Stephen King: Euro members' club needs a new rule to keep the house in order

Some countries are looking on aghast as the Germans try to have their birthday cake and eat it
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The Independent Online

"I don't want to belong to any club that will accept me as a member." Groucho Marx probably wasn't thinking about the euro when he came up with his famous remark. But the euro is a club and many of its members are increasingly disgruntled. Faced with the choice of membership today, rather than in the late 1990s, I wonder how many current members would now choose to sign up, and how many might instead have adopted Groucho's views.

Of course, no club remains unchanged forever. Each club may have its traditions, but evolution - and sometimes revolution - are still possible. Club rules are laid down, and members are asked to obey those rules, but some members will, from time to time, revolt, and others will look on aghast at this new, revolting, behaviour. That's exactly where we are with the euro club today.

The key issue is the Growth and Stability Pact (GSP), a misnomer if ever there was one. The GSP is designed to ensure that countries behave themselves fiscally, unless they want to be subjected to the humiliation of fines. Without going into the minutiae, countries are required to make a solemn declaration that they will not borrow too much and, specifically, that they will ensure their budget deficits remain below 3 per cent of GDP unless there is a particularly deep - rather than protracted - economic downswing.

Originally, it was the Germans who demanded that countries should sign up to the pact. The Germans looked around the rest of Europe and saw a bunch of fiscally unreliable nations. They were worried that, without a pact, countries would be free to borrow whatever they wanted, unhindered by the malevolent influence of foreign exchange and fixed income markets.

In the past, European countries that had borrowed excessively had been penalised by the financial markets. High government borrowing raised the risk of higher inflation. Foreign investors would react to this risk by selling a country's currency, thereby placing upward pressure on interest rates. This "penalty" reduced the incentive for countries to go down the "high borrowing" route. The GSP, through a series of threatened and actual fines for fiscal miscreants, was established to maintain, in a bureaucratic fashion, the financial penalties that had hitherto been provided by the financial markets.

Germany fretted about the southern European countries, particularly Italy. Here was a country that had a huge amount of government debt, that had borrowed as if there were no tomorrow, that had experienced much higher inflation than Germany and was, therefore, basically unreliable. Germany's view of the Italian economy was, in essence, rather similar to the average German car driver's view of Italian cars. In an ideal world, Germany would have preferred Italy to have stayed out of the first wave of euro entry. Politics, though, dominated economics and the Italians eventually got through, even though the Maastricht convergence criteria had to be stretched to the limit - and beyond - to allow Italy through the back door.

In response, and to safeguard the integrity of the euro project, Germany demanded that the GSP should be put together. Without it, countries like Italy would be able to borrow like crazy yet would not immediately suffer any significant financial penalty. Even worse, increased borrowing from the fiscally lax would lead to higher supplies of government paper within the eurozone, raising borrowing costs for everybody. Germans would then be paying a price for the foolish behaviour of others.

That was then. The euro is fast approaching its fifth birthday and, when the cake is served, there will be some fairly reproachful looks. The Italians have behaved rather better than expected. The Portuguese had their wrists slapped - and their economy thrown into recession - in an attempt to stick by the rules of the Stability Pact. Other countries, mostly the smaller ones, have stuck by the club rules. So it's no surprise that some of them are looking on aghast when it turns out that it is the revolting Germans - and the French - who are having their birthday cake and eating it.

Before joining, and in the first few years of membership, neither Germany nor France ever got to the point where their fiscal positions reached a state of health, when adjusted for the different stages of the economic cycle. So, when the global economic downturn came along, they suddenly found themselves with significantly lower government revenues and, because of weak labour markets, upward pressure on public spending.

As they got closer and closer to the 3 per cent of GDP government borrowing limit, they began to realise the Stability Pact was in danger of getting the "wrong guys". So, the easy thing to do was simply to say "non" or "nein" to the requirements of the Pact. Yes, they had excessive deficits but, adopting the approach of a bruiser facing up to weaker opposition - on this occasion, the European Commission and some of the smaller European countries - the Germans and French simply sneered and said "Yeah, so what are you going to do about it?"

"Not a lot" is the answer because the Italians never really liked the pact in the first place and, although outside the euro, the British have proved to be rather sympathetic too - Gordon Brown, after all, has always been against the pact, given its tougher requirements relative to his own fiscal rules. So we're now faced with the prospect of Germany's budget deficit rising to beyond 4 per cent of GDP, the biggest it's been in 30 years. So much for the life of discipline that the Germans themselves had espoused just a few years before.

So what happens now? If the Germans were right not to trust other European nations a few years ago, what sort of signal does Germany's own fiscal failure provide? Does it open the floodgates for a new wave of government borrowing? Not necessarily. Germany's own borrowing stemmed from its persistent economic weakness which, in turn, may have been partly the result of fiscal policies being followed elsewhere in the eurozone. In the euro world, each country faces the same interest rate. For those that have higher inflation given this single interest rate, they will experience a gradual loss of competitiveness. To prevent this loss, the easy option is to run an overly tight fiscal policy, which keeps inflation under control.

This creates a deflationary bias within the eurozone that, in theory, should be offset through lower interest rates from the European Central Bank (ECB). But if the ECB has chosen too low an inflation target - and I, for one, think it has - it may not go down this route. Countries like Germany then become rather vulnerable, finding themselves facing persistent economic weakness, threatened deflation and a structurally poor fiscal position.

It's hardly surprising, under these circumstances, that the Germans are less than happy with the baby they gave birth to a few years back and why fiscal infanticide has become a suddenly attractive option. Huge increases in government borrowing are still, in my view, rather unlikely because countries don't have the ability to create inflation any more to print their way out of the problem.

Nevertheless, the objective of balanced budgets through the course of an economic cycle is now looking less and less achievable. Persistent deficits, though, point to severe long-term problems given the dependence of rapidly ageing populations on state pensions within the euro area. Meanwhile, with the GSP now in effect dead in the water, debate will start on a replacement: and, let's face it, in a monetary union, the only sensible long-term solution is a federal fiscal authority. It will be interesting to see when the politicians decide to let that new club rule out of the bag.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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