John Walsh looks at what might happen in Europe over the course of 2012 and what the implications would be for Ireland.
The term the ‘sick man of Europe’ was first used one and a half centuries ago to describe the Ottoman empire. Since then it has been deployed, with alarming frequency, to describe countries in the region that are in economic difficulties.
Ireland had the dubious distinction for most of the 1980s. Britain in the 1970s and Germany in the 1990s. It is now a bit ironic that Europe has become the sick man of the world economy. Moreover, the euro zone has become the sick man of the European economy.
There have been several false dawns in attempts to get the European debt crisis under control. The luxury of doing nothing is not an option, but there is no agreement on the best way to proceed. Time is an implacable foe as the markets push for a comprehensive solution.
Successive EU summits have promised a fresh new initiative, which would pave the way for a stabilisation of the region and put it on the path to recovery. Each summit has come and gone without delivering anything substantive.
The G20 summit held in Cannes on November 2 was supposed to agree a roadmap that would stabilise the euro zone and put the world economy on a much more solid footing. The former Greek prime minister George Papandreou had other ideas however. The day before the summit, he announced that the EU/IMF Greek bailout package would be put to a referendum. Markets immediately went into a tailspin. Italian bond yields soared.
French president Nicolas Sarkozy and German Chancellor Angela Merkel did not attempt to conceal their displeasure. In fact, the summit rarely rose above the level of farcical. US President Barack Obama witheringly referred to the number of European leaders at the summit while at the same time bemoaning the lack of European leadership.
In the event, the Greek referendum was shelved and the government replaced with a technocrat administration. In the face of increasingly punitive borrowing costs the Italian Prime Minister Silvio Berlusconi also had to stand down to be replaced by a technical government headed by former European Commissioner Mario Monti.
The intersection between politics and economics will decide the fate of the single currency. At a conference in Brussels in May 2011, the German finance minister Wolfgang Schäuble, giving the inaugural Thomas Padoa Schioppa lecture, said there was a democratic deficit at the heart of the European project.
It is unlikely that the toppling of governments in Italy or Greece will allay concerns about the democratic legitimacy of European integration.
And this gets to the nub of the problem. If the single currency is to survive, then there will have to be a change to existing treaties. But with rising hostility towards the euro, particularly on the periphery, the passage of any new treaty will face quite a few obstacles.
Treaty change
The Irish Government is adamant that the changes that are needed to the working of the euro zone ought to be done within the boundaries of existing treaties. That hardly seems a surprise in view of the problems the last two treaties have created. The Irish electorate rejected the Nice Treaty in 2001 and the Lisbon Treaty in 2008. A second plebiscite was held on both occasions which were passed. But this time the stakes are much higher and the landscape has changed considerably. Both referendums were set against a relatively benign economic backdrop. Moreover, successive eurobarometer polls showed that the Irish electorate were generally well disposed to Europe. That has now changed.
Since the EU/IMF bailout in November 2010, there has been a steady rise in anti-euro sentiment. The chances of successfully negotiating a treaty change in this environment are quite low. But the chances of the single currency surviving without a treaty change are also quite low. The German and French governments were working on changes to the existing treaties at the time of going to press. It is inevitable that there will be a referendum in this country over the next couple of years.
Speaking at an event at the Dublin-based Institute of International and European Affairs (IIEA) in November, Jürgen Stark, executive board member of the ECB, says that there would have to be some sort of fiscal union. “What I mean by fiscal union is not some sort of huge European budget, or harmonisation of taxes. What it does mean is interference in national budgets. “
The German government has been agitating for a political and economic union for some time. Its view of the complexion of what such a union might look like chimes with Stark’s analysis. When Germany joined up to European Monetary Union, its biggest fear was that it would end up as a transfer union for southern European members. Merkel and Schäuble are currently engaged in a game of brinkmanship. They want a centralised fiscal authority to have as much control as possible over the preparation of national budgets.
Moreover, a future treaty change is also likely to include an exit mechanism for a country to leave the single currency. The Irish Government faces a series of politically loaded options. The Irish electorate is unlikely to cede further sovereignty to Brussels – even at a second attempt. In that event would the Government be forced to contemplate leaving the single currency or settle for second class citizenship status?
Ireland, unlike most other EU states has to put any treaty change to a referendum and that is because of a 1987 challenge to the ratification of the Single European Act (SEA). The government tried to ratify the SEA through the Houses of the Oireachtas. The economist Raymond Crotty challenged that decision. The Supreme Court ruled that it had to be put to a plebiscite. Since then, successive governments have erred on the side of caution and put every treaty change to a referendum. But legal experts say the Crotty case is open to interpretation. Could the Government decide to challenge the Crotty judgement?
Eurobonds & ECB
The euro zone debt crisis is close to a resolution – one way or the other. The core countries have now been infected. France is close to losing its AAA credit rating. If that goes, then it will have negative implications for its cost of borrowing. As it stands, the European Financial Stability Facility (EFSF) does not have the firepower to fund core countries if they are unable to tap the markets. Italy has roughly €330 billion in debt to be rolled over in 2012 alone. The consensus view is that the ECB will have to become lender of last resort until a more long-term solution can be found. Or, that should read, the consensus view outside Germany. The latter’s view is that the only remedy for this crisis is fiscal consolidation and structural reforms.
There is no doubt that periphery countries lost competitiveness over the past decade. Germany on the other hand engineered a competitive devaluation when it joined the single currency. Across the board wage freezes were maintained until labour costs lagged gains in productivity. Consequently, there was a glut of savings in the country.
German banks, bloated with capital, but facing a limited array of domestic investment opportunities, recycled German savings into the peripheral economies. Instead of market forces ensuring that countries lived within their means, spreads between euro zone member states narrowed to historically low levels.
That some euro zone countries are carrying too much debt is not in doubt. A private sector involvement will see a 50% writedown of Greek debt. But even then, it will have a debt-to-GDP ratio of 120% by the end of the decade. Whether Ireland defaults depends on growth prospects for the economy. But the elephant in the room is Italy; its stock of debt is €1.8 trn which makes it the third largest debt market in the world.
Commissioner for Economic and Monetary Affairs Olli Rehn and Commission President José Manuel Barroso issued a joint paper on November 23 calling for much greater surveillance of member states’ budgetary procedures. They also issued proposals for Eurobonds. The German government is opposed to Eurobonds on the basis that they will allow weaker member states to borrow at much cheaper rates. Berlin says what is needed are structural reforms and fiscal consolidation. Unfortunately this will not work in the short term. Pressure on the single currency will reach unsustainable levels until the ECB becomes lender of the last resort.
Debt forgiveness
Ireland’s national debt is forecast to peak at somewhere between 110-120%. If the Government successfully divests its stake in the two pillar banks combined with other state assets, then the debt-to-GDP ratio is likely to settle at the 100% level, which still means punitive interest rate payments. Up to 35% of the tax take would be earmarked for capital and interest payments on the debt, which would weigh on economic development as it would hamper the Government’s ability to make strategic investments.
The Minister for Finance Michael Noonan says that the Government is involved in negotiations to alleviate the debt burden, although he has declined to give any details. In return for not burning senior bondholders, despite intense domestic pressure to do so, the Government has assumed the cost of bailing out the banking system. Talks are believed to focus on the €31 billion in promissory notes the government used to recapitalise Anglo Irish Bank and Irish Nationwide. The Government is obliged to pay €3 billion per year each year until 2025. Could the maturities on these promissory notes be rolled out to much longer timeframes?
Another possibility is that the EFSF could invest in Bank of Ireland and AIB. Both options are freighted with political challenges as they could be seen as transfers by the German electorate. But in a looming referendum, they could form a crucial piece of negotiations between Dublin and Brussels.
Imbalances
The cause of the euro zone debt crisis is a politically loaded question. Unsurprisingly, there is cleavage between Germany and the rest of the zone over the answer. The German Finance Minister Wolfgang Schäuble cites fiscal deficits as the cause of the crisis. He says that the role of macroeconomic imbalances has been overplayed. His position finds little support throughout the rest of the euro zone.
In fact, both Schäuble and Merkel have been very prescriptive about the cure. Increase competitiveness and open up a trade surplus similar to what Germany did over the lifetime of the euro. Merkel has feted the Swabian housewife as the model German citizen. The Swabian housewife is famed for thriftiness. What this translates into is a low domestic consumption export-oriented growth model, which has huge implications for the rest of the euro zone. One of the cornerstones of the European Union is to create a single European market for goods and services, which would stoke robust levels of economic growth. But the German government has an anaemic commitment to liberalising its services sector. Unless the euro zone opens up a trade surplus with the rest of the world, which keeps growing every year, then there will be further imbalances within the region.
There is a clause in the Europlus Pact, which calls for the detection and prevention of macroeconomic imbalances. But whether Germany will abide by the rules of the Europlus Pact remains to be seen. If it doesn’t then there will be another debt crisis in the future.
