Inflated Threats: The Eurozone Crisis and the Challenges Going Forward

The photo shows Mario Draghi and the German Finance Minister, Wolfgang Schäuble.

When you have these massive differences in the current account balances between member states in a monetary union, you don’t get a balance of payments crisis, which is what you would normally get if the counterpart were deficits in other countries. You would get a credit crisis. So, the excessive wage moderation in Germany was purely selfish, perfectly legitimate and a politically legitimate policy. You want to be competitive and have full employment; you can’t really blame anyone for that. This is the same in every other Eurozone country; they acted rationally, it was not irrational behaviour.

We then got a financial crisis, not a balance of payments crisis but credit crisis. We have a private and public sector credit crisis. The latter was probably avoidable in some instances – certainly in Greece – but in the private sector crisis it was not. The German surpluses had to go somewhere. They were invested, usually at negative returns on investment. And private sectors in other Eurozone countries spent too much. That wasn’t the result of some behavioural error; it was the result of a system that has imbalances.

Afterwards, Germany agreed to bankroll the system. That wasn’t clear in the beginning because Germany was in a favourable position, it is a rule-based system. The no bail-out principle was enshrined in the treaty. Partially giving up on that was a big deal. They came to an agreement of having a bail-out treaty, the European Stability Mechanism (ESM), which was set up by a treaty among the participating members and became the blueprint. We bail you out, but you have to fulfil some criteria. We’re sending in the IMF, the ECB and the European Commission to oversee that you’re doing all the necessary adjustments. But it became also the kernel for why things have gone wrong subsequently. If you’re in a situation like that, the ideal adjustment for Germany is to accept higher inflation. This is now looking at it not from a German perspective but from a global perspective. And that’s what the Americans, the IMF and everyone else is saying: the ideal adjustment is for Germany to accept higher inflation, say 3% or 4%, and for the other Eurozone members to have slightly lower inflation so that we’re kind of reversing the process of the last decade and trying to achieve some normality. This is not happening. The opposite is happening because Germany is not inflating. Germany is very much in the mid-range in the Eurozone with regard to inflation rates, which are very similar to the core of the Eurozone. Therefore, the other member states are adjusting. The south is adjusting through deflation, and we see negative inflation rates in southern Europe and Germany having inflation rates of around 1%, which is below the ECB’s inflation target of 2%

Even the strongest economy is still inflating at only half the target rate, which is the reason why we are so concerned about inflation.

As such, the Central Bank would normally act to address the imbalance. It could pretty much solve the problem; however, it cannot do so when inflation is at the zero lower band. That’s a global scenario. We’re all at the zero lower band so this kind of thing couldn’t have happened at a worse time, when monetary policy is unusually constrained. And there are additional constraints placed on the European Central Bank – all sorts of laws that others don’t have. It is not the central bank of a country but of a monetary union. There are lots of things the ECB is not allowed to do that other central banks find easier to do.

What do we do now? It’s been talking about QE for the last 12 months and say it is ready to implement it. In reality, we know it doesn’t have it in place. Things first have to get worse for it.

Pablo Iglesias

This is probably the reason.

I was recently in Berlin talking to Schäuble and he made it clear to me that this is the red line.

Everyone you talk to in Germany tells you that QE is the red line. We’ve been willing to go along with the bail-out mechanism, but this is a real red line. We’ll see what happens when it is breached, which I believe is going to happen. The Germans are holding out on the system. The reason we don’t have QE is because of Germany.

Draghi wanted to bring Germany on board with all his policies; he outvoted Germany on interest rate cuts and on his famous official outright monetary transactions (OMT), the programme introduced two years ago that stabilised the financial system and ended the acute phase of the financial crisis, his backstop guarantee. The Germans were opposed to it, so was the Bundesbank, but not the government. On QE, it’s going to be difficult. Draghi didn’t want to force the issue earlier, at a time when he would have alienated Germany to an extent that there would have been an irrevocable breach of trust.

In January, there will be a court case on the OMT programme. My expectation is that the European Court of Justice will give the green light. That will encourage the ECB, given that the legal arguments are clear, so I expect that in the first quarter of 2015 we’re going to see a QE programme. I’m not very enthusiastic about it, although I am in favour. However, the QE programme will probably be 500 billion euros, which is small. The Eurozone is almost the same size as the US in terms of annual economic output, but the US QE programme was three or four times as large as the EU programme will be.

Of course, in Europe, when we decide something controversial, we don’t go 100% nor 0%. Draghi will say we have QE and the Germans will claim we don’t have it. When the announcement is made, you will spend quite some time interpreting what you’ve actually heard.

How will it work? 500 billion euros isn’t going to make a big shift. There is a valid argument against QE relative to the US and the UK. The European economy is much more bank-based, so a lot of the financial instruments whose interest rates you will manipulate through the programme matter less to the Eurozone economy than they would have mattered to the US. The main channel for the Eurozone will be the exchange rates, but don’t get too excited about that either. The reason is that people always focus on the dollar-euro rate, which has gone down significantly. But the nominal exchange rate effect, which is the one that matters, hasn’t moved as much. This is because the yen has depreciated against the euro, the other European currencies are fairly stable, as is the pound, but the Swiss franc is certainly not – it is not revaluing against the euro. Many of the currencies are fixed. Italy gained a boost when installing the exchange rate mechanism in the 1990s, but there needs to be a 30% devaluation in the currency for Italy to get the same kind of effect through a euro devaluation. As an example, the euro would need to devalue by 60%, but it’s not going to happen. It would be like a 60 to 70 cent devaluation in the dollar; this is just too big, the reason being that the US is a large economy.

The Eurozone is in many respects similar to the United States. The exchange rates are not completely irrelevant, but it’s not as important as it would be for a small island economy. And since the Eurozone consists of 18 mostly small countries, everybody talks about the exchange rate as though it was the exchange rate of 18 small open economies, when it is the rate of a large, closed economy. The latter is very different in its behaviour from that of small countries.

If you wanted to make QE work, you would probably have to do more – not just buy more but also use other channels than the exchange rate. My favourite channel would be an expectation of the future. We could shift inflation expectations by changing the inflation target. One thing you could do, and that would still be in line with the treaties and with our 2% inflation objective, is a price level target. Not an annual inflation rate but a long-term price stability objective, which would mean that even if inflation rises, if that were to happen in the next ten years, we wouldn’t stop this programme immediately. People always fear that when inflation arrives, the ECB will be the first central bank to break, which will impact on the programme, knowing that they don’t give you a target, they don’t give you a guarantee about how long or how much they will buy and for how long. This will impact confidence. The way to boost it would be to introduce some kind of target change. Now that’s not going to happen. I understand they discussed it on the governing council, and, for the moment, it has been rejected. The question is: what will happen if QE is put in place but doesn’t work?

The photo is a man from Spain, Pablo Iglesias. Why this is dangerous for Europe is that it’s already a ‘secular stagnation’ we’re falling into. This recovery we were supposed to have seen isn’t happening. This fact is more dangerous than the financial crisis when the central bank stepped in and ended it. What we’re now seeing is the financial crisis translated into an economic crisis because of the way we have reacted to it and all the constraints we have imposed on ourselves. This economic crisis is not just a malaise; we’re not like Japan with zero growth rates and a country that’s still functional. We will have a lot of insurrection and political discontent, especially in the countries that are affected.

Spain is a good example of a country that had two very strong parties – the centre-left party and the centre-right party, which has dominated the political spectrum since the democratic revolution of the 1970s. There have been no other serious political players in Spain except for this party until Podemos. Its foundation was not that long ago and it is now leading in all polls.

Mr Rajoy

The above is a photo of Mr Rajoy a talented sociology professor, who is probably of the new breed of leaders to be taken most seriously. We’re going to see political issues arising that we haven’t seen before. Will Mr Rajoy be the Spanish prime minister at next year’s election? It looked a pretty certain prospect even six months ago but is now much less clear. People are talking about a grand coalition, which is bad news because that’s the best recipe to encourage opposition. Rajoy will then be the opposition leader and that will change the politics of that.

Alexis Tsipras may become the next prime minister of Greece. He is leading in the polls and the government is not looking good. I don’t take him as seriously as Podemos because I think he will ultimately do what his predecessor did. He has a different rhetoric, his party is clearly different, but he’s very much part of the policy consensus. He’s not nearly as radical as he appeared to be two years ago, so I would expect him to present a different style; however, I’m not sure whether the substance will be all that different.

Casaleggio (left) and Beppo Grillo (right)

The above photo shows two Italians, Casaleggio and Beppo Grillo. Beppo Grillo is the party leader of the Five Star Movement in Italy. Casaleggio is the intellectual and financial power behind the party. They believe that Italy should leave the Eurozone. This was the party with the most votes in the last election, but because in Italy you have parties forming pre-electoral coalitions, it isn’t even the main opposition party in the parliament. The main opposition party wants to exit from the euro. That’s different from the consensus 10 years ago when both the government and the opposition consistently supported the euro.

Marine Le Pen said that if she becomes president of France, the first act in office will be to instruct the Treasury to leave the euro. I don’t think she will become president of France at the next election because these political changes take a long time to come to fruition. There are many things that could happen between now and the next election; for example, Hollande might not run and therefore she might not face him but someone from the conservative party. There may be political developments and intrigue, but it’s already telling us that the National Front is leading in the polls, which is completely new. While I don’t expect her and Grillo to become the next generation of leaders, Podemos and Tsipras, Iglesias and Tsipras are more likely challengers.

This would change politics, just as oppositions change politics. When the opposition is against the euro, you’re going to be more careful. The same is happening in Germany with the anti-euro party. The effect will not be that the party gets into power – it won’t – but it constrains the government’s ability to say ‘no’ in public and ‘yes’ in private, to be pragmatic. We’ve heard Germany saying no to QE, no to fiscal expansion and so on.