they may suspect the actions of the ECB, they cannot prove anything beyond reasonable doubt. This may be an instance where the court has bitten off more than it can chew.

Divided we stand

The euro zone’s credibility took a significant beating in the wake of the Greek debt crisis which began to spiral out of control a decade ago. By 2012 it was clear that the monetary union project would have to be reformed, with more emphasis on building internal shock absorbers if it was to avoid the fate of previous attempts to create a union based on fixed exchange rates. Despite all the warm words, however, little progress has been made to create any form of fiscal union. Indeed, the efforts of Emmanuel Macron after he assumed office in 2017 have fallen on deaf ears, particularly in Germany. We now find ourselves faced with the deepest economic crisis since 2008 and arguably the most severe social crisis since WW2 with a fiscal framework which is not fit for purpose. This will be an existential test for the euro zone which cannot afford a rerun of the events of the past decade.

One of the most contentious issues in European economics right now is the prospect of issuing coronabonds – a common debt instrument that will enable the hardest hit countries, such as Italy and Spain, to issue securities guaranteed by all euro zone nations, including Germany. It is, as one might imagine, a hard sell in Germany where the idea of debt mutualisation contravenes the spirit of what the German public thought they had signed up to when agreeing to a single currency (not that they were ever asked). We have been here before: It was a major topic of discussion in 2012 when the prospect of Eurobonds was floated – and rejected – as a solution to help out highly indebted euro members.

To understand today’s concerns we need to recall our history. Whilst it is true that a number of euro zone members were heavily indebted, they were financed by capital flows from surplus countries prior to 2008. But when the music stopped, their creditors decided no longer to play ball. This was understandable but we should not overlook the fact that the heavily-indebted southern nations were allowed to become members of EMU despite not fulfilling the excessive debt criterion. Their creditors actually gave them the keys to the kingdom only to throw them away a few years later. Part of the reason for this lax attitude was because in the late-1990s, the EU only paid lip service to sovereign debt issues. After all, it had been on a downward trend relative to GDP for the preceding 50 years. The real focus was on deficits. Yet when France and Germany continually flouted the 3% of GDP deficit threshold just after the turn of the millennium, they escaped without any fiscal sanctions. Then the bust came and governments started to worry about debt again. Greek anger at the way they were treated in the wake of the 2008 bust is not without foundation.

Today’s problems are different. The world faces a humanitarian crisis and nowhere is suffering more at the present time than Italy or Spain, where coronavirus-related deaths continue to rise. The measures required to curb the spread of the disease are expensive, entailing massive wage subsidies and potentially a nationalisation programme as states are forced to prop up large parts of the economy. Italian anger at Germany’s refusal to sanction coronabonds is thus understandable. But as Lorenzo Bini Smaghi, a former ECB Council member, pointed out whilst coronabonds are a great idea in theory, in practice they “entail a major political choice to transfer sovereignty, on a whole range of issues, from the national to the European level.” He has a point: If the euro zone is to act as guarantor for debt, it needs to be backed up by tax raising powers. As Bini Smaghi put it, “Eurobonds cannot be issued to finance current expenditure, unless such expenditure and the resources to cover it are brought under the responsibility of the EU.” Moreover, if we introduce such mutual bonds today, what is to stop countries from issuing them in future to finance pet projects backed by Germany’s excellent credit rating?

Instead, Bini Smaghi and large parts of the northern European establishment prefer the idea of using the European Stability Mechanism, established in 2012, to disburse the funds. Unfortunately, any funds disbursed by the ESM are conditional on an adjustment programme, whereby borrowers must agree to abide by a series of conditions. Some form of legal change would thus be required to make it acceptable to Italy because as it currently stands, the ESM has a stigma attached to it.

Whilst the arguments against coronabonds have a sound legal basis, this is not the time to be hiding behind the letter of the law. Something has to give, and the longer northern European EMU members drag their feet, the more pressure will build up inside the euro zone. And as I have pointed out before, Italy is not Greece – it has the largest sovereign bond market in the euro zone which is five times that of Greece, and it will not be so easy to intimidate. And if we do not get some form of common bond and Italy is forced to issue BTPs and significantly expand its debt-to-GDP ratio, it will certainly not accept a period of austerity after the crisis has passed, simply to placate those who believe its debt level is too high.

It may be stretching it too far to suggest that failure to act on this issue will precipitate a breakup of the single currency. But the bloc simply does not have the automatic stabilisers which are necessary to combat shocks in a fixed exchange rate system. And the longer this problem is ignored, the greater will be the problems in the longer term. As the German economic historian Albrecht Ritschl has pointed out  “Germans prefer to let their history start with the zero hour of 1945“. But German historians know the price of failing to tackle deep-seated economic problems, particularly when it comes to debt.