EU deal: Permanent austerity, permanent stagnation

Posted: December 14, 2011 in Uncategorized

James Meadway
Senior Economist

Political fallout over David Cameron’s veto has distracted from the shortcomings of the deal itself

Cameron’s early morning exit from EU crisis negotiations exposed the most painful tensions around Britain’s relationship to Europe; and, alongside them, Cameron’s craven servitude to a City of London that now supplies over half the Conservative Party’s funding, in defence of whose interests his hissy fit was conducted. Cameron’s inept special pleading may, however, have inadvertently aided the rest of us. His veto has pushed the other 26 EU members onto a more legally uncertain path towards implementing the deal.

We should be quite clear about this. The “fiscal compact” is a catastrophe in waiting. It moves to enshrine austerity in law; it will, if it survives, make an expansionary policy by any signatory government illegal.

Leave aside the baleful social consequences of austerity. Leave aside, too, the continuing disintegration of democracy in Europe. Even on its own terms, as an attempt to resolve the debt crisis, the deal is woefully misguided.

It gives legal grounding to the mistaken presumption that what we are dealing with in Europe is a crisis of public debts driven by bad fiscal policy – a crisis of excessive government deficits, the result of profligacy. This is clueless, for reasons Martin Wolf detailed last week. Governments will be expected to aim for balanced budgets, with a 3 per cent of GDP absolute limit on deficits, beyond which penalties will be applied. But of those countries now worst hit by the debt crisis – Portugal, Ireland, Spain and Greece – all bar Greece had average deficits below the 3 per cent limit from the time of the euro’s creation in 1999, to 2007 when the crisis began to break. Germany and France both had worse average deficits over the same period. The 3 per cent criterion would have missed later problems.

Similarly for public debt. The deal reinforces the existing 60 per cent Maastricht limit. Greece and now Italy would have fallen foul of the tightening. But Ireland and Spain would have sailed through.

It is only after the crisis broke that debts and deficits went haywire. There was, for the majority of countries, no indicator in the public balance sheet that trouble was brewing. It was the private balance sheet, and specifically the weakness of the banking system, that wreaked havoc.

Yet the private sector financial system is treated with kid gloves. There are to be no more losses for private bondholders in any future EU bailouts. The tightening of the regulations that so upset Cameron are minimal. The chronic weaknesses of the system remain; indeed, as new stress tests by the European Banking Authority suggest, they are worse than previously thought. German banks, in particular, will need to increase their capital base by nearly three times more than was believed necessary.

So the deal fails to understand the drivers of crisis. What occurred over 2007-9 was a failure of a weak, overextended private sector financial system. This system-wide failure was then turned into a weakness of the public balance sheets, via the recession and the bailouts. Chronic current account imbalances inside the eurozone exacerbated the breakdown.

Increasing chance of financial crisis

But it gets worse. If implemented, the deal will make a further financial crisis more – not less – likely. The reason is simple. Austerity wrecks weak economies. As governments pull back on their own spending, they suck demand out. As demand shrinks, firms sell fewer goods and services. They cut wages and make redundancies. Tax receipts fall. A cycle of decline is set in train.

For countries with substantial public debts, this is a disaster. Far from reducing that burden, as intended, austerity can balloon it. Take Greece, which has suffered the most. At the end of 2009, Greece had a debt to GDP ratio of close to 130 per cent. Now, after nearly two years of tightening austerity and with the economy shrinking by close to 6 per cent this year alone, that ratio is forecast to hit 189 per cent.

Shrinking economies means swollen debt to GDP ratios. The risk of default increases as economies find they are less and less able to meet repayments. Default hits creditors: what creditors thought was a valuable loan asset, producing a steady return, is wiped out. And since the creditors for European states are European banks, the threat of default threatens the European banking system.

No default has to occur for banks to begin to panic. The mere threat of a wipeout is enough to terrify them into shrinking their loan book. This is already beginning to happen, with banks across Europe desperately trying to ditch the loans they consider most at risk – those made to southern Europe, for instance– for the safety of the ECB and other seemingly safe havens. This is the credit crunch at work, and if it worsens, the whole banking system freezes – just as it did in 2008. By locking Europe into austerity, European leaders have brought us still closer to disaster.

The immediate alternatives are clear. Reflation and investment are needed to create sustainable jobs and drive the green economy. The crippled giants of the private financial system have to be broken up and placed under strict public control. To cope with financial instability, controls on the movement of capital are needed – as recent Bank of England research concedes. Defaults will be necessary, with private interests taking the pain.

A complete reverse, in other words, of existing policy. If Friday’s deal is applied, there is precisely no realistic hope of recovery across the continent. Cameron’s hapless exit was for the worst possible motives in the interests of the least worthy causes. But if he has helped undermine the EU’s capacity to deliver a farcical 1930s redux, we may yet have reasons for gratitude.

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