Economic and monetary union (EMU) in Europe, now comprising 19 members following the accession of Lithuania on January 1, is still in a parlous state. The psychological, political and economic division of EMU between creditor and debtor members looks durable. This is partly a result of credit-easing measures by the European Central Bank (ECB) to try to overcome the twin spectres of low inflation and sluggish growth in many parts of the bloc.
But it also reflects deeper-seated cultural disparities, broadly speaking, between the north and south of Europe. This fragmentation, inimical to the ambition of enhanced integration that lies behind the single currency, has been exacerbated by years of battling against excessive debt and dangerous competitive problems.
At the start of EMU, the weaker euro states used a period of economic calm to live well beyond their means. This intense polarisation explains why the ECB is moving only hesitantly towards the option of large-scale government bond-buying to try to rectify low inflation.
Former haven
During its early years, the euro area appeared to be a haven from storms beyond its borders. Members were able to run large-scale payment deficits with apparent impunity on the grounds that financial markets would automatically clear the disequilibrium in a non-disruptive way.
This illusion of tranquillity and benignity has now been dispelled. Within a bloc which has cancelled foreign exchange rates among member countries, there can be no devaluations and therefore no currency crisis. Unless of course individual members decide to leave, something that can only happen at great cost, but which can still not be entirely ruled out.
But EMU still faces threats of a credit crisis; and, indeed, this is continuing. Member countries have acquired the notion of stability only in a nominal sense. In real terms, taking into account the differences in economic performance and behaviour that would normally necessitate changes in exchange rates, euro states have suffered and are continuing to suffer from a great deal of instability, as seen in the wildly differing date for growth rates, debt and unemployment.
The legacy of massive current account imbalances in the first 10 years of the euro after its introduction in 1999 is that the single currency bloc now features some of the largest net foreign creditors and net foreign debtors in the world. Among the former are Germany, the Netherlands and Switzerland, which is a quasi-member on account of the Swiss National Bank’s unilateral pegging of the Swiss franc at 1.20 to the euro. However, the central bank dropped the peg on January 15. Among the latter are Spain, Italy and France, which according to IMF now comprise three of the world’s sixth biggest debtors in net dollar terms.
Inflation risks
Considerable attention has focused on a slide in inflation expectations across the euro area to well below the 2% figure to which the European Central Bank aspires over the medium-term. In December, prices fell 0.2% across the euro bloc, mainly as a result of the sharp fall in energy prices.
This means that the ECB is formally not respecting its mandate of keeping inflation ‘close to but below’ 2%. The central bank has become increasingly eager to find appropriate means of correcting this state of affairs.
The risks of low inflation are clear. Although few at the ECB appear to believe that the euro bloc is actually in, or even close to, actual deflation, defined as a prolonged period of falling prices, wages and output. Such a phenomenon impedes adjustment in countries with competitiveness problems – such as the peripheral members like Spain, Portugal and Greece that have suffered most – because they may be forced to accept a period of falling prices for a considerable period in order to regain their economic health.
After a debate lasting well over a year, the ECB has concluded that large-scale government bond buying is a necessary measure but the transactions will be carried out at different paces and on different scales among debtor and creditor states, especially Germany, in a way that may well severely limit the measure’s effectiveness.
Creditors have a different view about inflation than debtors. Countries, like Germany, like low inflation because they believe, however erroneously, that this safeguards the value of their assets. Debtors are hostile to low inflation and especially deflation since it increases the real value of their debts.
Greek concerns
The calling of a snap Greek election on January 25 greatly complicated a decision on comprehensive purchases of sovereign bonds of all of EMU’s 19 member states at the ECB’s monetary policy meeting on January 22. The ECB could not purchase Greek bonds ahead of the poll, where the issue of Greece’s continuing EMU membership played a major role.
Any QE involving purchases of Greek bonds that may fall dramatically post-poll would expose the ECB to unacceptable losses. Yet, equally, the ECB would find it very difficult to launch QE involving purchases of all EMU members’ government bonds apart from Greece’s. This would stigmatise Athens, and precipitate the very Greek bond sell-off that the ECB wishes to avoid.
Alex Tsipras, leader of the left-wing Syriza party which was ahead in the polls in mid-January, has condemned any ECB move to exclude Greece from a QE package. Tsipras challenged ECB president Mario Draghi to go ahead with full-scale QE including Greece – but he also said that Greece would write off much of its foreign debt after the election, a measure that would pose a question mark over the value of the ECB’s own holdings.
Peter Praet, ECB board member responsible for economics, has put forward the theoretical option that the ECB could decide to buy only bonds rated triple-A, or allow each central bank to carry out its purchases at its own risk.
Both ideas have been floated as possible conditions by Jens Weidmann, the Bundesbank president, who opposes government bond purchases on the grounds that they are unnecessary (because already-decided ECB credit-easing measures may well produce a necessary uptick in inflation), may not work, could be counterproductive and may even prove to be illegal, depending on how they are carried out.
If the ECB decided to limit purchases to triple-A securities, that would substantially increase the amounts required to be purchased, which would run into further German objections. It would open up a debate on whether France should be seen as a triple-A borrower along with Germany and the Netherlands. And it would place the ECB in the supremely illogical, if not untenable, position of lowering interest rates in core countries where economic prospects are already quite strong, and raising them in the struggling periphery, which is a technical, legal and political minefield from which no country would emerge unscathed.
If the ECB went further to meet German conditions and allowed countries to invest in government securities at their own risk, and on their own terms, then that would dramatically impinge on the spirit of mutual solidarity that lies behind the euro.
Paradoxically, it could end up increasing rather than diminishing demand for top-rated German government bonds, as large foreign holders of, say, French euro issues could take advantage of Banque de France purchases of these bonds and switch to less expensive German issues. There are good reasons for thinking that Draghi would rather avoid such an outcome.
David Marsh is managing director of Official Monetary and Financial Institutions Forum,
a London-based monetary think tank and research group, and author of The Euro: The Battle for the New Global Currency and Europe’s Deadlock.
