Two more mantras now in trouble
Major economic crises don’t just claim the reputations of the odd banker, finance minister, or two. Part of the ensuing blame game also discredits certain widely held mantras that guide policymaking. The mad dash over the past week to “save the euro” looks like steps will be taken that will inadvertently claim two more such mantras. The upshot is that the conservative hold over macroeconomic policymaking will be weakened even further.
The starting point is that after all this time, the French and German governments now perceive a material threat to the long-term viability of the euro, their most precious post-war creation. Although, both recognise that there is a long-term problem (bolstering economic growth and improving public finances) and an immediate problem (the threat of government defaults on the European banking system and on the economy), until very recently, the French and German leaders haven’t agreed on how to deal with the first problem.
In fact, the second problem is almost entirely not in their hands — the new Italian government and the European Central Bank (ECB), which could act as the lender of last resort. The ECB, however, is by treaty supposed to be independent of governments and cannot be seen as being bossed around by national capitals. For many months now, the ECB had taken a strong stance against financing the euro zone’s public spending through debt purchases, whatever the circumstances. Doing so put its independence on the line.
The technocrats have been making some of the right noises. Most importantly, the ECB has signalled that if the euro zone governments put in place a credible mechanism to penalise future governments for over-spending, then the ECB may be willing to intervene more actively in support of the banking system. This overture is seen as the ECB signalling that it is willing to act as a lender of last resort, which could be buying (indirectly through Europe’s banks) large amounts of euro zone government debt.
This signal from the ECB was justified by the argument that any new public spending control mechanism would likely induce cuts and raise the risk of deflation in the euro zone. The purpose of the ECB’s action is, therefore, not to act as a lender of last resort in the traditional sense, but to counter the deflation that further austerity might bring.
The technocrats in Rome improved the mood music by unfolding their “Save Italy” programme, which plans on cutting the deficit by a further €20 billion over three years. Still, most of those deficit cuts come from tax increases. Some supply side reforms were promised. The headline-grabbing reform was a rise in women’s pension age, which the welfare minister announced with tears in her eyes! Rome may be burning, but at least, the fire brigade has arrived.
Government leaders in Paris and Berlin sought to capitalise on the ECB’s signal, agreeing to a system of fiscal rules that will be presented to all 27 European member states at a summit this Friday. Even if these rules are accepted in principle, their specific terms will have to be negotiated and then ratified — possibly, after referendums in several countries — a process which could take up to three years.
What eurozone governments are supposed to do in the interim is unclear, but that isn’t the point. Agreement on new fiscal rules at this summit would then put the ECB back in the spotlight, which is exactly what the governments want. Pressure on the ECB to intervene whenever the interest rates on government debt on any euro zone member reach unsustainable levels — typically in the range of 7 to 9 per cent, depending on the euro zone country — would then intensify. Given its public signal, the ECB would find it much harder to resist.
The worst possible outcome for the ECB would be to be seen as caving in to demands to lend (directly or indirectly) to governments and those governments respond by slackening off on austerity programmes. This is the moral hazard that keeps conservative central bankers awake at night. To keep governments on the path of fiscal redemption, another disciplining action is needed for the short term and that comes in the form of the International Monetary Fund (IMF). IMF monitoring and possibly financing (which the ECB could supplement) would then be needed to maintain the credibility of both the governments’ austerity plans and the ECB’s commitment to intervene.
While the Italians have accepted IMF monitoring, full-scale IMF monitoring and intrusion in the euro zone would be hard for many policymakers to swallow. What if the system of fiscal rules doesn’t get ratified or doesn’t work? What if IMF surveillance is rejected? So what is really going on? The prospect of ECB action is already lowering interest rates on euro zone government debt, creating huge profits for speculators who bought such debt at scarier moments over the past few months. In addition, ECB’s action will enable even more European and American banks to sell off troubled government debt at better prices.
Two lessons follow. First, so relieved are financial markets at the prospect of ECB intervention that the private pressure on eurozone governments to improve their public finances has weakened. Indeed, private vigilance must be replaced in the short term at least by IMF monitoring. Second, the ECB has put its credibility on the line and in a way that makes it a hostage to fortune.
Also published in the Financial Chronicle, 7th December 2011