This is astounding - a leading former central banker smashing the euro
Lord Mervyn King: 'Forgive them their debts’ is not the answer
What is the relationship between money and nations?
The main building of the International Monetary Fund in Washington DC is shaped roughly as an ellipse. As you walk around the corridor on the top floor, on one side are symbols of each of the member nations. On the opposite side are display cabinets of the banknotes used by those countries. There is a remarkable, almost uncanny, one-to-one relationship between nations and their currencies. Money and nations go hand in hand.
European Monetary Union (EMU) is the most ambitious project undertaken in monetary history. EMU has not proved to be an easy marriage, with the enterprise trying to navigate a safe passage between the Scylla of political ideals and the Charybdis of economic arithmetic.
How long this marriage will last is something known only to the partners themselves; outsiders cannot easily judge the state of the relationship.
The basic problem with a monetary union among differing nation states is strikingly simple. Starting with differences in expected inflation rates – the result of a long history of differences in actual inflation – a single interest rate leads inexorably to divergences in competitiveness.
Some countries entered European Monetary Union with a higher rate of wage and cost inflation than others. The real interest rate (the common nominal rate of interest less the expected rate of inflation) was therefore lower in these countries than in others with lower inflation. That lower real rate stimulated demand and pushed up wage and price inflation further.
Instead of being able to use differing interest rates to bring inflation to the same level, some countries found their divergences were exacerbated by the single rate.
The resulting loss of competitiveness among the southern members of the union against Germany is large, even allowing for some overvaluation of the Deutschmark when it was subsumed into the euro. It increased full-employment trade deficits (the excess of imports over exports when a country is operating at full employment) in countries where competitiveness was being lost, and increased trade surpluses in those where it was being gained. Those surpluses and deficits are at the heart of the problem today. Trade deficits have to be financed by borrowing from abroad, and trade surpluses are invested overseas.
Countries such as Germany have become large creditors, with a trade surplus in 2015 approaching 8pc of GDP, while countries in the southern periphery are substantial debtors.
Greece collapses
The situation in Greece encapsulates the problems of external indebtedness in a monetary union. GDP in Greece has collapsed by more than in the US during the Great Depression. Despite an enormous fiscal contraction bringing the budget deficit down from around 12pc of GDP in 2010 to below 3pc in 2014, the ratio of government debt to GDP has continued to rise, and is now almost 200pc.
All of this debt is denominated in a currency that is likely to rise in value relative to Greek incomes. When debt was restructured in 2012, private- sector creditors were bailed out. Most Greek debt is now owed to public- sector institutions such as the European Central Bank, other member countries of the euro area, and the IMF. Fiscal austerity has proved self- defeating because the exchange rate could not fall to stimulate trade. In their 1980s debt crisis, Latin American countries found a route to economic growth only when they were able to move out from under the shadow of an extraordinary burden of debt owed to foreigners.
It is evident, as it has been for a very long while, that the only way forward for Greece is to default on (or be forgiven) a substantial proportion of its debt burden and to devalue its currency so that exports and the substitution of domestic products for imports can compensate for the depressing effects of the fiscal contraction imposed to date.
The inevitability of restructuring Greek debt means that taxpayers in Germany and elsewhere will have to absorb substantial losses. It was more than a little depressing to see the countries of the euro area haggling over how much to lend to Greece so that it would be able to pay them back some of the earlier loans. Such a circular flow of payments made little difference to the health, or lack of it, of the Greek economy. It is particularly unfortunate that Germany seemed to have forgotten its own history.
Germany forgets its own history
At the end of the First World War, the Treaty of Versailles imposed reparations on the defeated nations – primarily Germany, but also Austria, Hungary, Bulgaria and Turkey.
Some of the required payments were made in kind (for example, coal and livestock), but in the case of Germany most payments were to be in the form of gold or foreign currency.
The Reparations Commission set an initial figure of 132bn gold marks. Frustrated by Germany’s foot-dragging in making payments, France and Belgium occupied the Ruhr in January 1923, allegedly to enforce payment. That led to an agreement among the Allies – the Dawes Plan of 1924 – that restructured and reduced the burden of reparations. But even those payments were being financed by borrowing from overseas, an unsustainable position. Reparations were largely cancelled altogether at the Lausanne conference in 1932. In all, Germany paid less than 21bn marks, much of which was financed by overseas borrowing on which Germany subsequently defaulted.
The most compelling statement of Germany’s predicament came from its central bank governor, Hjalmar Schacht. In 1934, writing in that most respectable and most American of publications, Foreign Affairs, Schacht explained that “a debtor country can pay only when it has earned a surplus on its balance of trade, and… the attack on German exports by means of tariffs, quotas, boycotts, etc, achieves the opposite result”. Not a man to question his own judgments (the English version of his autobiography was titled My First Seventy-Six Years, although sadly a second volume never appeared), on this occasion Schacht was unquestionably correct.
As the periphery countries of southern Europe embark on the long and slow journey back to full employment, their external deficits will start to widen again, and it is far from clear how existing external debt, let alone any new borrowing from abroad, can be repaid. Inflows of private-sector capital helped the euro area survive after 2012, but they are most unlikely to continue for ever.
Much of the euro area has either created or gone along with the illusion that creditor countries will always be repaid. When a debtor country has difficulties in repaying, the answer is to “extend and pretend” by lengthening the repayment period and valuing the assets represented by the loans at face value. It is a familiar tactic of banks unwilling to face up to losses on bad loans, and it has crept into sovereign lending. To misquote Coleridge (in “The Rime of the Ancient Mariner”), “Debtors, debtors everywhere, and not a loss in sight.”
Seeds of division in Europe?
Debt forgiveness is more natural within a political union.
But with different political histories and traditions, a move to political union is unlikely to be achieved quickly through popular support. Put bluntly, monetary union has created a conflict between a centralised elite on the one hand, and the forces of democracy at the national level on the other. This is extraordinarily dangerous. In 2015, the Presidents of the European Commission, the Euro Summit, the Eurogroup, the European Central Bank and the European Parliament (the existence of five presidents is testimony to the bureaucratic skills of the elite) published a report arguing for fiscal union in which “decisions will increasingly need to be made collectively” and implicitly supporting the idea of a single finance minister for the euro area. This approach of creeping transfer of sovereignty to an unelected centre is deeply flawed and will meet popular resistance.
In pursuit of peace, the elites in Europe, the United States and international organisations such as the IMF, have, by pushing bailouts and a move to a transfer union as the solution to crises, simply sowed the seeds of divisions in Europe and created support for what were previously seen as extreme political parties and candidates.
It will lead to not only an economic but a political crisis. In 2012, when concern about sovereign debt in several periphery countries was at its height, it would have been possible to divide the euro area into two divisions, some members being temporarily relegated to a second division with the clear expectation that after a period – perhaps 10 or 15 years – of real convergence, those members would be promoted back to the first division.
It may be too late for that now. The underlying differences among countries and the political costs of accepting defeat have become too great.
That is unfortunate both for the countries concerned – because sometimes premature promotion can be a misfortune and relegation the opportunity for a new start – and for the world as a whole because the euro area today is a drag on world growth.
Germany faces a terrible choice. Should it support the weaker brethren in the euro area at great and unending cost to its taxpayers, or should it call a halt to the project of monetary union across the whole of Europe? The attempt to find a middle course is not working. One day, German voters may rebel against the losses imposed on them by the need to support their weaker brethren, and undoubtedly the easiest way to divide the euro area would be for Germany itself to exit.
But the more likely cause of a break- up of the euro area is that voters in the south will tire of the grinding and relentless burden of mass unemployment and the emigration of talented young people. The counter-argument – that exit from the euro area would lead to chaos, falls in living standards and continuing uncertainty about the survival of the currency union – has real weight.
But if the alternative is crushing austerity, continuing mass unemployment, and no end in sight to the burden of debt, then leaving the euro area may be the only way to plot a route back to economic growth and full employment. The long-term benefits outweigh the short-term costs. Outsiders cannot make that choice, but they can encourage Germany, and the rest of the euro area, to face up to it.
If the members of the euro decide to hang together, the burden of servicing external debts may become too great to remain consistent with political stability. As John Maynard Keynes wrote in 1922, “It is foolish… to suppose that any means exist by which one modern nation can exact from another an annual tribute continuing over many years.”
It would be desirable, therefore, to create a mechanism by which international sovereign debts could be restructured within a framework supported by the expertise and neutrality of the IMF, so avoiding, at least in part, the animosity and humiliation that accompanied the 2015 agreement on debt between Greece and the rest of the euro area.
It is only too likely that a sovereign debt restructuring mechanism will be needed in the foreseeable future. Without one, an ad hoc international debt conference to sort out the external sovereign debts that have built up may be needed.
But debt forgiveness, inevitable though it may be, is not a sufficient answer to all our problems. In the short run, it could even have the perverse effect of slowing growth. Sovereign borrowers have already had their repayment periods extended, easing the pressure on their finances. There would be little change in their immediate position following explicit debt forgiveness. Creditors, by contrast, may be under a misapprehension that they will be repaid in full, and when reality dawns they could reduce their spending.
The underlying challenge is to move to a new equilibrium in which new debts are no longer being created on the same scale as before.
Extracted from The End of Alchemy (Little, Brown £25) © Mervyn King 2016. To order your copy for £19.99 with free p&p, call 0844 871 1514 or visit books.telegraph.co.uk
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