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Future of Europe’s Economic and Monetary Union

Avinash Persaud (apersaud@me.com) is chairman of Elara Capital Limited and emeritus professor of Gresham College, London.

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As a result of the extraordinary and unconventional monetary policies in response to the Great Recession of 2008, the United States (US) Federal Reserve, the European Central Bank (ECB), the Bank of Japan, and the Bank of England, along with the Swiss and Swedish central banks, now hold more than $15 trillion (tn) of assets—dwarfing Middle-East sovereign wealth funds. Most of these assets are government bonds they purchased in quantitative easing operations. Today, these central banks own one dollar in every five of the $46 tn total outstanding debt owed by their governments. The ECB and Bank of Japan are still buying more. On 26 October, ECB President Mario Draghi announced a slowdown in these purchases from an annual rate of €720 billion (bn) ($828 bn) to 360 bn ($414 bn), but no date for a final exit.

Monetary support for government bond markets is not always and everywhere a bad idea. It must stop because it is no longer required. While it was the right idea at a specific moment in time, it is a generally dangerous idea. From the vantage point of the financial crisis, the absolute prohibitions of the original European Union (EU) Treaties appear to be an indulgence of theory over practice, but the architects of the EU Treaty were right to make it hard for governments to monetise their deficits, however indirectly. The more monetary support for the bond markets persist when it is no longer required, the more dangerous it will become: capital will be misallocated. When rates are lower than they should be, the risk is that productive investment will give way to excessive financialisation. Watch the return of the corporate–financier while real investment and productivity remains downbeat.

The long history of finance tells us that the seeds of the next crisis are sown in moments like these when the authorities have been bold, they have done the job, but no one wants to run the risk of exiting from the policy “early.” At these times inflation tends to be low and the spectre of deflation only recently past. The risk of being late seems modest. The last boom was forged in 2002 and 2003 when central bank officials were debating aloud the merits of helicopter money to avert the risks of deflation.1

These apparently reasonable assessments of the balance of what we can see today propagates the cycle of boom–bust. By the time risks step out of the shadows, it is too late. Lest we have forgotten, the responsibility of policymakers runs deeper than reacting to measures of consumer price inflation.2 Predicting future risks is, of course, fraught with difficulty in finance. Risks that are predicted tend not to erupt. However, the argument for leaving the central bank emergency room today is not just an observation that unseen risks brew when rates remain low for too long. It is also that the circumstances that created the emergency have passed. It is time to emerge, blinking, from the bunker. It is worth reminding ourselves why we are here and why those circumstances have changed before deciding where we must go next. While the past is no less contested than the future, it is more vulnerable to analysis. Lasting solutions are those grounded in a review of the real problem we are trying to solve rather than imagined ones.

The problem originated with the long boom that ultimately ended in 2007. In the Eurozone, this boom was amplified in countries that previously exhibited higher bond yields than average, by the arrival of European Economic and Monetary Union (EMU) and the convergence of bond yields that followed. Financial convergence ran ahead of real convergence, causing real yields (inflation-adjusted) to diverge as nominal yields were converging. Diverging real yields drove the direction of intra-Eurozone capital flows. Borrowers in the periphery were paying low real yields and borrowed more while those in the core were paying high real yields and borrowed less. The quantum of these cross-border banking flows was unmatched elsewhere or in recent history.3 The emergence of the subprime mortgage crisis in the US ended the international boom. The defining feature of the unfolding crisis in Europe was not public debt, as is often thought in the corridors of power of those countries that were least affected, but the scale and proportion of cross-border flows (Baldwin and Giavazzi 2015).

When booms come crashing down, investors become risk-averse and want to reduce risks and pile up cash. Emerging market investors and citizens are of course very familiar with sudden stops. At the onset, these “sudden stops” are liquidity problems. There is a desire to sell the same assets at the same time, causing prices to crash below a considered discounted cash flow valuation. The crash in asset prices creates new gaps in balance sheets causing further selling. When these liquidity crises fester, they become solvency crises. From 2009 to 2013 as the overseas holders of Eurozone debt securities issued in the balance of payment deficit countries tried to exit, collectively, bond yields spiked. The refusal of foreign investors to buy more local securities meant that the balance of payments deficit in these countries transferred, disruptively, into fiscal deficits which jumped higher, justifying even higher bond yields. There was a diabolical loop.

Between 2009 and 2013, rising deficits, increasing yields, and bond buyers strike caused debt service to slip into unsustainable territory in some countries and spiralling bond yields to feed upon itself. It was a classic speculative run which required a speed of response outside of the capacity of European institutions at the time. Moreover, trying to cut fiscal deficits in this environment, initially, made matters worse (DeLong and Summers 2012). Fast forward 10 years from the start of the crisis and the situation is incontrovertibly different. National bailouts of private debt and ECB purchases of public debt have ended the overhang of foreign holders of the debt of crisis countries. Collapsing consumption has sharply narrowed balance of payments deficits. The speculative run is over. An announcement of a gradual end of the ECB’s bond-buying programme, to be speeded up or slowed down depending on conditions, would be greeted well by the debt and currency markets. There is no need for current proposals to mutualise large amounts of Eurozone debt.

We have argued above that the Eurozone crisis was a classic balance of payments crisis. In thinking about what caused these current account deficits, the consensus has focused on national competitiveness problems. The classic illustration of these is the divergence of unit labour costs, often accompanied by a story on the importance of Gerhard Schröder’s Agenda 2010 Reforms in Germany at the beginning of the century. These reforms lowered minimum wages, unemployment benefits and employers’ contributions to pensions and social security.

While national labour market policies are real issues, there is a more proximate explanation for the patterns in unit labour costs, which is the flow of credit to the non-tradable sectors in the crisis countries. Despite all of these national policy considerations, the tradable goods sectors in the crisis countries were highly competitive. It was the non-tradable sectors that were not. During the boom years, because the non-tradable sectors were insulated from international trade, they offered higher rates of return than the tradable sectors and received more substantial credit flows. This allowed them to boom further, drawing workers away from other industries by paying more, driving up unit labour costs nationally (Sy 2015).

Economics textbooks describe non-tradables as hairdressers, car mechanics and such like, but the most significant non-tradable sectors are government, finance, and real estate development. These are not fully or intrinsically non-tradable; restrictive practices make them so. Competition policy needs to shrink the relative size of the non-tradeable sector with the tradable sector.

Macro-prudential policymakers should be attuned to the relative flow of capital to the tradable versus non-tradable sectors, varying capital ratios on bank lending to these sectors to bring credit flows into balance. This does not require the macro-prudential regulator to know what the right level of credit flow should be, the bugbear of macro-prudential policy. It just needs them to consider the balance of payments dangers and the signals of macro-financial imbalance of credit to the non-tradable sector growing at a faster pace than to the tradable sector.

Macro-prudential regulation in Europe is not applied in this way and will not gravitate in this direction without a nudge. Macro-prudential regulation, and I write this as one of its protagonists, was meant to counter the pro-cyclicality of finance. In good economic times, financial markets tend to underestimate risks, fuelling a boom that leads to a crash, after which markets tend to overestimate risks, weighing down the recovery. But partly through an absence of a guide as to which fault lines macro-prudential regulators should follow, “macro-pru” has become a catch-all for all of those issues that are normally considered for enforcing a commonality of micro-prudential rules.

European regulators need to consider macro-pru at the geographical level at which booms take place, and this is not regionally, but nationally and sub-nationally. Authorities should be pressing for a much higher degree of diversity in capital ratios across countries and sectors than currently exists. A European body can act at a national and subnational level, but not as easily as national central banks. A pan-Eurozone institution would be tempted to consider action pan-regionally, and its critics would be tempted to accuse it of undermining the integrity of the single market across the region whenever it acted nationally (Persaud 2013). In reality, national, not European macro-prudential regulation, along with an end to monetary support of certain bond markets, and a more aggressive competition policy is what would make the single currency whole.

Notes

1 See “Deflation: Making Sure “It” Doesn’t Happen Here,” remarks by Governor Ben S Bernanke, before the National Economists Club, Washington, DC, 21 November 2017.

2 There has been a long debate in central banking between final targets like inflation and intermediate targets, like money supply or nominal income measures that forewarn inflation is in the system before it emerges.

3 In 2008, 50% of cross-border bank lending by destination to major advanced economies was into the Euro area, three times the amount into emerging market economies. Cumulatively, by origin, cross-border bank lending from the Euro area was more than almost four times cross-border bank lending from the US between 1999 and 2008. See Lane (2013).

References

Baldwin, R and Francesco Giavazzi (eds) (2015): The Eurozone Crisis: A Consensus View of the Causes and a Few Possible Solutions, VOX, CEPR, 7 September, http://voxeu.org/article/eurozone-crisis-consensus-view-causes-and-few-possible-solutions.

DeLong, B and L Summers (2012): “Fiscal Policy in a Depressed Economy,” paper presented at the “Brookings Panel,” Spring.

Lane, Phillip R (2013): “Capital Flows in the Euro Area,” European Commission, Economic Papers 497, April.

Persaud, A (2013): “Vive la Difference,” Economist, 26 January, https://www.economist.com/news/finance-and-economics/21570657-guest-article-avinash-persaud-emeritus-professor-gresham-college.

Sy, M (2015): “Overborrowing and Balance of Payment Imbalances in a Monetary Union,” Review of International Economics, Vol 24, No 1, pp 67–98.

Updated On : 10th Nov, 2017

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