Although the European Summit reached agreement on how to develop the bail-out mechanism for sovereign countries after 2013, it was an agreement about process rather than content. Germany remained adamant that there would be no fiscal transfers to troubled economies, and that the best way forward is further fiscal consolidation, along with plans for the private sector to share in any losses after a sovereign default. EU finance ministers have been charged with filling in the blanks by 31 March, 2011 – if the markets are ready to wait that long. I am not confident that they will be. Nor do I believe that the present path is necessarily in the best interests of Germany itself, let alone other EU member states.
The key problem with the present strategy is that it allows the markets to take matters into their own hands. This is because the interest rates, which the markets charge to refinance sovereign debt, have a very large effect on the solvency of governments over the medium term, and assessments of that solvency then have feed-back effects on the market determined interest rates. As we have seen in recent months this feed-back effect can easily overpower the actions of governments, even if they are very determined to pursue a programme of fiscal consolidation.
In terms of its effect on the long-term ratio of government debt to GDP, the damaging effect of a permanent increase in the interest rate spread of 1 per cent over Germany fully offsets the beneficial effects of reducing the budget deficit by 1 per cent of GDP for the troubled EU economies. Since the spring of 2010, interest rate spreads have increased by several percentage points for these countries and, if maintained, this would swamp the hard work done by several governments, including Ireland and Spain, to reduce their budget deficits.
The implication of this arithmetic is twofold. First, the strategy which has emerged from the EU Summit may not work, even if the troubled economies continue to deliver on their plans for fiscal tightening. Although they have managed to do this (on the whole) in 2010, the medium-term path for public debt has worsened considerably because of deteriorating refinancing costs as interest rates have risen. Second, the stronger EU economies could make a big difference to this outlook if they were willing to provide liquidity to the troubled economies at lower interest rates than they have been willing to countenance so far.
Recently, many economists have argued that the provision of liquidity will be insufficient to solve the EU debt crisis, because the real problem is one of solvency not liquidity. But the terms of the EU’s liquidity provisions, and the ultimate solvency of the troubled governments, are impossible to separate. Easier terms improve the likelihood that governments will achieve a path to solvency.
This is clearly demonstrated in an excellent paper published last week by Joseph Lupton and David Mackie of J.P.Morgan. I have summarised part of their argument in the table, which shows the possible path for government debt ratios under two scenarios – (i) the current EU regime (where lending rates are about 6 per cent, or roughly 3 per cent over German bond yields up to 2013, and are at market rates thereafter); and (ii) a more generous regime, where the EU provides liquidity at a lending rate of 1 per cent over the German bond yield from now on. The arithmetic shows that, on present EU plans, it will be difficult for the four troubled economies to bring their debt ratios under control by 2020, even if they are able to maintain their austere fiscal plans (which is doubtful). By contrast, if liquidity were to be made available at lower than market rates, it is much more likely that debt ratios would start to decline from about 2015 onwards.
Germany has so far rejected the provision of liquidity at heavily subsidised rates because it does not want to reward countries which have taken on too much debt, and because it wants to maintain a market sanction for governments which fail to adhere to their fiscal plans. This is the attitude which has almost always been taken by creditor nations, for obvious and perfectly understandable reasons. But Germany now needs to consider whether this strategy is really in its own interests. If any of the peripheral economies are forced to default, German banks will suffer as much as any. And if the euro were to break up, the German economy would be hit very hard by the exchange rate appreciation which would inevitably accompany the introduction of a narrower euro, or a new deutschemark. Axel Weber, the President of the Bundesbank, pointed this out in a speech on Sunday.
By contrast, the costs to the creditor nations of making loans available to the troubled economies at lower rates would be relatively minor. Lupton and Mackie calculate that the notional cost over a whole decade would be equal to 2.5 per cent of the combined annual GDP of Germany and France, or 0.25 per cent per year. And that notional cost is just the difference between the theoretical amount which they could earn on loans to the periphery at market rates, compared to the suggested subsidised rates. This is an opportunity cost, which would never appear on any country’s budget deficit.
Of course, this does still amount to a disguised fiscal subsidy, and the cost would be much higher if any of the troubled economies subsequently defaulted on their debt. But default, or restructuring, seems more probable under the present EU plans than it would under the suggested alternative. Paradoxically, the creditor countries need to consider the possibility that they may actually be better off if they provide liquidity on more generous terms than they so far been willing to contemplate.
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