Europe’s deceptive aggregate deficits

Top officials from the European Central Bank (ECB) and Commission are fond of noting that the aggregate deficits of the euro zone (EMU) are inferior to those of the US and of other big countries (Japan is probably meant here since it has a public debt above 200% of its GDP). By asserting this they want to underline that the overall state of the Eurozone is no worse than that of the US, or of other major economies; and that, consequently, it should not cause bigger concerns. 

It is true that public debt in the US (which has gone over 95% lately) is above the aggregate level of the EMU. It is also true that the latter’s budget deficit was around 6% in 2010, whereas the figure for the US exceeded 9%. However, these numbers need to be judged in conjunction with the roots of the Eurozone crisis, of the sovereign debt crisis in the EMU. Although the level of aggregate public debt does matter, the main cause of the Eurozone crisis lies elsewhere – in its poor design. Until the eruption of the current financial and economic crisis, this flawed construction was obscured by cheap credit and cheap imports, by markets’ myopia.

A monetary union cannot function properly (survive) without adequate fiscal underpinnings (including burden-sharing arrangements), common regulation and the supervision of financial markets. Economic history, of longer and more recent vintage, is clear about this. Think about what differentiates the US and Canada, as federal structures, from the Eurozone. A US sovereign debt crisis cannot be ruled out, in the long run, were its public debt continue to grow and markets lose confidence in the US dollar as a reserve currency. But an “American crisis” would rather occur as a massive depreciation of the US dollar, which would entail high domestic inflation. For the foreseeable future, US treasury bills and bonds stay among the safest investments in the world, in spite of a downgrade made by one of the leading rating agencies. Nobody assumes a disappearance of the US dollar, whereas not a few people are worried about the fate of the Eurozone (and implicitly, of the euro), and an array of scenarios has already been imagined. Markets have already priced in, more or less, tail events (default), contagion, and linkages between sovereign debt and bank balance-sheets in the Eurozone. Were an American state threatened by bankruptcy hardly anyone would doubt the existence of the US as a monetary union. Bank recapitalisation in the US has proceeded better and more transparently than in Europe, and there are federal institutions for the regulation and supervision of financial markets on the other side of the Atlantic. That their functioning has been inadequate, not least because of waves of deregulation (including the rescinding of the Glass Steagall Act of 1999 and the Commodity Futures Modernization Act of 2001), is a different matter for discussion. The US “single market” simply functions better than the EMU.

An obvious, telling argument that markets do not pay much attention to the “aggregate” numbers of the EMU is that, since the start of the current crisis, they have increasingly discriminated among the sovereign debt of Eurozone member countries. The interest rate convergence of the past decade was, arguably, a market myopia, a market failure, which brought about over-borrowing by state and private sectors and resource misallocation. This crisis has forced a wake up call, though this is happening with damaging overshooting, panics and vicious circles. Another question can be illuminating on aggregate numbers: would a diminishing external Eurozone deficit mitigate fear, if it were accompanied by a growing cleavage, competitiveness-wise, between Germany, the Netherlands and the periphery (Greece, Portugal, Spain, Italy)?

The very setting up of the European Financial Stability Facility (EFSF) proves the weakness of  aggregate numbers as an argument. An analogy could be made between TARP (Toxic Assets Recovery Program) in the US and EFSF. But TARP was aimed at propping up financial entities; it was not set up because of the threat to the US as a monetary union. In contrast the worries regarding the future of the EMU are undisguised. The very operations of the ECB, buying sovereign debt from member states, firm up the thesis that the EMU is lacking common fiscal (budget) underpinnings. The EFSF tries, inter alia, to relieve the ECB of an immense burden that has been bestowed on it as it operates as a “fireman”, much beyond its traditional mandate of preserving price stability. It appears, however, that the EFSF, be it with substantially bolstered resources and a broader range of operations (including bank recapitalisation and sovereign debt purchases in secondary markets) would be an imperfect substitute to a solid budget arrangement. The EFSF needs to beef up its firepower (probably to more than €2,000 billion) in order to deal with a crisis infecting Italy and Spain. Unfortunately, there is a major cognitive dissonance on fiscal (budget) integration among Eurozone leaders. One approach, embraced by countries such as Germany, the Netherlands and Finland sees euro-bonds as a culmination of a gradual process of integration, apart from political and legal impediments. The other approach sees euro bonds as an effective method to combat speculative attacks, and as a major step toward creating a solid fiscal complement to the common monetary policy. The fact that there are such conflicting views on this subject, the lack of capacity to make decisions in due time (as has happened constantly since the Eurozone crisis started), and the precarious intervention tools the EMU has at its disposals, make the aggregate deficits-based observation even less convincing. It may be that the deepening crisis would force a radical change of outlook and action, and trigger a speedy pace of fiscal integration in the Eurozone. If not, it is pretty hard to see how the Eurozone will survive in its current configuration. Asking governments to deflate now and again, for the sake of closing down productivity gaps and reducing overall indebtedness, is arguably not sustainable. Structural reforms may look nice on paper, but actual results may be too time consuming and uncertain and, therefore, further damage the cohesiveness of the EMU. The attempts of various governments to reinstate the gold standard during the inter-war period, in the past century, gives plenty of food for thought on this matter (at that time governments could also still use their own national monetary policy instruments).

This crisis shows that incrementalism does not work. Fiscal rules are needed, as are sanctions. But fiscal rules are far from being sufficient; they cannot be a substitute for a solid fiscal arrangement that must include a common treasury. Appointing a Eurozone finance czar to make judgments and recommend penalties is not enough either. There are EMU countries (Ireland, Spain) that had pretty cautious budget policies and (relatively) low public debts before this crisis, but excessive borrowing on the part of the private sector, inviting a boom and bust cycle, undid them. The Eurozone needs a rounded up common policy in order to survive. This policy would have to respond to asymmetric shocks, as is done in the US and Canada via the federal budget, where unemployment insurance is provided. It would also have to deal with deep financial integration via common regulation and supervision of financial entities, as well as joint resolution mechanisms. For all this to operate there is need for fiscal integration and a common treasury. It is true, however, that this would require deeper political integration, following the basic rule of democracy that there is no taxation without representation. Even if Greece were to exit the Eurozone in an orderly fashion and without entailing major contagion (is it possible?), the EMU would still need fiscal integration. When ECB top officials talk about low aggregate imbalances in the Eurozone, they use a logic that supports the very idea of issuing euro bonds and of developing common institutions and policies further.