The official start of the European transfer union

There are basically three scenarios for the future of the European Monetary Union as I argue in my book The Tragedy of the Euro.

First, the Stability and Growth Pact (SGP) is reformed and enforced with automatic sanctions for countries not complying with its conditions. This requires harsh austerity measures, privatizations, labor market reforms and reduction of living standards in the periphery. The case of Greece shows that this option may just not be viable considering political structures and socialist voters resisting a reduction of the state’s size. Indeed, for 2011 the Greek deficit is expected to be at 9.5% of GDP, far above of the 3% limit established by the SGP and the 7.4% target established by the European Commission.

The second scenario is a break-up of the monetary union. The periphery has no interest in exiting the Eurozone. Periphery governments are benefitting from guarantees by the core and from monetary redistribution. An exit would imply a substantial reduction of living standards in the periphery. But why are core countries not leaving the Euro? While a euro exit would be in the interest of the common population, the political elite and their financiers from the banking sector want to continue the Euro project. As we have seen in the summit on the second Greek bailout, German Chancellor Merkel not only defied the “no-bailout clause” of the Maastricht Treaty but also a resolution of the German parliament against purchasing commonly-guaranteed bonds from February 2011. This leads us to the third scenario, which we are approaching fast: a transfer union and a European superstate. The EU summit of Thursday, 21st of July 2011 marks a big step in this direction.

The Greek government will get an additional €109 bn. bailout loan until 2014. Maturities for Greek bonds from the first bailout were raised from 7.5 to 15 years (originally it was 3 years). Interest rates were reduced from 4.2 % (originally at 5.2 %) to 3.5 %. Likewise, interest rates on loans to Portugal and Ireland were reduced.

The day brought also another bailout of banks. Banks, insurance companies and other private investors can swap their old Greek government bonds against new ones with a longer maturity. Joseph Ackermann, CEO of Deutsche Bank, estimates write-downs for banks around 21%. Politicians sell the  so-called “participation of private investors” in the bailout as a great success. However, it is just another bailout for the banking system, limiting losses to 21% and putting taxpayers’ money on the hook. Old bonds are swapped into new bonds that are guaranteed by the EFSF and such by European taxpayers. Without the second bailout the Greek government would have had to default. Banks would have had to take much higher losses in a restructuring. Estimates of losses range between 50-70%. After the swap, banks are effectively protected. The financial industry, the governments’ main financier, can be very happy about this covert bailout.

The most important consequence of 21st of July was the official establishment of a transfer union by granting more powers to the EFSF (the European bailout fund). In the Eurozone, there have always been transfers through monetary redistribution: The ECB accepts bonds from the periphery as collateral thereby monetizing deficits indirectly. Last year, the ECB even started to buy government bonds from the periphery outright, spreading the burden of the bailout to all users of the currency. Yet, from now on, direct purchases by the ECB may become unnecessary. The burden of the bailouts will be more concentrated. Not all currency users will pay in form of a dilution of the Euro but rather taxpayers in countries that effectively guarantee the EFSF.

The EFSF now can give credit lines to countries that are expected to have financing problems. In addition, the EFSF may purchase government bonds on the secondary market. The role of the ECB is thereby partially taken over by the EFSF.

The possibility of financing through the EFSF reduces the pressure for countries to eliminate deficits and reduce government debts. Why introduce harsh austerity measures, reform labor markets and privatize the public sector if there are loans available from the EFSF at ridiculously low interest rates? If you want to win elections, you should not reform but spend. Only through deficit spending one can maintain the artificially high living standards in the periphery. Indeed, debts are still on the rise. Deficits are huge and far from being eliminated. Most probably, Greece, Ireland, Portugal and soon Spain, Italy and even Belgium will borrow exclusively from the EFSF. To be effective, the size of the EFSF will have to be extended. The main guarantor will be Germany. Considering peripheral funding needs, a report from Bernstein calculates:

As the guarantees of the periphery including Italy are worthless, the guarantee Germany would have to provide rises to €790bn or 32% of GDP.

If France is downgraded, the German share increases to €1.385 trillion — 56% of GDP.

The transfer union implies a transfer of power to the European Commission. We get ever closer to a European superstate. Incentives to reduce deficits will be reduced both in the periphery and in the core. Germans will start to resist cuts in public spending. Why save if the savings flow to the periphery? Instead of reducing German pensions to guarantee Greek pensions, German voters will push for more public spending. To pay for welfare states and transfers, more taxes (maybe a European tax) and money production will become necessary. The centralization of power allows for harmonization of regulations and taxes. Once tax competition ends, there will be a tendency towards ever higher taxes. With the transfers, the power of Brussels will continue to rise. There seems to be only one bold, albeit costly way, to stop the process towards a EUSSR: withdrawal from the transfer union. With an exit from the Euro, Germany could bring down the whole Euro project and save Europe.

5 Comments

  • Tim Lucas says:

    Agreed. The stitch-up is reminiscent of the Bretton-Woods treaty in which a newly created IMF was the mechanism through which strong-currency blocks were required to contribute funds in order that weak currencies could be puchased, thus ensuring stability in exchange rates and dicincentive for any country to reign in deficit spending. Continuous expanding of private and public sector debt, and inflation, with the eventual breaking of the gold-exchange standard were the results.

    A similar outcome is therefore surely likely here as Prof Baggus points out. Currently, we wonder whether the German tax payer will put up with this inflationism. The lesson from Bretton woods was that the US, rather than revolting against the reality of subsidising other nations, was incentivised to deficit spend as much as the next man. History is repeating itself; the prudent German has rapidly had his incentives changed. How long will it take him to respond?

  • Croydonius says:

    Great article, but perhaps Prof Bagus would tell us what is the narrative that the media in Europe are delivering to the electorate about the economy and the Euro crisis, and in particular the young? Is it not that manipulative ‘Anglo Saxon’ speculators are destroying all the EU’s hard work? That the Euro needs protection from this, via the banning of credit agencies as advocated by no less than President Barroso? That the economic crisis is the fault of ‘unfettered capitalism’ and would never have happened had, for instance, the USA enjoyed ‘Europe’s social model’?

  • Croydonius,

    the current crisis is not due to capitalism nor speculators, but stems from the fundamental “disequilibrium” of State-incentivized investments and lacking (real) savings, on the illusion that mere printing new money can fill the gap. To be more precise a full course in business cycle is needed, so I cannot resume everything in few words.

    But I think I can tell you one thing about speculation: I graduated in economics in ’98 with a discussion on the ECB; in the meanwhile the ECB was built. The idea was explicitly to free monetary policy from political biases, and let the market discipline on debt work: if a State is badly managed, market would have punished by a sudden stop and reversal of funding i.e. selling its bonds – this menace involving the rising of interest rates was considered the mechanism for fiscal discipline to hold.
    Well, now that markets – or speculators, call it what you like – are punishing some States (including my Italy) for its bad management, politicians don’t say “hey, it’s market discipline, it’s working!” but “it’s mean speculation! it’s mean speculation! stop’em! stop short-selling! put markets under State power!!!”. I think this quickly resumes the media’s “narrative” problem, if you want to be aware thereof.

  • Croydonius says:

    Thanks Leonardo, I quite agress as to the root causes of Europe’s problems, but I would be interested to know how the European media are presenting and discussing the crisis.

    My fear is that, like the politicians you characterise, opinion-formers in Europe are blaming everyone but themselves.

    Your post suggests that you are happy with the Euro’s structure, and would like the countries that really cannot afford to be in it (including perhaps Italy) to either accept their ‘medicine’, the first of Prof Bagus’s options, or to get out of the Euro, the second. Is that correct?

  • My opinion is not Bagus’s, and viceversa. But I suppose we both do not like the Euro. By what I have understood of Bagus’s thought, his post is not a wish-list, but a description of what might happen. Describing and hypothising does not mean expressing own desires.

    In my opinion, serveral States cannot affort a break up of the eurozone, Italy included, unless they wish to immediately default because of sky rocketing interest rates. This is due to the Euro is not the problem, Euro is a money, a means… The main problem is bad government, the fatal conceit of guiding the economy like a car. For this illusion to survive the current mess (due to debt problems which the one-measure-fit-all Euro central monetary policy has in some cases triggered) the European Union project must go on; Bagus is right when expectes centralism to increase, where EFSF is test for a central fiscal policy.

    I am wondering why Germans, Dutch and few others have not yet decided to leave the project, as they look like net payers… I think their banks and other industrials have overwhelmed or deviated public opinion.

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