Wednesday, June 6, 2012

The Fundamental Flaw

The Fundamental FlawAtlanta, GA 6/6/12 (StreetBeat) -- Look at yourself. C’mon, you’re better than this and you know it. Where do you think you’re headed? Because you had better figure out where it is that you want to go, and you had better do it soon. All I know is that you can’t keep going on the way you have up to now. It is time to get your house in order. I can’t do it for you, you have to help yourself, and I think you know how to do it. It won’t be easy and it won’t be quick, but you have to start moving in the right direction and you have to convince everyone else that you really mean what you say. You know you can count on me to help, but remember you’ll have to make me believe that you are ready to be helped. Carpe diem, you knuckleheads.

Just to be clear, the above paragraph is not the verbatim text of ECB boss Mario Draghi’s speech before the European Parliament last week. But it can be said that in a certain respect he did throw down the gauntlet and challenge the governmental leaders to make some tough decisions.

M. Draghi: “How is the euro going to be, to look like in a certain number of years from now? What is the Union vision that we, that you have a certain number of years from now? And I think the sooner this has been specified, the better it is.

“But Mr. Draghi said Thursday that the crisis now demanded solutions that could only come from political leaders—like creation of a Europe-wide deposit insurance program. Such a system, like deposit insurance in the United States, would reassure bank customers that their money was safe in any euro zone country, and that might prevent the sort of money flight that is now sapping Spain,” said The New York Times. “He also backed calls by European Commission leaders on Wednesday for a more unified banking system. But he has no authority to affect change, as only the lawmakers of the euro zone countries could together create such a deposit insurance system.”

As helpful as those steps would be, they are only remedies for the symptoms and not solutions to the root cause of the recurrent euro zone problems with debt and banking. And, by the way, it is probably true that the banking safety net would be a good thing to have in place if one or more countries exit the euro zone. But the unmentioned elephant in the room whenever there is a discussion about the European crisis is the absence of a common fiscal policy; it is a fundamental flaw of the common currency union. “That configuration that we had with us by and large for 10 years, which was basically considered sustainable, I should say, I should add, in a perhaps myopic way, is being shown now to be unsustainable unless further steps are being undertaken,” explained Draghi to the Eurocrats in Brussels. But the time has come to talk of the future, and in Draghi’s opinion it must be built on a sustainable foundation, not jury rigged with schemes that are destined for failure because the cause of the trouble goes unaddressed. I think that Draghi was imploring governments to show, in a credible way, convincing to the markets, that they are moving toward a fiscal union.

Although it is understood to be the crux of the matter, the lack of pan European fiscal rectitude has generally been side stepped rather than confronted. That’s because the there is not the common will to sacrifice a bit of one’s national sovereignty, especially when the parameters that would be laid out are not necessarily the ones that you would choose in the first place. In the years preceding the implementation of the euro the Bundesbank had few takers within the currency bloc for its disciplined style of economics. On the other hand Germany was not likely have enough voters agree to budgetary guidelines that fell short of the standard set by their central bank.

As it turned out the political desire to have a common currency trumped the economic calculation that it should be accompanied by a fiscal and or political union. “A special feature of European monetary union will, in fact, be that it will not have a complementary political union—at least in the foreseeable future,” said former Bundesbank economist Otmar Issing in March 1998, before the currency began to circulate. “The principle of ‘one country, one currency’ runs like a thread throughout monetary history. In EMU, this link is being broken for the first time and replaced by the principle of ‘one market, one money.’”

In an ECB paper published last September called The Stability and Growth Pact; Crisis and Reform, the authors addressed this situation. “The sovereign debt crisis in the euro area is a symptom of policy failures and deficiencies in –among other things—fiscal policy coordination. It reflects the as yet unresolved challenge of how to place public finances on a sufficiently sound footing in EMU.” They explain that as the currency member countries converged their economies in the years leading up to the euro’s introduction the debt and budget ratios were in good shape. “But almost as soon as the euro had been introduced, consolidation fatigue set in. Fiscal policies were broadly relaxed, especially during the mild downturn of the early 2000s, and the lower interest rates achieved thanks to EMU were used for increases in primary spending and tax cuts. The period prior to 2007 (i.e. before the crisis) saw a renewed improvement in fiscal balances, but this improvement was modest in cyclically adjusted terms. Strong growth and buoyant revenues owing to an unprecedented boom in real estate markets helped to disguise the expansionary expenditure policies of a number of countries. When the financial crisis hit, fiscal expansion and support for the financial sector meant the public finances deteriorated significantly in the euro area.” Despite all of the efforts, say the authors, skepticism prevails, ”The latest reforms continue to reflect Member States’ unwillingness to transfer the necessary degree of sovereignty over macro-fiscal objectives to the European level. While the latest reforms go in the right direction, it is far from clear whether they will be sufficient to ensure sound fiscal policies.”

The ECB can still pull a rabbit out of their policy hat; Draghi did not deny that possibility. It’s also likely that a grand European summit might come up with another policy bandage that calms the market for some amount of time. But it seems that Draghi is warning that there is a limit to how many times the EMU can deal with the symptom and avoid the root cause. Time, as Draghi suggested, is running out.

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