By Peter Boone and Simon Johnson
The verdict is now in: traditional German values lost and the Latin perspective won. Germany fought hard over many years to include “no bailout” clauses in the Maastricht Treaty (the founding document of the euro currency area), and to limit the rights of the European Central Bank (ECB) to lend directly to national governments. Last week, the ECB governing council – over German objections – authorized purchasing unlimited quantities of short-term national debts and effectively erased any traditional Germanic restrictions on its operations. (The finding this week by the German Constitutional Court — that intra-European financial rescue funds are consistent with German law — is just icing on this cake, as far as those who support bailouts are concerned.)
With this critical defeat at the ECB, Germany is forced to concede two points. First, without the possibility of large-scale central bank purchases of government debt for countries such as Spain and Italy, the euro area was set to collapse. And second, that “one nation, one vote” really does rule at the ECB; Germany has around ¼ of the population of the euro area (81 million out of a total around 333 million), but only one vote out of 17 on the ECB governing council – and apparently no veto. The balance of power and decision-making has shifted towards the troubled periphery of Europe. The “soft money” wing of the euro area is in the ascendancy.
This is not the end of the crisis but rather just the next stage. The fact that the ECB is willing to purchase unlimited debt from highly indebted nations should not make anyone jump for joy. The previous rule forbidding this was in place for good reason – the German government did not want investors to feel they could lend freely to any euro area nation, and then be bailed out by Germany. Now investors know they can be bailed out by Germans, both directly through fiscal transfers and through credit provided by the European Central Bank. How does that affect the incentives of borrowers to be careful?
Spain’s Prime Minister Mariano Rajoy has now launched the next front in the intra-European credit struggle. Despite the announcement of ECB support, Mr. Rajoy remains elusive regarding whether he would seek the money. His main concern is that the ECB is insisting that the International Monetary Fund, along with the European Union commission and perhaps the ECB itself, negotiate an austerity program with any nation that needs funds. Such an austerity program is the “conditionality” which the ECB had to claim will exist in order to justify the large bailouts they are promising.
So the new battleground moves from whether the ECB can bailout nations to whether austerity programs should be required for bailouts. The periphery will fight this issue tooth and nail, and they will win. Unemployment in Spain is now around 25 percent and in Greece it is at 24.4% (with unemployment for young people aged 14 to 24 now at 55 percent). Both Portugal and Ireland have made progress implementing their austerity programs, but they are not growing and their debts remain very large (gross general government debt is projected by the IMF’s Fiscal Monitor to be 115 percent of GDP next year in Portugal and 118 percent of GDP in Ireland). The current Italian government is well regarded, but there are large political battles ahead and it is also burdened with big debts (to reach 124 percent of GDP in 2013).
At the same time, European countries that are outside the euro – such as the UK, Sweden, Poland and Norway – are all seen as faring much better.
The Germans will be increasingly drawn towards one plausible conclusion: Perhaps the euro area is simply the wrong system. If tough austerity programs do not wrest nations free from high unemployment and over-indebtedness, then how are they to get back on the path to growth? If a one-time devaluation could help release nations from their troubles rather more quickly, perhaps Germany should instead admit – or insist – that the single currency is a failed exchange rate regime?
The ECB is now fighting for its survival as an organization. ECB President Mario Draghi and his colleagues have stretched the rule book in order to open the money spigots to purchase troubled nations’ debts. The leaders of troubled nations will fight hard to get all they can with as few promises in return as possible. Elected officials must do this, or they will lose elections.
Europe has strong institutions – good property rights and vibrant democracy. An independent central bank was long seen as an important manifestation of such institutions. But powerful interests have shifted towards wanting easy credit above all else. And the more the ECB provides such credit, the more powerful those voices on the periphery will become.
We’ve seen such a dynamic operate time and again around the world. When strong regional governments are fighting for resources against national governments, there is a tendency for regions to accumulate large debts, and then demand new bailouts at the national level. Often these battles end in runaway inflations or messy defaults, or both (think Argentina many times or Russia in the 1990s).
The ECB has handed the euro zone’s peripheral governments a great victory at the expense of those who hoped to keep the euro area solvent and a “hard currency” zone through disciplined public finance.
It may be difficult to imagine that wealthy European nations could follow the tragic path to inflation and defaults seen for so long in Latin America, yet with each “step forward” in this euro crisis, Europe moves further along that same route.
An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission. If you would like to reproduce the entire column, please contact the New York Times.