The events of the last few weeks have shone a very harsh searchlight on the nature of sovereign debt within the European Monetary Union. Although critics of EMU have always argued that monetary union without fiscal union is “impossible”, it was only when Angela Merkel started to call for a procedure to handle a possible default on the sovereign debt of a member state that the markets began to focus on the fact that such a default really is possible. In substance, nothing much has changed with Mrs Merkel’s remarks: it always was possible for a sovereign state within the EMU to default. But now that the markets have realised that some key elements of “sovereignty” are missing from the EMU member states, market psychology has changed. It will be very hard to put this genie back into the bottle.
When the euro was launched a decade ago, critics of the single currency said that it would prove impossible to run a single currency without also establishing a fiscal union. The reason generally given was that the countries inside EMU would face a free rider problem, under which those governments with a history of fiscal profligacy would choose to run much higher fiscal deficits, secure in the knowledge that they would not face either a run on the currency, or a rise in domestic interest rates. In practice, this situation did indeed arise in the case of Greece but, contrary to fears, it did not arise elsewhere. Ireland, Portugal and Spain all found themselves in severe financial difficulties, but in none of these cases was fiscal profligacy the root cause of the problem. So fears of fiscal free riding were, for the most part, misplaced.
However, the critics of EMU also aimed another argument against the design of the monetary union. They said that in the absence of a central fiscal authority (i.e. a European central budget), there would be no mechanism to redistribute the costs of a severe economic shock from the weakest members to the strongest. They pointed out that the federal government in the US has a budget which is many times bigger than the central budget of the European Union, a fact which would greatly increase the efficacy of the burden sharing mechanism within the US dollar zone. In the US, the financially strong states of the union would automatically support the weak states when the economy hits trouble. This would not be the case in Europe. And the problem would be even greater if there were an asymmetric shock which hit one group of countries harder than others.
This criticism has proven accurate. Several economies find themselves stuck in a situation where they are forced to choose between a massive fiscal retrenchment and leaving the monetary union. A conceivable third choice, under which strong countries like Germany and France mimic the effects of a fiscal union by increasing budgetary inflows into the peripheral states does not seem to be on the agenda. (See this excellent analysis by Wolfgang Münchau on the topic.)
Inside EMU, this would be classed as a “donation” from one country to another, and would almost certainly be politically infeasible. In consequence, the financially strong member states have limited themselves to making loans – loans which are at preferential interest rates, but which otherwise involve no fiscal transfer and which eventually have to be paid back in full. This may solve a liquidity crisis, but will not handle a solvency crisis, any more than the solvency crisis of the global banking sector was solved by liquidity injections in 2008. The analogy in 2010 is that the peripheral countries of Europe may need a capital injection, as did the banks two years ago.
It does not seem at all likely that they will get one. Instead, Germany and France have agreed that a mechanism is needed to handle future defaults of sovereign debt inside the EMU. In a truly sovereign nation, the government has two mechanisms for ensuring that it cannot go bankrupt – the ability to use its central bank to finance government debt by printing money, and the power to raise tax revenue from the private sector. These are among the powers which are unique to a nation state. The first of these powers has been removed from the members of EMU and their sovereign debt has in effect been issued in a “foreign” currency, the euro. Member states cannot print the euro, which automatically increases the risk that they will default on their debt. (Admittedly, it also reduces the risk that they will inflate their debt away. The markets are not too worried about this in these deflationary times, though one day they might be.)
Now that markets have been forced to focus on the fact that EMU members are more likely to default than truly sovereign states, they have started to charge a variable risk premium to finance the debt of these troubled economies. In the days of the old ERM, this market pressure eventually forced adjustments in the exchange rate regime, though the arena for market speculation in those days was the currency market. Now, the bond market has replaced the currency market. It is no less dangerous for that. A very unpleasant feedback is developing between a weakening fiscal position, higher bond spreads, and further weakening in fiscal solvency. This is very reminiscent of the ERM crises in the early 1990s.
The markets, which for a long time had no effective way of undermining the monetary union, now recognise that it can be done. And so far the response of European policy makers to this new threat has been inadequate. No one wants to accept fiscal transfers, and no-one wants to see the monetary union breaking up. Something, somewhere has to give.
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