The Eurozone Crisis in Catalonia, with economist Edward Hugh: Part Two Featured
Second of a four-part series in which economist Edward Hugh explains the causes of the current Eurozone crisis and its potential implications for Catalonia.
In this interview series, Edward Hughes looks at the background to the Eurozone economic crisis and what its outcome might mean for people living in Catalonia.
Edward is a respected macro economist whose focus is on the effects of democratic changes on economies. He is regularly quoted in international publications such as the Financial Times and The Economist magazine. Edward has spoken to BcnIn before and contributes to a number of economics blogs as well as overseeing a lively Facebook community page which you can find here.
2.What do you see as the three most likely future scenarios for the euro from this point, in order of increasing probablility?
As I have suggested, the Euro Area crisis is similar to that in other developed countries, but worse due to the institutional deficits with which the monetary union was created. In particular attention has focused on two areas, the role of the central bank (the ECB) and the lack of a common fiscal treasury. To some extent these deficiencies are now being remedied, but the pace of adaptation is slow, and the financial markets are starting to lose patience.
Alarm signals have been going off over the last week, not only due to the surge in the yields on Spanish and Italian debt but also due to evidence that the infection (contagion) is now spreading to what was previously considered to be the core (France, Austria) with the evident danger that more countries will lose their triple A rating. Should this materialise it will make some earlier strategies for financing Euro Area debt essentially non-viable. Thus the crisis is in grave danger of turning critical, with market attention increasingly focusing on the viability and the sustainability of the common currency itself. As President Barack Obama said last week, the key question that now needs answering is who (or what) stands behind the Euro? We are talking money here. What is the financial backstop which lies behind and guarantees the currency?
This has put the spotlight on the ECB as an institution, but the bank is reluctant to adopt the role of ultimate guarantor. This is not principally due to the so called "inflation fear" - demand driven inflation is extremely unlikely in the Euro Area in the near term - but rather due to a fear of accumulating sizeable losses in the event that large quantities of bonds are purchased and then countries like Italy and Spain have to restructure their debt. The fear in Germany is that the German treasury could then be asked to shoulder the central bank recapitalisation. Hence there is a great reluctance to let this happen. Naturally some argue that a central bank can simply accept losses, since the bank doesn't necessarily need recapitalisation and could be allowed to carry on regardless of the red ink on the bottom line. I am not very convinced by this argument, in part because banking and currencies are all about confidence, and it is not clear to me how the world would react to a headline like "European Central Bank Goes Bust". I think my fears are shared by the Bundesbank, and that they are not at all keen to run the experiment just to see what actually happened.
Hence we have a logjam, with the investor world asking for clarification about who stands behind the Euro, and no one stepping out from behind the curtain to say "I do". In addition there is a kind of "dialogue of the deaf" taking place between the investor community and Europe's political leaders, with the latter asserting that what we have is simply a liquidity crisis, while the former are not convinced, and often consider that what we are facing to be a solvency crisis.
The latest proposal to emerge - that the ECB lend to the IMF who then lends to countries like Spain and Italy - simply highlights the sum total of all these difficulties. According to the argument as it is going the rounds, the ECB is not allowed, according to its charter, to purchase sovereign bonds in the required quantity, or to lend to the stability fund (the EFSF) for the same express purpose. But the EU normally has little difficulty finding its way round initial regulations and treaty clauses when needs must (wasn't there an opinion once that bailouts would be illegal?), and in this case I am sure that if there were a will there would be a way. The problem is, as I am suggesting, there is no will for this solution from the German political leadership, due to the kind of losses which could be incurred.
So the ECB asks the IMF to accept a loan and then lend on its behalf, but is this solution really credible? If a bank doesn't want to lend to a client due to concerns about the ability of the client to repay the loan, why should a neighbouring bank accept a loan from the first bank in order to lend to a client the latter does not want? What is involved here is a risk transfer, and it is not clear that non-European members of the IMF have any more stomach for accepting the losses which have been generated by 10 years of the Euro experiment than the core members of the Euro Area have. The UK posture in this regard is indicative - "you made the mess, now you clean it up".
Of course, matters are not that simple. In the first place the global economy is experiencing a slowdown, a slowdown which is in part being fuelled by the decline in global risk sentiment associated with the European debt crisis. So everyone has an interest here in finding solutions. The rise in bond spreads in both France and Austria is associated with a similar process. In the French case investors are worried about the sustainability of French debt should Italy be forced out of the Euro, or be forced to restructure. French banks have something like 400 billion euros in exposure to Italian debt (both public and private), and were anything bad to happen to Italy then something bad would also inevitably happen to France. Which illustrates another feature of the crisis, the interconnectedness - via debt chains - of all the Euro Area economies. In principal the French economy is sound. It doesn't have an irresponsible government spending problem, and it didn't have a housing boom. Certainly the French economy is in need of structural reforms, especially in the labour market area, but it is not a deeply sick economy in the way that most on the periphery are. So the fact that French sovereign debt stability is now in question is a huge warning signal that things here could rapidly get out of hand.
The Austrian case is similarly worrying. "Contagion" means what it says, that parts of the body economic which get infected risk passing the infection to previously healthy parts if the underlying issues are not treated rapidly. This is what is now happening, and the clearest example is in the East, where many economies are now slowing rapidly as a result of the crisis in the Euro Area. This is putting pressure on debt instruments in the region - and in particular in Hungary - and this increase in risk aversion is then feeding back into Austrian bond yields due to the Austrian bank exposure to the East of Europe.
So basically we are all in this together, whether inside the Euro Area or out of it, here in Europe or in China or the United States. It is vital that some clear solution is found to the problem, and in particular that Europe make some rapid institutional changes which put real money on the table, and in sufficient quantity to calm the markets. Basically this means a common fiscal treasury in tandem with a much more interventionist ECB.
Will this happen? At this stage in the game it seems unlikely, but then the alternative is the abyss, and peering directly into the abyss does have the strange property of concentrating people's minds, so you never know.
Another possibility, which I have actively advocated, would be to divide the Eurozone in two, between a Northern core and the Southern periphery. This would be doable technically, and while being far from perfect would certainly go a long way towards easing the present stresses, but again, it would need clear, co-ordinated and determined action from the European leadership, and given everything we have seen so far there is little to suggest they will be able to rise to the challenge.
So we have the last "alternative" which is simply that markets push the issue to the limit, the centre does not hold (Germany, for example could be threatened with being stripped of its triple A), and the whole thing flies apart in the most disorderly and disagreeable of fashions. If you were to ask me at this point which of the three above alternatives I considered most probable, I would have to say the latter, although naturally in no way do I wish this to happen, it is simply the risk that Europe's leaders are now taking.
The worst part is that if involuntary Euro fragmentation did occur it could all happen very quickly indeed, as was the case with the initial attempt at EMU in 1992, although unfortunately this time round the consequences would be much more serious.
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