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Europe trilemma is global dilemma

Publication Date : 28-04-2012


The European think tank, Breugel, recently produced a report suggesting that there was a fundamental trilemma between the European monetary union, national banking systems and the lack of fiscal union (Pisani-Ferry, 2012). This added a twist to the old argument that for a single currency, you need a single fiscal policy.

The argument for a banking union arose because European national governments were able to finance their deficits largely through their national banks, which could buy their long-term paper. This created an interlocking crisis. If national banks hold lots of national debt, when debt prices fell, the banks became insolvent, but illiquid governments cannot bail out insolvent banks without further borrowing at higher real rates.

The illiquidity trap was relieved when the European Central Bank undertook long-term refinancing operations (LTRO), effectively giving the national banks three-year money at 1 per cent to buy their government paper. Liquidity and capital shortage are simultaneously relieved, because the more the national banks buy national bonds, and bond prices rose, the less capital is required. But LTRO (just like quantitative easing in the U.S.) only relieved the symptoms without sorting out the structural issues of excessive debt.

Unitary states like the US, China and India do not have this peculiar problem, because their provincial governments do not have large local banks to fund their deficits and anyway, these local governments cannot constitutionally run large deficits without approval from the centre.

Should Europe have a banking union as well as fiscal union?

My answer is that the banking union debate is a distraction from the real argument over fiscal discipline. If all European national banks were today instantly merged to become a single transnational European bank, would it solve the European problem of lack of fiscal union? That transnational bank would still have the problem to buy or not buy national debt paper and whether to mark them to market. A banking union may solve the problem of eurozone funding, but it does not solve the problem of write-offs between surplus and deficit members, which only a fiscal union can solve.

The fundamental issue is the exercise of fiscal and financial discipline. Should this be exercised at the national level (this is clearly not working) or at the central level (who decides — the surplus “winners” or the deficit “losers”?)

The European tragedy is that member governments ran large deficits for years, because there was neither a central mechanism to discipline them nor did the market, which priced deficit state credit risks like Greece wrongly. I am amazed that financial institutions that helped governments to disguise the size of their debt have not been sanctioned for violating the most basic of market discipline — truth in transparency. Having overspent and overborrowed, deficit countries face two unenviable choices — deflation through austerity or a combination of debt forgiveness and funding to grow out of the crisis.

Market discipline exercised through rising interest rates seems to doom the deficit countries to impossible situations. Deflation is extremely painful and perhaps politically unacceptable. Unemployment among youth is already unacceptably high, and if there are riots in the streets or the polls reject further austerity, then the eurozone can fragment.

It is too expensive for the whole to break up, but for those undergoing deflation, it may feel like it is too expensive to stay in.

To this pair of Asian eyes, the European crisis is deja vu. Remember the lesson of the 1997/98 Asian crisis — a fixed exchange rate is incompatible with independent monetary policy and open capital accounts. Spain is asked to cut its balance of payments deficit from 10 per cent of GDP to less than 3 per cent. If it does not, it cannot finance a current account deficit and capital outflows without rising domestic interest rates that deflate the economy further. Unlike Thailand and South Korea in the 1990s, Spain cannot devalue its way out of the deflation.

Hence the big debate is essentially political. Who pays and why? To keep the euro, the deficit countries must deflate through austerity, or the surplus countries must be willing to lend or spend, so that the deficit countries can grow out of the debt (the Keynesian solution). In my view, the present solution of very loose monetary policy is still the wrong medicine — central banks cannot solve structural problems through monetary creation. This is a shotgun solution in which everyone is sprayed to pay in the future just to buy time to find a political solution. A structural solution must by definition be targeted and implemented at the national level — spend to stimulate growth where necessary and cut waste where necessary.

The surplus countries like Germany know they have to pay, but are worried about moral hazard — pay but don't get the desired reforms. The deficit countries worry that the surplus countries would become too powerful politically and exact too much pain for too little money, too late. Europe is rich enough to solve its own problems, but it cannot politically agree within one family who should bear the losses of its trilemma.

The global dilemma is that Europe is too important a member of the global economy to sink, but too big for the rest to help. Japan and the U.S. have enough of their own problems and do not want to be seen to interfere in Europe's woes. Individually, none of the emerging markets can justify to their own poorer citizens why they should help a rich and powerful Europe.

The solution to Europe's woes is in Europe's own hands. Family members cannot enforce discipline within one's own family. The IMF, which Europe controls with the U.S. in majority voting power, can act as the independent enforcer of discipline and finance reflation by recycling global surpluses for deficit countries. But this requires Europe and the U.S. to significantly recapitalise the IMF by enabling surplus emerging markets to have better representation. There is no global taxation without representation. The price is dilution of European and U.S. voting rights. But they don't want to do so.

Hence, the real global dilemma is that advanced countries are reluctant to improve democracy and legitimacy in the IMF to help solve their own problems.

Andrew Sheng is President of the Fung Global Institute.


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