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North-South split risk to the euro

Friday, 13th June 2008

Dr John Whittaker, Party Chairman

The European Central Bank's one-size-fits-all interest rate policy is leading to a dangerous imbalance, writes John Whittaker.

The Euro was supposed to be the centrepiece of the single market and it has been hailed as one of the EU’s most successful projects.

But even before it started, sane people were warning that a shared currency was not a good idea for countries with independent government finances and widely differing standards of living, economic cycles and productivity. More bluntly, it would be madness to marry Germany with its reputation for monetary prudence with Italy and other Mediterranean countries that had quite the opposite reputation.

So the plan was to help countries to "converge" by means of cash transfers ("structural funds") and rules restricting government budgets (the "stability pact").

Nine years since the euro was launched, it is now clear that these measures have not worked. While the German economy has been doing relatively well following labour market reforms, the usual delinquents of the Mediterranean fringe are in very poor shape. To cite a couple of figures, the debt of the Italian government remains stubbornly high at 106% of GDP, despite the stability pact rule that this should be less than 60%. Greece has a trade deficit of 13% of GDP and Spain has a trade deficit of 10% of GDP.

These figures are symptoms of borrowing that has been cheap and easy. The Spaniards and Greeks have been using borrowed money to import goods. The Italian government has been able to keep borrowing cheaply because its debt is in euros. Not any more.

All over the world, lenders have become more wary – we are in a credit crunch. The Chinese are cutting back on lending to the Americans – hence the weakness of the dollar. The Germans are reluctant to lend any more to the Spanish. The Italian government is having to pay 0.5% higher rate for its debt than the German government. And within countries, banks are afraid of lending to other banks in case their mortgage-backed assets turn sour.

In attempt to shore up the financial system, the major central banks – the US Fed, the Bank of England and the European Central Bank – are all continuing to take on private debts on an unprecedented scale. All commercial banks have been suffering to varying degrees from the epidemic of lending too cheaply. Northern Rock in the UK and Bear Sterns in the US are just two examples where state support has been explicit. The state – i.e. the taxpayer – is effectively bearing the risks of private loans quite generally.

This is not a position that central banks and governments like – hence the complaints from Mervyn King, the Bank of England governor, about "moral hazard" – the notion that bailing out banks leads them to take on more risk, thus raising the likelihood that further bailouts will be needed in the future.

This is bad enough when taxpayers are bailing out banks in their own country. But in the eurozone, the common currency has the effect of spreading the burden. Thus the ECB has been taking on Spanish mortgage-backed debt just as the Spanish construction industry is grinding to a halt and making this debt more risky.

However, the Club Med countries are looking for more help than this. They want the ECB to reduce interest rates to prop up their flagging economies and to allow higher euro inflation which would write down their debts. This is quite the opposite of the German position, where the concern is that current euro inflation of over 3% is already well above its target level of 2%.

If Germany wins this fight and the ECB refuses to go soft on inflation, a bad situation in Club Med may become desperate, raising the scenario that some countries could leave the euro altogether and re-establish their own currencies. This would allow them to devalue and inflate away their debts without the help of the ECB, just as they used to do before the euro started.

The one-size-fits-all euro interest rate does not fit all, and it is beginning to show.

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