The balance of power in the Eurozone, and the independence of the ECB

                Just over a month ago, I wrote a postentitled ‘Why I can still believe the euro will survive, just’. This was not based on any forecast of the Greek elections, but rather a judgement about the balance of power within the Eurozone. (It is also based, as Paul Krugman points out, on the optimistic belief that the actors concerned recognise this shifting balance.) The talk at the time was all about how Greece would 'have to' leave if they tried to renegotiate their loans. I thought this was not a credible threat, because other Eurozone countries (including but not just Germany) had at least as much to lose as Greece if such an outcome came to pass. Satyajit Dasdescribes the potential losses for Germany here.

                I think the outcome of the recent summit is consistent with that view. Charles Wyplosz is rightthat it does not represent a sea-change, but the hard line position that Germany had taken has begun to crumble. In part this is because other major countries (Italy, France) have, perhaps for the first time, aggressively argued against that line, but I also think that Germany is beginning to realise how weak its position is. Change will be slow, if only because German public opinion has also to recognise its objective position, rather than staying comfortable on some imagined moral high ground. (For German attitudes on Greece, see here, and for hard line attitudes to banking union, here:HT MT). The problem, as Paul Seabright eloquently pointsout, is in seeing this as a one sided moral issue, which is why I wrotemy – admittedly also one sided – alternative moral tale. For a much more reasonable and interesting discussion between a German (Kantoos) and Greek (Yanis Varoufakis) economist, follow this link.

                Here is just one aspect that contributes to the weakening position of creditor countries like Germany within the Eurozone.

Underlying Primary Budget Balance, OECD Economic Outlook June 2012

	2009	2010	2011	2012	2013
France	-4.3	-3.4	-1.5	-0.5	1.3
Italy	0.3	1.4	1.6	4.5	6.2
Germany	0.8	-0.1	1.0	0.9	1.1
Greece	-10.1	-4.2	0.4	3.2	5.5
Ireland	-7.1	-4.7	-2.7	-0.8	0.9
Portugal	-5.9	-5.1	-2.3	1.4	2.9
Spain	-7.7	-4.9	-3.3	0.5	3.7

These are the OECD’s estimates and forecasts for the cyclically adjusted primary budget balance (i.e. the budget balance excluding interest payments on debt). Now these figures look much better in 2013 than actual deficits, because all countries are expected to have negative output gaps. But these cyclically adjusted numbers are more meaningful in perhaps two respects.

                First, they show just how much fiscal adjustment has been done by Greece, Ireland, Portugal and Spain, and is expected to be done by Italy. (Sebastian Dullien contrasts this with what Germany has done here.) Too much, too fast, from an economic point of view, but the line that these countries have not done enough is simply absurd. If there is a problem, it is that austerity has been so severe that it has substantially reduced output, masking the true extent of fiscal adjustment. Menzie Chinn analyseshow much this has already reduced output. Now an interesting question is why the markets have so far been unimpressed by these national efforts. That brings us to the threat of default.

                It is generally argued that once the actual primary balance moves into surplus, the incentive for a country to default increasesbecause it only needs to borrow to pay interest on its debt. One could make a case that the cyclically adjusted primary deficit, and not just the actual primary deficit, is relevant here. If default was accompanied by a suspension of plans for additional austerity, this would help the economy recover more quickly. In addition, if default was accompanied by Euro exit, after initial chaos devaluation would again support activity.

                Anyhow, the direction of travel is clear. As deficits fall, the options of debtors increase, and the position of creditors gets weaker. For exactly this reason, the chances of default may actually rise (at least as seen by the markets), and so interest rates on this debt may stay high. Only when governments have both achieved primary surplus, and show a clear desire not to default, will the risk premium on debt begin to fall. (Of course you could believethat high risk premiums are all down to critical comments from non-Eurozone economists! I guess we all knew in our hearts that it was Krugman's fault.)  

If nothing else, this analysis shows the folly of using the risk premium as an indicator of fiscal responsibility. (You could put this down as a mistake due to Ordoliberalism.) The combination of a sound fiscal position in terms of flows, but a weak position in terms of a debt burden, may be just the time in which default risk is highest. What the Eurozone has so far failed to do is recognise the nature of this problem, let alone do something effective about it. As Paul DeGrauwe and many others have pointed out, the only institution that can effectively tackle this is the ECB. The means by which it could happen are various, but an ESM bank backed by the ECB would be one of them, and Karl Whelan lamentsthat the ECB seems to have ruled this out.

Unfortunately my balance of power argument has much less force with the ECB, because it is designed to be independent of such influences. Tim Duy is incredulousthat the ECB has not come to the aid of Italy and Spain with bond purchases. To quote “Only the most irresponsible policy body would take such a risk.” The problem here may be a deep seated fear of fiscal dominance, which is why I wrote this post. If Eurozone leaders do collectively move on issues like banking union, austerity and growth (albeit much too late and much too slowly to prevent a serious recession), but their efforts are frustrated by the ECB, then John Quiggin may be right that the ECB will go down in history as the central bank where the idea of independence was pushed too far.