Eurozone crisis: in defence of Berlin

by George Hatjoullis

Fiscal policy

Fiscal policy (Photo credit: Wikipedia)

Germany has been widely criticised for its emphasis on austerity in resolving the eurozone crisis. There is however a logic to this approach which needs to be given some credit. The architecture of monetary union had left an incomplete structure, notably in harmonising the fiscal policies of the member states. It had failed even to address the banking system. The Maastricht Treaty had created an independent central bank wielding a single interest rate and single currency and little else of use.

The problems that led to the crisis were two-fold: sovereign fiscal policy and banking. The interaction of the two was particularly pernicious.

In the area of fiscal policy, the limitations of Maastricht had been papered over with the Stability and Growth Pact. This had laid down strict restrictions on member state fiscal policy. However, the EC proved less than effective in measuring,monitoring and policing. This is why Berlin insisted from the start of the crisis that the IMF be involved. It was less about IMF funds and more about IMF expertise and independence from EC institutions. There was no effective policing mechanism for the GSP and no crisis resolution mechanism. All had to be conjured up during the crisis.

The source of the sovereign debt crisis was not simply a cyclical overspend by vote hungry  governments, though this was an element. It was, to varying degrees, structural. That is to say, there was a bias to excessive deficits. It was this bias that concerned Berlin and it was in this bias that lay the moral hazard. Simply providing loans to cash strapped member states would not eliminate this bias. There was a need for widespread structural reform across the eurozone to remove this bias. There was also a need to put into place structures that effectively policed member state fiscal policies and provided conditional support in times of need.

The source of the bias varied across member states but had common elements. Over-staffed, overpaid and over-pensioned government sectors is one common area. Ironic if you look at the staffing, pay and pensions of the EC and IMF but that is another story. Failure in tax collection is another common theme. Excessively generous ‘social wages’ also figure in some states. Governments of the eurozone had a predisposition to spend more than they could raise in taxes and habitually borrowed the balance. Moreover, financial markets had habitually treated all member states as somehow collectively guaranteed and lent money to some at, unrealistically low, interest rates and this encouraged the borrowing.

The banking sector of each member state remained the liability of each sovereign member state and largely a law unto itself. Banks habitually held large amounts of the bonds of their sovereign and thus the sovereign crisis infected the banks. Banking models and practices also varied, as did controls, which led to very severe banking crises in Ireland, Spain and Cyprus. This infected the sovereign that was solely liable for its domestic banking system. The result was the unholy mess that is the eurozone crisis.

Germany of all the member states grasped the nature and seriousness of the problem and set about dealing with it in a rigorous way. It imposed severe austerity as a first aid response and made the provision of financial assistance conditional upon achieving budget targets and reforms. Berlin insisted on the introduction of various pieces of legislation/agreements that would force each member state to introduce fiscal constraints akin to the GSP into national legislation. The overriding objective of Berlin was to ensure this situation could not arise gain.

Austerity played a poorly understood role. Prima facie it directly addressed the offending budget deficits. However, it was, I believe, grasped that the short-term effects would be perverse and lead to lower growth and wider deficits. The reason is that the austerity was being applied aggressively and synchronously across the eurozone. Lip-service was paid to Reinhart and Rogoff (see my earlier blog ‘Growth in a time of debt…’) but it must have been understood that, even if valid, this research did not apply in the eurozone situation. Reinhart and Rogoff compared growth rates with debt level variations in nation states acting in isolation and having full control of the currency and monetary policy.  There is no reason to expect the results should apply to a group of nation states simultaneously applying austerity and bound by a common currency and common monetary policy that was also bound by the needs of Germany et al. It is a nonsense to argue otherwise and no doubt the smart people in Berlin understood.

The true role of austerity was as a tool of enforcement. It was to ensure that the reforms and treaty changes took place and did not get forgotten as the next election approached. It was to avoid moral hazard. The level of austerity applied in each case was determined by the degree of enforcement it was judged was necessary. Hence the especially harsh treatment of Cyprus (but this has already been discussed at length in ealier blogs).

The lesson has been learned in many states and reform is proceeding quickly as a means of exiting austerity. Other states such as Italy still seem to be struggling with the issue internally. In Cyprus the austerity is overkill and unless Berlin relents the Republic will be forced out of the eurozone. I get the impression no one really cares one way or the other. Cyprus is a special case for other reasons.

The question also arises as to whether after all the pain and reform the eurozone will be a stable institution. However, it is too early to say.

Advertisements