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A way to break the eurozone deadlock
13 Sep 2012
Stephen King, Group Chief Economist
Mario Draghi's bond buying plan has restored some control over interest rates in those parts of the eurozone which, it seemed, were in danger of becoming detached from the European Central Bank mother ship. While many in the private sector harbour doubts, the ECB president has to be fully signed up to the euro's survival. He can therefore justify purchasing assets that others might regard as untouchable. And with yesterday's qualified ratification of the EU bailout programmes by the German constitutional court, the ECB can look back on an effective week.
Yet problems remain. To get their hands on the ECB's largesse, countries have to sign up to austerity and structural reform programmes. That's entirely understandable. No one - least of all, the Bundesbank - wants to see the ECB writing unconditional cheques to renegade governments with dubious fiscal ambitions. However, no government will want to sign up for blank cheques if the cost ends up being excessive austerity and political downfall - one reason why Mariano Rajoy, Spanish prime minister, nervously looking at Catalonian protests, has yet to buy into the ECB's plan.
Imagine that a country volunteers for the ECB's deal. Once the European Financial Stability Facility or the European Stability Mechanism buys in the primary market, the ECB buys bonds in the secondary market at the short-end of the yield curve, ensuring relatively low interest rates.
There are then two risks. The first is the danger of fiscal backsliding. If the country fails to deliver - perhaps because the regions are recalcitrant or because the electorate is uneasy - does the ECB, doubtless prompted by the EFSF/ESM, withdraw support? The answer surely should be "yes". In the eurozone, however, failure in one country has a nasty habit of infecting others.
The "circuit breakers" - allowing countries to postpone the day of fiscal reckoning - do not seem to be flexible enough.
The second, more worrisome challenge, is the possibility that even with low interest rates, economies may still end up slipping into recession, thanks to a combination of fiscal austerity and losses of competitiveness. We surely know by now that monetary policy has its limitations. The Bank of England, for example, has been able to deliver remarkably low interest rates, quantitative easing and a much weaker currency, yet the benefits of these policies have not been good enough to prevent a return to - admittedly shallow - recession.
Let's say that Spain or Italy stays in recession - or, worse, that their current recessions deepen - despite the help provided by the ECB. Budget deficits might then end up spiralling out of control even if governments were sticking to austerity measures pre-agreed with the higher powers. The European Commission rightly focuses only on "structural", not "cyclical", deficits but disentangling one from the other in the midst of ongoing stagnation has become nearly impossible. A cyclical deficit is only cyclical if there is eventually recovery.
The Stability and Growth Pact, the EU's fiscal rulebook, allows for delays in fiscal consolidation if the excess deficit "results from a negative annual GDP volume growth rate or from an accumulated loss of output during a protracted period of very low annual GDP volume growth relative to potential". Importantly, however, "the excess ... shall be considered as temporary if the forecasts provided by the Commission indicate that the deficit will fall below the reference value (3 per cent of GDP) following the end of the ... severe economic downturn." This is another way of saying that there is a risk of fiscal tightening at the wrong time, locking in recession and stagnation for the long term.
The "circuit breakers" - allowing countries to postpone the day of fiscal reckoning - do not seem to be flexible enough. In contrast, for example, under the Gramm-Rudman-Hollings law, US deficit reduction was to take place each and every year in the late-1980s and early-1990s but the process would be automatically suspended in the event of a recession or weak growth: there was a bias against pro-cyclical fiscal tightening. But in the eurozone, this type of bias is hard to find.
What if such a bias was introduced in the eurozone? It might be a good thing for growth but, to the extent that fiscally-weak countries would then become even more dependent on handouts. It would only serve to emphasise the limits beyond which monetary policy cannot go. Ultimately, successful monetary unions are invariably successful fiscal unions too. Mr Draghi's actions, the German Constitutional Court ruling, or the Dutch election do little to change that conclusion.
Stephen King originally wrote this article for The Financial Times newspaper, published on 13 September 2012.