Far from prising the euro-zone apart, Frank Velling argues that current traumas will bind members closer together
You may be wondering why is a strategist from Denmark here to talk about the future of the euro? Didn’t the Danes vote against joining at the referendum in 2000? Well, we may have voted ‘no’ - but Denmark joined, anyway, by pegging the kroner to the euro, and an important conclusion regarding the euro endgame is that the Europeans do not want an economic and political union but, just like the Danes and the euro, they will get it anyway.
The euro crisis is a continuation of the sub-prime crisis, and is characterised by a return to the political economy, as well as a collision between impatient hot money flows and slow policy reactions. In the new economy, we will see much less economic growth but also occasional and more frequent pockets of high volatility. This will not only require more growth-friendly economic policies, but also underscores the need for changes to the mandate of the ECB.
This summer is a reminder that the euro has significant flaws that put the entire euro system at risk. Clearly, significant reforms are needed. The task will be to safeguard the euro. This can only be achieved through regulatory reforms:
• Stronger incentives for national parliaments to tackle debt problems and competitiveness;
• Reduced financing costs through sharing of credit risk by the EFSF and euro bonds;
• Minimising political risk by incorporating automatic budget rules within national treaties;
• Recapitalisation of systemic important banks;
• Pursuing growth-oriented reforms.
Some of these changes cannot be implemented without amendments to treaties, difficult ratification processes and referendums. Meantime, we will have to undergo painful transition periods with political uncertainty. The introduction of euro bonds probably lies a few years ahead. But they are necessary in order to restore the confidence in the markets, but also to create collective fiscal responsibility.
A challenge lies ahead in making the fiscal policy more long term and growth oriented than is the case today. In the meantime, the enhanced EFSF will serve as the central vehicle for stabilising the euro-zone and the financial markets.
Before 2008, the capital markets were more or less left alone. Financial innovation and global financial integration flourished. This proved to be dangerous and we have already seen a lot of new regulation: there will be much more. Why? First, the prevailing capitalist system has been shown to be flawed; financial markets are too important to be left to investors. Second, policy makers have to deal with systemically important banks. Third, capital flows are primarily speculative, and have often proved damaging.
The collision between the slow political economy and the impatient markets increases the risk of vicious self-feeding loops, from the capital markets to the banking sector to the real economy. Bailout was the key policy tool during the financial crisis, and it seems that the markets are addicted. We need our frequent ‘quick fix’ in the form of monet ary and fiscal bailouts of whatever gets in the way of asset inflation.
A recent example of this was the press conference held by German chancellor Angela Merkel and French president Nicolas Sarkozy on 16 August. The market had been criticising European policy makers for the lack of leadership. They got it - big time - that day. The market had also been nervous about the large countries’ willingness to support the poorer countries. They got such assurances as Merkel and Sarkozy announced that they wanted more economic co-operation and integration - not less - and called for changes in the constitutions with respect to automatic budget rules, which will remove a lot of political risk. Nevertheless, the market seemed disappointed. It did not get the ‘quick fix’ euro bonds.
But one of the primary problems is the timetable for these things to be implemented, and the associated risks evolving in the meantime - and it cannot be denied that European policy leaders had cleared the road for the speculative attacks that occurred this summer. Lack of confidence in policy makes everything much more path-dependent, and we all have to analyse the potential policy responses in each path, which are a function of national political stability and the ability to make unpopular decisions. The EFSF could not yet deal with such large economies, and the ECB’s Securities Markets Program (SMP) was restricted to Greece, Portugal and Ireland, so there were no private investors willing to catch the falling knife.
Meanwhile, ongoing discussions about private sector involvement in a new aid package for Greece rattled investors, making a thin summer market even thinner. And even if one thought that the Italian and Spanish debt situations were manageable, an attack could be self-fulfilling in nature as it drove yields to unsustainable levels. Ultimately, the ECB reluctantly had to step in, and save the euro and the economy from Armageddon - the tail wagged the dog. But this is precisely why the EFSF and ESM will grow in importance and de facto will become two of the most important institutions in Europe.
First and foremost, the enhanced EFSF is expected to be able to intervene in primary and secondary bond markets, offer bank recapitalisation funds to governments and provide long-term loans at concessionary rates. As the EFSF does not provide the necessary security for fiscal discipline, the German-French proposal for automatic budget rules and the creation of a European government are very important.
Nevertheless, a United States of Europe seems like a mirage: the cultural, social and economic differences are simply too big. Not all euro-zone members agree with the wishes outlined by the German and French leaders. Finland and other countries’ demand for collateral for loans to Greece is the obvious example. Such demands are highly irrational, but we cannot ignore them. I do not think any one country will leave the monetary union, but at some time in the not-so-distant future, we may see one or more countries exit from economic co-operation at some level. And these windows of transmission will be associated with fresh uncertainty and volatility.
So the obstacles to fiscal unity are big but, as already stated, Europeans will get it anyway - but in a less formal sense. What is happening in Greece and other indebted countries right now is not only in the national interest of these countries - but also of great importance to more affluent member countries, thanks to our high degree of economic and financial integration.
European policy makers seem to realise that the cost of saving Greece is far less than the cost of letting Greece default and leave the euro. Exactly the same applied to the American states before they united in signing of the Declaration of Independence in July 1776, when Benjamin Franklin is quoted as saying: “We must all hang together, or assuredly we shall all hang separately.”
Besides more economic integration, there will be changes to the framework for the ECB. First and foremost, it will, at some point, adopt a dual mandate based on core inflation and growth/employment. The current mandate, partly based on headline inflation, easily tends to become backward-looking, with the risk of the monetary policy finding itself being ‘behind the curve’. Also, the link between monetary aggregates and future inflation seems flawed today - the rate hikes in July 2008 and this year are good examples. The ECB will argue that it has been immensely successful with regards to its sole mandate - keeping inflation close to, but below 2%. But who asks whether this goal could have been achieved with a more accommodative monetary policy? The same objective could have been achieved with more than just one monetary policy framework.
Most people will probably agree that the debt problems in Europe will be a drag on economic growth for many years. For the euro-zone we must expect unemployment to be unacceptably high for a longer period of time, entailing both economic and socials costs. This is a likely catalyst for more political pressure to implement more explicit goals for growth and employment. This discussion is taking place in the US right now, where Chicago Fed president Charles Evans recently proposed an alternative model for monetary policy, which included higher core inflation and a numeric target on unemployment.
As we find ourselves in a more path-dependent political economy, the journey will be just as important as the end game - indeed, the end game will, to a large extent, be a function of the turbulence during this exciting journey. To summarise:
• European policy makers deserve more credit than they seem to get from myopic and impatient speculative money managers;
• The Europeans will see more economic and political integration - not less;
• Today’s focus seems totally biased towards debt problems; sooner or later, the focus will have to be diverted towards long-term growth
• Phases between important political decisions will continue to be characterised by high volatility, as impatient markets collide with slow policy reactions. A sub-goal for the policy makers will be to reduce volatility;
• Risk premiums in equity markets will gradually fall, albeit remaining elevated, as there is no panacea that will solve the debt problems;
• The bias in economic and monetary policy will become more balanced between debt reductions and future growth as well as between stable inflation and economic growth;
• The euro will survive, or assuredly we shall all hang separately.
This is an edited version of a speech given by Frank Velling, chief strategist at BankInvest, at the ALFI Conference in Luxembourg on 27 September 2011