Vladislav Inozemtsev: How the EU could wake up from its economic coma and restore Europe's influence in the world
The solution is in front of the member countries - they should grasp it, now
Friday 28 February 2014
The European Union continues to be plagued by financial crisis arising from fiscal problems inside the eurozone. Economic growth remains stalled (US GDP was 5.7 per cent larger in 2013 compared with 2008, Canada's was 6.3 per cent up, even Russia's grew by 5.3 per cent, while the EU's fell by 0.9 per cent).
Public debt is rising too high and produces no visible results (US government debt grew 4.1 times faster than GDP from 2008 to 2013, while in the EU it went up 7.0 times faster). And although the eurozone is expected to grow in 2014, the combined deficit of its nations' budgets may reach €368bn (£302bn), meaning that the crisis drags on.
It should not be like this: the creation of the euro was one of the most audacious undertakings in global financial history. But two problems loomed from the outset: the eurozone authorities were unable to punish those who mismanaged their finances; and, crucially during an emergency, the EU did not possess its own mechanism for borrowing.
The crisis was caused by some of the member countries' determination to cling to the pre-euro economic model. For 30 years before the introduction of the single currency, Spain, Italy and Greece had high inflation and constantly devalued against the German mark. This allowed the southern European economies to stay competitive, while high inflation encouraged consumer spending and low levels of savings.
After the launch of the euro, growth was spurred by low interest rates that enabled investors in those countries to economise on loan-servicing costs, and the governments to spend and to increase their borrowings. But this situation could last only as long as investors' faith held – and as that belief diminished, the problems mounted.
When the bailout came it was made in the form of a loan to whichever country happened to be in dire straits. Assistance to Ireland reached €84bn, and an extra €163bn has been supplied to Greece. The funds were conditional on government spending cuts.
But the knock-on effect was further depression: the reduction in spending drove down consumer demand, and stricter tax collection also had a negative impact on business. Therefore, the challenge facing the EU is how to overcome the public finance crisis without dramatic cuts in current expenditure? It may seem unsolvable at first glance, but it's not quite so.
Most Western economists argue that the eurozone's problems can be solved using traditional methods – specifically by cutting public spending together with restructuring the debt and arranging for its partial relief. But it's obvious that the drop in spending and the overall economic slowdown causes the threat of deflation (inflation decreased from 2.2 per cent in 2006 to 1.4 per cent in 2012, and was a mere 0.7 per cent year on year in October 2013 and once again in January 2014) and a rise in unemployment (from 9.2 to 11.4 per cent).
This is why an alternative approach is needed. Today, the overall face value of government bonds issued by the eurozone countries is €8.8 trillion, with more than 50 per cent of them maturing before 2020. Almost 68 per cent of those bonds are on the books of EU banks and companies. The European Central Bank could buy most of the securities maturing in the next 5 to 7 years at a minor premium to the current price. The bonds would be purchased on condition governments stopped all public borrowing until 2020, and agreed to create a single EU finance ministry and approve new financial stability criteria.
The impact would be immediate. The purchase of €4.2-4.5 trillion of bonds would spark an explosive increase in money supply and a massive influx of free funds into the banks. This may lead: first, to increased lending to manufacturing; second, to a surge in inflation; third, to higher values for fixed assets, real estate and stocks; and fourth, to sustained low interest rates due to the oversupply of loans.
Soaring inflation (which could reach 3-4 per cent in the first year and 4-6 per cent year on year in the later period) would have a number of consequences. First, the bulk of pension and savings funds would shift from fixed income to equities and real estate, which would allow European markets to pick up and eliminate the commercial and residential estate overhang in southern Europe. Second, people would spend more, and an inevitable decline of the euro would switch this demand from imported goods to domestically made ones. Third, having access to cheap loans, and driven by growing demand, entrepreneurs would be more willing to invest in their businesses, which, in turn, would create jobs and reduce unemployment. Fourth, better economic conditions in the eurozone and the expected growth of asset values would bring more direct investment into Europe from abroad.
All this could accelerate European economic growth from the current near-zero level to 2-3 per cent and, further, to 3.5-4 per cent annually by 2016-2017. Unemployment could return to pre-crisis levels over a period of 3-4 years and drop further, to 5-6 per cent in the eurozone as a whole, and to 1.5-2 per cent in the most successful countries by 2020. This programme would give Europe what it has long needed: significant acceleration of economic growth and stabilisation of the labour market.
Public finances, too, would improve just as much. In 2012, the Italian government spent €78.2bn on servicing the state debt, which made up 13 per cent of its entire budget. France, Spain and Greece spent €50.6bn, €22.3bn, and €17.4bn respectively. This spending would be cut 6 to 8 times.
Since Italy, France, Greece and Spain ran budget deficits of 3.0, 4.8, 9.0 and 10.6 per cent of GDP respectively in 2012, all these countries could achieve a zero-deficit budget in one to two years at most. Moreover, up to 4.7 per cent of budget funds in 2012 were used to support the employment programme and/or unemployment benefits. Halving unemployment alone would help to save at least 2.5 per cent of budget funds, or up to 1.2-1.4 per cent of GDP in the majority of European countries.
Public coffers would grow much more substantially due to the economic upturn, so eurozone countries would achieve a sustainable budget surplus of 2-5 per cent of GDP within two to four years after the start of the proposed measures. And this would allow them to save enough funds in six to eight years to repay their debts to the ECB after the programme expires by 2022-2025.
The impact the bond buy-back would have on external markets and EU exports would be huge. A dramatic increase in supply on the eurozone's money market would improve the terms of borrowing for foreign investors in Europe. The euro may be used more widely as an international borrowing tool, which would guarantee high demand for the EU currency in the future as a loan repayment instrument. In the short term, the euro would fall against leading world currencies, of course, but this is actually a positive development as it would make EU goods more competitive abroad and raise the cost of imports.
Seven to eight years after the start of the programme, the euro would be down 35-40 per cent from today's level. EU countries would run a budget surplus from its second or third year. By 2020-2022, the governments would start paying off bonds on the ECB books, thus indicating that tighter fiscal policies were in store. Investments would go back, from the stock market to fixed-income instruments, the euro would stabilize on the global market, and economic growth would decelerate to 2.5-3 per cent. This journey would not turn the EU into a new economic centre of the world, but it would enable it to overcome structural problems caused by the introduction of a single currency – the right step but taken a bit hastily.
The EU's reputation would be damaged by publicly admitting the mistakes made in the course of the euro's introduction – but that does not matter. The EU made great headway in the past 50 years in closing the productivity gap with the US. It has never devalued its major currency, even while its trading partners did this many times: Mexico in 1994; South Korea, Thailand, Taiwan and Indonesia in 1997; Russia in 1998-1999; Argentina in 2002; and Brazil in 2004. These days, the EU should be more concerned with its own problems than with international reaction, following the US move of 1971 when John Connally, the then Secretary of the Treasury, announcing the dollar was no longer exchanged into gold, famously said: "It's our currency, but it's your problem."
The EU must overcome its financial troubles and restore Europe's influence in the world, to rise up to its historic mission, to wake up from economic coma and to announce a new political agenda. The solution is in front of the member countries – they should grasp it, now.
Vladislav Inozemtsev is an ex-adviser to former Russian President Dmitry Medvedev. He is Director at the Moscow-based Centre for Post-Industrial Research and a Visiting Fellow at the Center for Strategic and International Studies in Washington
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