The Euro, Greece and Important Policy Lessons for Malta

The last project of a single (rather than a fragmented or differentiated) Europe goes back at least 6 decades to when the French Foreign Minister Robert Schuman proposed the European Coal and Steel Community (ECSC) in the aftermath of the second world war as a way of bringing France and Germany commercially closer together with a view to preventing yet another devastating Franco-German war. That the community was based on coal and steel, two of the most important economic sectors back then, comes as no surprise as the two previous wars involving Europe’s continental behemoths had brought the whole European continent on its knees, especially France and Germany. It was then thought, in the wake of the appalling destruction and waste of life, that Europe could not bear the brunt of yet another such conflict. Indeed, Albert Einstein, in a terse phrase that captures the essence of what this was all about (here being quoted out of context and originally with reference to the technological advancement in weapons of mass destruction to which he was privy), is said to have remarked that he knew not with what weapons World War III would be fought, but that World War IV would be fought with sticks and stones.

The ECSC was therefore born as the first step towards the development of closer European ties, based not on the power that flows out of the blade of a sword or the barrel of a gun: military prowess, conquest and the ensuing Pax Romana; but on the more sublime power of trade and persuasion: a round table of countries based on compromise and quid pro quo politics. Given the importance of trade to the well-being of states, to the vesting of interests across states, and to the welfare of these states’ citizens, this process started off with a free-trade arrangement, that subsequently came to be known as the Common Market and that eventually evolved to usher in the machination of the European Economic and Monetary Union that embodies the Euro.

Since a long time before its incipiency, the European Currency Unit has been more than just a common European currency. For many believers in the peaceful and voluntary European integration project, it has also symbolised the nascence of a unified (or what would eventually have evolved to be a unified) market, a supranational European government structure and an instrument for getting the populations of the euro-zone countries socially closer together through trade and the interchange that trade brings about. Back then many had welcomed the European Union’s removal of trade barriers with great acclaim, but had also cautioned that imposing a single currency on a very motley group of countries might create serious problems. A single currency denies countries the ability to adjust monetary policy to local conditions, leading to unemployment levels in excess of what historically has become to be viewed as the norm and to the kind of bubbles in real-estate prices that have recently hurt Ireland and Spain and that threaten to spill over to Portugal, Italy and Malta. Fiscal transfer mechanisms that siphon off money from more developed regions towards less developed ones were accordingly devised with a view to minimise the impact of disparity and to promote cohesion. Such measures went beyond altruism, as the richer countries expected to eke out a return on their investment through higher demand levels for their produce over time.

Ever since Malta has joined the European Union on the first of May of 2004, with one of its conditions for access being the adoption of the European single currency, the local euro analytical debate has tended to be a rote political debate intended more to persuade the people at large and to endeavour to win their hearts and minds over an overly-politicised issue, than to realistically shed light on the opportunities and challenges that this political-economic move brought about for better or for worse. The parameters of the discussion, most often a reverberative reflection of the political divide on whether to join the EU or not, have, in that spirit, been a disservice to the civil service, the business community and the household sector alike.

With the recent happenings in Greece, it is perhaps high time to look at the euro more closely from a non-partisan analytical perspective and to say things as they are and to try to make out what implications these might have for Malta’s current and prospective situations, and in doing so, looking at the Greek experience might prove to be instructive.

Greece joined the European Monetary Union (EMU), also known more colloquially as the Eurozone, in January 2001 after having qualified for joining in 2000. It is now, a decade later, exposing two of the worst weaknesses of the EMU, viz. that despite the claims of the neoclassical economics school of thought – now proven beyond any reasonable doubts to be erroneous, but somehow still being relied on to inform the formulation of policy – Eurozone countries are not economically in synch and that the coexistence of a single European currency and a single European Central Bank, in juxtaposition with a set of separate state budgets and heterogeneous differentiated markets is, to say the least, contradictory. This proposition gathers more momentum if one takes a peek beyond Europe’s shores across the Atlantic, as the United States of America has a similar arrangement with the US Dollar, the Federal Reserve Bank and the states who manage their own budgets at the state level.

Both unions on the far side of the Atlantic lack a mechanism for adequately co-ordinating these state budgets. The result is the unseemly spectacle of some states (like California and Nevada in the USA and Greece and Ireland in the EU) chronically overspending while others (West Virginia and Wyoming in the USA; Germany and Luxembourg in the EU) live within their means. In the overwhelming preponderance of cases, the deficit countries and states are now the ones with high unemployment rates and serious competitiveness problems.

From a European perspective, these weaknesses, though somewhat obfuscated by the same theories that failed to see the coming dip, were to some extent surmised long before the launch of the Euro, when it was hoped that member countries would ponder on and subsequently recognise the implications.

That Greece did not rise to the challenge does not imply that the monetary union itself has failed, though it certainly gives rise to failure and fragmentation risks, which for the time being seem to be remote, and contagion, which seems to be less remote especially with the recent happenings in Portugal whereby it was forced to pay borrowing costs in excess of what it had to pay a month earlier. In fact, Portugal had to pay  a rate of 5.225 per cent to raise a new €816m tranche of 10-year bond debt, which levels are more than half a percentage point higher than Lisbon’s previous 10-year bond auction on the twelfth of May 2010 when the average yield was 4.523 per cent, as well as €701m worth of three-year bonds maturing in September 2013 issued at an average yield of 3.597 per cent, up from a comparative sale at 1.715 per cent two months ago, thus putting strong pressures on the Portuguese fisc that may, if they keep their ardour, make default a likelier prospect through the self-fulfilling prophecy mechanism.

At this stage, nevertheless, nobody in his right mind would deny that Greece is in very rough waters without any prospects of getting out anytime soon or unscathed, as are other countries that have made similar errors of judgement. Nor can anyone say that the economic advice being meted out by the European Commission and the European Central Bank in conjunction with the I.M.F. is very helpful to Greece. Indeed, the Greek government’s agreement is likely to make the current economic problems even worse. Projections show that if the austerity program “works,” Greece’s debt burden will rise from 115 % of gross domestic product today to 149 % in 2013. This means that in less than three years, and most likely sooner, Greece will be facing the same crisis that it faces today on a somewhat larger magnitude.

Greece was also not alone in this failure which opened a Pandora’s box for financial institutions with stakes in Greek happenings, even from the relatively well-behaved countries of France, Switzerland and Germany, which according to data from the Bank of International Settlements own over 50% of Greek government bonds. Indeed, the recent Interbank Offered Rate levels (such as the LIBOR and the Euribor) speak volumes about the perceived change in inter-bank riskiness following the Greek jolt.

This does not imply, as some analysts have been asserting, that a speedy exit from the Euro area is the better solution for Greece, though the solution would spuriously seem to tempting on account of the increased leeway on debt monetisation and the acquisition of the ability to depreciate away the loss in competitiveness that has ensued since hell broke loose on that fateful day when Greece announced that it had been falsifying its accounts. A considerable depreciation would boost exports and the real economy by making Greek produce more attractive abroad, generally dent the attractiveness of imports as their cost in terms of the Greek currency would rise more in relation to those produced in Greece itself, and would make it much easier to close down the twin external and budget deficits that underlie Greece’s ailments. But we also know that the other side of the coin in the trade-off involved would trigger some very painful unpleasant consequences whichever the exit route opted for. We already have some similar, not-too-distant natural experiments at our disposal to shed light on the possible consequences for countries that unpegged their currencies in the middle of a crisis (like, say, Argentina in 2001 and South Korea in 1997).

With public debt standing at almost €300 billion, a GDP in the region of €240 billion, 20% of which is exported-generated, and crippling private sector indebtedness, quitting the Eurozone will most certainly result in a speculation-led run on the new Greek currency as well as a steep rise in debt servicing costs ascribable to both the increased objective risk of default per se and the self-fulfilling speculation-led run. Indeed, this alone can trigger a series of public and private sector defaults that would impair the entire Greek economy further in a relatively short period of time. The 80% of GDP that is not export-oriented would then lose its value thereby raising the debt burden even further. The brunt may be borne mostly by owners of wealth and lenders or by borrowers depending on how the Eurozone exit would be engineered. Euro-denominated debts would remain unchanged, so with a devaluated currency, the real value of these debts would rise thus making defaults by both the government and private borrowers to some extent unavoidable.

At the end of 2007, Greece’s net external liability position stood at €220 billion. The present position is anyone’s guess, but I would reckon that by now it will have gone up to about €250 billion. If Greek GDP had to fall, which makes for a very realistic prospect whether Greece leaves the Eurozone or not (more so, however, if it does) the debt burden will also become more onerous on that account alone – even if it had to stay exactly the same in nominal terms – and deflationary pressures like the ones seen in Japan could ensue.

Moreover, devaluation of any newly-introduced Greek currency (whether intended or unintended) would work by acting as a tax on domestic citizens. Exports would rise only because they would become cheaper in foreign currencies, which means that wages must decline in real terms or, put differently, in terms of their purchasing power of goods and services produced outside Greece. The first tax would come in the form of a decline in domestic real incomes. The second tax would come in the form of a wealth tax on assets denominated in the Greek currency and an increase in external indebtedness. The truth is that no devaluation can ever be painless and neither can the solution to Greek woes.

If Greece remains within the euro area, on the other hand, the Greek government is committed, under the IMF/EU programme, to cut its budget deficit by 10% over the next four years, the preponderance of which needs to be undertaken in the initial stages. The impact of the austerity measures required to achieve such cuts is bound to deepen the recession and, quite probably, worsen the budget deficit. The solution would be for Greece to attain some manoeuvring space. This effectively translates into getting cover from daily, partly speculation-led pressures on its debts, which will need to be regularly rolled over if they are not to be defaulted on. The IMF/EU programme provides this cover but under sadistic conditions that have been requested by the euro-area countries in exchange for their support, to satiate the thirst for blood that naturally arises when the well-behaved have to make good for the ill-behaved and, at the same time, to make it clear to national governments that such actions will not be taken lightly. It would have been easier and cleaner for the IMF/EU programme to organise a standstill in debt repayments, tied to a commitment to an orderly debt rescheduling agenda. Politically, however, it might be more palatable to wait till that unavoidable time when Greece fails to deliver on its promised deficit reduction plan to come as it will always be less painful, even out of mere national Member State self-interest (given banks’ and financial markets’ interconnectedness), for Europe to bail out Greece than to let it falter.

Greece also has to somehow contend with the loss in external price competitiveness that it has suffered since it joined the euro area in 2001 and which has been quantified by several analysts at around 10%. All that is needed is a sustained lower inflation rate than in the rest of the euro area accompanied by a bout of labour productivity gains. Such a gradual but steady improvement would clearly be more attractive than the immediate collapse of real wages that overshooting currency depreciation usually brings about, followed by a slow and painful recovery through high inflation. At this stage and for these reasons, therefore, it is very difficult, if not impossible, to see an exit from the euro area as the silver bullet to Greek woes.

In any case there are lessons to be learnt from this debacle that we would better hearken to in order to make sure that we keep any similar woes at bay.

Some of these lessons, like those that transpire from the irrationalities of IMF/EU programmes, the credibility-denting Central Bank interventions to prop up markets in weak securities, the contradictory setup of a single currency with a single interest rate and differentiated markets and fiscal regimes, as well as the basic fact that countries cannot be assumed to be destined to be well-behaved by default, have to be learnt at the supranational level.

Others need to be learnt and acted upon at the domestic (national) level and it is to these that we have to turn our attention to most ardently.

The Euro has undeniably brought about a reduction in exchange rate volatility and the risks associated with such volatility when it comes to doing business with other Eurozone members accompanied by lower transaction costs. Of course, exchange rate volatility and risks when doing business with countries outside the EU are still there.

It has also been conducive to increased competition and price transparency, both of which lead to lower search costs and thereby trade creation. This, however, is not necessarily a good thing for Malta. It can be a good thing until local prices and quality are competitive against those in other Eurozone and non-Eurozone countries plus shipping and handling in the case of physical exportable goods. The instance of the Euro’s favourable exchange rate in relation to the Pound Sterling has been quite instructive in this respect.

The initially-assumed and initially-valid premise of lower risk premia on borrowing costs clearly does not hold anymore following the Greek debacle. Without the risk of exchange-rate changes, Eurozone countries used to share a common level of interest rates. This made it simpler for the profligate to live beyond their means. When everyone woke up to the fact that government finances are unsustainable, all hell broke loose with the consequence that we have now returned to a world where investors look at different Eurozone countries differently.

The aspect of fiscal policy discipline touted by ardent Euro supporters is also no longer a benefit that may be attributed to the Euro, as the Greek and Portuguese experiences – possibly with more empirical examples to come – amply illustrate.

There are also some policy implications that we, as a nation, have to keep in mind.

Firstly, being part of a single currency area means that all nations partaking in the single currency mechanism have the same exchange rate, thereby removing the natural response mechanism of the individual members’ currencies to shifts in regional and global demand. Over time, this fixed exchange rate leads to chronic trade surpluses for economically healthier nations and deficits in relatively less economically-healthy nations. Malta, in this respect, has to take great pains in ensuring that it falls in the league of the economically-healthy nations, for the consequences of being found lacking in this area could be catastrophic.

Greece, Spain, Italy, Ireland, Cyprus and Malta have all made strenuous efforts (some more than others) to qualify for entry into the Eurozone, but once in, they have all, to some extent or another, relaxed their efforts of pushing through the much-needed reforms to buttress and sustain price competitiveness, boost productivity, and keep inflation and labour costs (both intimately linked in Malta through the COLA mechanism) in check. In Malta’s case, relenting on these issues will jeopardise Malta’s ability to sustain its productive activities competitively and also the welfare state that we have all become so accustomed to and which many have now come to expect.

Secondly, a single interest rate and exchange rate also encourage less-disciplined parties to a single currency area to run excessive fiscal deficits as market feedback (not all of it rational, but still serving the role of a disciplining bludgeon) through the interest rate and exchange rate that would otherwise, depending on the exchange rate mechanism deployed, raise the alarm or act as a means to the resolution of the fiscal excesses in a country that had its own currency. In this respect, Malta needs to do more in the area of fiscal consolidation and needs to rein in its public sector deficit to sustainable levels. This can be done, and has to be done, not so much through increasing revenues that act as a drag on the private sector and on its competitiveness as through decreasing expenditure in the form of efficiency-augmenting policies and initiatives for which locally the scope is enormous. An additional reason for doing this was provided earlier on this week (third week in July 2010) by a strongly-worded European Commission communiqué that makes the Commission’s position clear inasmuch as public debt levels are concerned. In this respect, it is worth noting that the Commission is pondering slashing funds for countries with public-debt-to-GDP ratios higher than 60% and is also considering removing such member states’ voting powers at the supranational level.

Thirdly, when a country has to reduce a large fiscal deficit by cutting spending and raising taxes, the single currency means that it cannot soften the adverse effect on GDP by a currency devaluation that would otherwise act as an occulted and therefore more politically-palatable tax.

Fourthly, insofar as each country in the Eurozone must compete on the same level playing field with respect to the national currency value, the exercising of fiscal discipline and refraining from inflating away public debts, especially in view of the fact that countries remain sovereign in fiscal matters, is going to be imperative. During the past year a substantial portion of the registered inflation can squarely be attributed to Government policy. While the decision to disincentivise economic “bads” such as energy consumption is laudable, the loss in competitiveness that this has brought about is definitely not. Malta must come to understand that inflating debts away when in a monetary union is conducive to ruin inasmuch as having relinquished the exchange rate, any home-made inflation must perforce hurt price competitiveness.

Lastly, the local real estate bubble is going to be a major headache. On the one hand, Malta has an incentive to prop up the real estate sector with a view to sustaining prices at their current levels so that one of the most popular local storages of wealth is not discounted overnight through a big crash, wiping out wealth and affecting consumption. On the other hand, the more these bubbled-up prices are held, the longer our productive activities and our competitiveness are going to suffer from the consequences of this bubble. Indeed, property and other asset prices go up in good economic times because people come to see a self-reinforcing trend where asset prices are unrelentingly going up. When this happens, it makes sense to leverage and purchase such assets, and usually, for a time, asset appreciation by far exceeds debt servicing costs on leveraging and speculative activities that make money on the assumption that someone else is willing to buy your asset at a higher price reign supreme. At some point in time, however, after this situation has gone too far, a country’s productive activities are no longer able to sustain the servicing costs of increased leverage and the markets for these assets implode bringing down the real economy with them.

The solution to this major headache should have been a solution a la China, viz. the regulation of rising asset (including real estate) prices, but since no action was taken when prices were rising, there are now very valid reasons for inaction as fixing or propping up prices to unsustainable levels can have very serious repercussions on the rest of the productive sectors of the economy.

There will undoubtedly be other lessons that one can learn from the recent happenings. However, given the domestic circumstances of Malta, I believe to have highlighted the most important ones in the foregoing article in the hope of contributing to an informed policy process in relation to the economy of the Maltese Islands.