Europe at the Crossroads: Pulling Back Money, Putting Off Reforms
Tax payers in Europe won a groundbreaking victory last week. According to new measures just passed by the ECB, albeit yet to be ratified by the European Parliament, the idea of banks being “too big to fail” is being reigned in. The onus on bank failures is to be shifted away from the sovereign, essentially the tax payers, and on to bank owners. If the new rules are finally passed, funds of the exchequer will only be allowed to be used to rescue banks in exceptional cases, while the burden is largely on the banks themselves. While many have questioned the lack of consensus and integration in Europe in recent years, it must be recognized that this is the first set of countries globally to adopt such rules after the dramatic 2008/09 crisis and generous bank bail outs that followed. Irish Finance Minister Michael Noonan called this new set of rules “bail-ins”. This move is seen as significant in preventing a heavy debt burden on governments in the event of future financial collapses of the scale seen in 2008/09.
This is one of many new developments currently taking shape in Europe, as people, politicians, governments, firms, banks and pan-European institutions begin facing new realities – an era of subdued growth combined with high youth unemployment; the prospect of reduced competitiveness unless important structural reforms are made; and a struggle to commit to more Eurozone integration on the institutional and fiscal front, while managing the tensions that this raises with national politics and laws.
Doing Whatever It Takes
The lattermost is playing out right now. This is the clash between German courts and the European Central Bank (ECB) on the constitutionality of the ECB’s Outright Monetary Transactions (OMT) programme announced last year in which the Bank pledges to buy, unlimitedly, sovereign bonds of troubled Eurozone economies, conditional on their fulfillment of certain fiscal conditions.
Why is the OMT seen as unconstitutional? It is argued that the European Treaty provisions do not permit the ECB to engage in such monetary financing of Eurozone members. The real political-economy issue, though, is that through the OMT scheme the ECB has committed German and other northern European taxpayers to unlimited bail-outs without the concurrence of their own parliaments.
The line between ‘the fiscal’ and ‘the monetary’ has become increasingly blurred as the financial crisis, and subsequent debt troubles, unfolded. Especially in Europe. Yet, economists in Germany seem to be dead set on the principle that the sovereign debt issues of troubled Eurozone economies are matters of the fiscal, and monetary policy (run from Brussels) should not come in the way. The ECB’s OMT is essentially a monetary policy act.
However, the positive effect on markets of the mere announcement of the OMT scheme by the ECB cannot go unnoticed. It calmed financial markets by affirming the ECB’s readiness to “do whatever it takes” and buy sovereign debt before a country goes bust. ECB President Mario Draghi called it “probably the most successful monetary-policy measure” undertaken in recent times. As the OMT scheme was announced mid last year, interest rates for firms and governments came sharply down, helping the flow of credit to the private sector in many crisis-hit states, and bringing confidence back into the viability of the Eurozone. Yet, in the same way markets reacted positively to this, the flip side is that if the German Constitutional Court rule that the OMT contravenes with national laws and impose some limits on it, the markets could react equally negatively. Fears that surrounded the same period one year ago could resurface. As the ruling would essentially make the ECB’s commitment to “do whatever it takes” ineffective, policy would be in limbo and countries like Spain and Italy may be sent into a “panic-induced insolvency”.
Pump Now, Reform Later?
In the midst of all this, however, what is getting sidelined is the question of how to get growth and a real recovery back on track in Europe. It is now widely acknowledged that the answer to this question largely lies with the two words “structural reforms”. Sounds simple enough, but implementation is far from it. Deep reforms are not easy in times of economic uncertainty, but without them the long-term outlook for Europe is bleak. Along with structural reforms come a need for a reinvestment in real growth drivers like infrastructure and connectivity. While it is understandable that in these times of fiscal restraint the European Commission (EC) had to cut the latest EU budget by 3.4% for the rest of the decade, it is surprising that the cuts came in what can be easily described as growth-promoting sectors like cross-border infrastructure, including high-speed broadband, transport and energy. These could determine the longer-term competitiveness, and hence future growth prospects, of Europe. Yet, the critical area of youth unemployment has been taken notice of and got increased budgetary attention. In the new budget the EC introduced an innovative package called the ‘Youth Guarantee Scheme’ to ensure that young adults receive a quality job offer, continued education, an apprenticeship, or an internship within four months of leaving formal education or becoming unemployed.
The debate on the question ‘has Europe pushed austerity too far and is the tightening choking off growth?’, continues apace. But the calls for structural reforms to put post-crisis growth on a sustainable path have been echoed by many. Releasing its Annual Report last week, the Bank for International Settlements (BIS, a grouping of fifty-eight central banks) said that the world’s central banks have done their job in offering breathing space during the financial crisis and it is now time for national governments and the private sector to undertake essential reforms to boost productivity and competitiveness. Governments of crisis-hit countries have shied away from labour and product market reforms, amidst public sentiment that is dominated by severe opposition to austerity. At the release of the report, Chief Economist of the BIS noted, “It is others that need to act, speeding up the hard but essential reform and repair work to unlock productivity and employment growth. Continuing to wait will not make things any easier, particularly as public support and patience erode.”
Timing the Pull Back
Meanwhile, there are growing calls for central banks in crisis-hit countries to begin a timely pull back of cheap money that they pumped in to calm markets during the crisis. Central banks in these countries slashed interest rates and hugely expanded their balance sheets in response to the crisis. The US Federal Reserve is the first of the world’s central banks to indicate that it is planning a gradual pull back of its 3rd tranche of quantitative easing (QE3). But the Fed can afford to as the US economy is seeing signs of a real recovery. Europe isn’t there yet. European governments, especially, are hoping for prolonged expansion so that growth can pick up without the need for the tough reforms, including cutting deficits.
The biggest challenge facing both the central banks and the governments in these countries is finding the right timing and balance in pulling back the current accommodative monetary measures before it becomes harder to do so, while simultaneously not spooking the markets. The dramatic market reactions across the developed as well as emerging world to the US Fed’s announcement on QE3 pull-back was indication of how sensitive markets are right now.
Longer-term View and Implications for Sri Lanka
While the short-term uncertainty is in markets, the long-term uncertainty is in the Eurozone’s institutional make-up. Institutional integration and institutional strengthening will be critical to the longevity of the Union and the currency, because as one analyst put it, “[its] weakness derives from its unfinished construction”. Either way, the challenge for Europe over the medium- to longer-term is one of growth and job creation – without which many of its countries (especially in the South) risk a “lost decade”. With the Euro area entering into its sixth consecutive quarter of recession, and youth unemployment hitting 60% in Greece, 55% in Spain, and 39% in Italy, Sri Lanka will have to watch how Europe’s economic fortunes evolve over the next few years. Prolonged unemployment in Europe will depress wages and reduce purchasing power of the region’s people. It will have a significant impact on not just how much of Sri Lanka’s exports would be demanded there, but also who will buy them and what type of products will be demanded. Because the new European generation may not be as rich as the generation before it.