Letter from Germany 3

The Euro Crisis: A View from Germany, Ray Rees

For the RES Newsletter, July 2012, Online Issue 3

In this letter, Ray Rees argues that Germany has made substantial, but unrecognised, transfers to some members of the eurozone and that the country’s caution about fiscal co-ordination should be supported.

"The budget should be balanced, the Treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed, lest Rome become bankrupt. People must again learn to work instead of living on public assistance".

— Cicero, 55 BC.

A view of the historical causes of the current crisis in the Eurozone which would find wide agreement in Germany was recently put forward by Charles Blankart, a specialist in political economy at the Humboldt University, Berlin. He identifies two kinds of countries in Europe, those which espouse a ‘stability regime’, such as Germany, Austria and the Netherlands, and those believing that inflation can be used as a stimulus for growth, implying an ‘inflation regime’, exemplified by countries such as France, Italy and Spain.

Germany: a victim of the euro?

Blankart argues that the foundation and subsequent development of the euro represented a clear victory for the latter group. In exchange for support of German reunification, a Bundesbank type of regime for the new European Central Bank (ECB), and the 1991 Maastricht Treaty that was supposed to ensure an appropriate degree of convergence of the economies of the member states, Chancellor Helmut Kohl agreed to January 1 1999 as the starting date for the Currency Union. German misgivings led subsequently to conditions on the values of the ratios of government debt and the current public deficit to GDP being added as a requirement for membership, and these were further consolidated in 1997 in the Stability and Growth Pact, that was supposed to ensure continued adherence to these criteria of fiscal responsibility. In fact however countries such as Italy, Spain and Portugal were accepted into the eurozone members even though they did not satisfy the criteria, and no-one was really surprised when it turned out that Greece had falsified the statistics on which its claim for membership was based.

There are good reasons for seeing Blankart’s view as overly simplistic. Despite the fact that a majority of its governing body is made up of ‘inflation countries’, the ECB’s control of monetary policy as such cannot be said to have been inflationary. A further difficulty with the ‘inflation countries vs. stability countries’ story is that a central problem has been the ineffectiveness of the Stability and Growth Pact, with above all Germany and France responsible for its early demise. For a time at least, Germany would have to have been reclassified as an ‘inflation country’. Nevertheless, Blankart expresses the fears of many Germans when he pictures a future in which Germany, outvoted not only at the ECB but in other major decision bodies of the EU, is trapped in a ‘Transfer Union, a system in which Germany has to transfer its wealth to the ‘inflation countries’ to meet the consequences of their profligate policies. Indeed, the ECB is seen as having already instituted such a system, not only explicitly, in its large purchases of government bonds of the countries in dire straits and issuance of loans against junk bonds as collateral, but also implicitly and perhaps even unknowingly, in its operation of the so-called Target2 system.

The problem with Target2

My colleague at Munich, Hans-Werner Sinn, with his co-workers, has been responsible for identifying and quantifying the scale of the problem associated with the Target2 system, and despite criticism from some quarters, which he seems to have been well able to deal with, has gained the support of most German monetary and macroeconomists outside the Bundesbank and ECB. In some ways it is a remarkable story. The name is quite misleading, it has nothing to do with targets, but is simply an acronym derived from its ugly bureaucratic title: Trans-European Automated Real-time Gross Settlement Express Transfer System. Target2 is as this name suggests a payments settlement system through which the central banks of eurozone countries (as well as private institutions) transfer payments arising out of transactions between economic agents in their respective countries. A seller of goods effectively generates a credit for the value of the goods sold in his country’s central bank account with the ECB, the buyer (if in the eurozone) generates a debit of the same amount in his country’s central bank account, and the clearing system simply processes these debits and credits, with of course at any one time the total across all countries netting out at zero.

It seems to have been envisaged that these transactions would, over relatively short periods of time, also net out to zero for each central bank involved, but it appears that instead some central banks, for example the Bundesbank, have accumulated very large credit balances, while other countries, in particular Greece, France and Italy, have accumulated large deficits. These are however nowhere reported by the ECB and have to be extracted from the reports of the individual central banks. It is almost as if the ECB were unaware of their existence. The worrying problem lies in the fact that individual central banks, by creating credits for their domestic banks, are able to add to the total stock of euros in existence. Indeed, as Sinn argues, it is as if individual country central banks can print euros to fund their national payments deficits, effectively creating their own overdrafts at minimal interest rates, and there is strong evidence to suggest that Greece has indeed been doing that since the onset of the crisis in 2007, thus avoiding the need to take the painful and unpopular steps required to put its finances in order. The solution he proposes is that this should only be possible against the backing of first class financial assets as collateral, thus of course raising its cost. At the very least, Sinn seems to have established the existence of a serious design fault within the eurozone banking system.

Although there is room for debate about the exact extent to which the deficits of the debtor countries can be said to be funded by the surpluses of the creditor countries (Germany, Luxembourg and Finland), there is certainly a strong case for arguing that the existence of these balances implies a significant increase, in the order of well over 300 billion euros, in the already very large amount that Germany has at risk, given the possibilities of default in the deficit countries.

Invisible integration

In the light of all this, it is surely not surprising that German economists, and the German public generally, oppose the immediate introduction of Eurobonds as a solution to the current crisis. In a certain sense, eurobonds already came into existence when, following the introduction of the euro, the borrowing rates of the eurozone countries converged. Capital markets obviously believed that defaults on sovereign debt by eurozone countries would not be allowed to happen, and so the interest costs on debt issued by countries such as Greece, Spain, Portugal, Ireland and Italy, previously at times at least as high as those they have been paying in the last few years, fell to German levels and remained there until the financial crisis hit in 2007. There is a strong case for arguing that the sources of the current crisis, the housing bubbles in Spain and Ireland and the public sector deficits in Greece, Portugal and Italy, have their roots in this failure of interest rates to reflect the risks of lending to the countries concerned. The opposition in Germany to institutionalising the moral hazard involved in bundling the debt of all eurozone countries into a single instrument is surely fully justified, as is the argument that any steps toward an explicit fiscal union must wait until the public finances of the problem countries have been put in order.

The current ‘austerity regime’ in place in the UK suggests that, in Blankart’s dichotomy, we would be placed among the ‘stability countries’. Moreover, whatever the outcome of the debate about the UK's long term future in Europe, it is surely undeniable, and is at last becoming generally perceived, that this country can only lose from the existence of a eurozone characterised by fiscal disorder and recurrent crises. The original decision not to join the euro system looks an even better one from today’s perspective, but this should not induce smugness and schadenfreude. On the European political stage Angela Merkel often looks isolated as she obstinately insists that sound, coordinated fiscal policies and labour market reforms have to precede any steps toward fiscal union, but anything less would be political suicide for her in Germany. She deserves the UK’s support.

From issue no. 158, July 2012, pp.3-4.

Page Options