Monday, 2 January 2012

Europe needs ERM-3 to solve the Eurozone crisis

Prior to the New Year period the matter of the Eurozone went somewhat into hibernation as the resources supplied by Europe bought some breathing space, or, alternatively, as political commentators attention was distracted towards the acrimony and triumphalism which accompanied Cameron's veto/attempted veto.

Indeed Greece has sufficient funding from the 130bn Euro bailout to pay it's bills until March, when the matter will reach a head again. At which point Germany and France will have to decide if they can support lengthy subsidies for their peripheral partner.

More pointedly they'll be asking: 'is Greece a special case or basket case?' Let's hope they're making their minds up.

You can guarantee, however, that this will get entangled in French Presidential elections as opposition socialists demand fiscal solidarity is written into the continental pact in exchange for any concentration of financial powers and Angela Merkel is tempted to concede to the issue of Eurobonds.

The problem remains that Greece is headed in a different direction. The IMF reported a fortnight ago that sufficient reforms are not deep enough (pdf) while 'unnamed officials' expressed concern that even the 50% 'hair-cut' on privately-held government bonds may be insufficient.

This position has since been picked up and augmented by national media reporting tax revenues for the year-so-far have fallen behind expectations and 7.5bn from the Winter quarter is not achievable. The result will be that the target for the 2011-12 Greek deficit has been revised from 7.5% to 9%, and will probably exceed 10% when everything is added up.

This is no mean difference, with the contraction in the Greek economy adjusted from -3% to -5.5% in 2011 and continuing to shink 3% through 2012, projections for the elimination of the Greek deficit are being pushed back from 2020 till after 2022-23.

The IMF reports details one particular area where the country lags: tax evasion.

Ekathimerini perfectly expresses the challenge: "unless the government finds a way to contain tax evasion, there is no prospect for any improvement in state revenues."

Yet with on-going popular unrest at the era of austerity, and the prospect of no new dawn in sight this decade, Greeks are actually showing their displeasure by refusing to pay taxes which many see as being channelled to fund the extravagant lifestyles of the people who they blame for creating the mess in the first place.

It's a vicious circle and one which the rest of the EU may feel perfectly justified if they wish to wash the blood from their hands over the matter. However if markets take fright and see this as a prelude to collapse of the single currency this would amount to using a razor-blade for soap - which is like placing an accumulator bet when you're playing Russian Roulette!

The IMF predicts total Greek debt will peak at 187% of GDP in 2013, provided growth returns, although this is uncertain if the can't pay-won't pay attitude isn't addressed.

But while Costas Douzinas asks whether using austerity to treat the disease is worse on account of the pain caused to the vulnerable, Commerzbank's Peter Dixon asks whether the universal chaos caused by the alternative cure of leaving the Euro is the greater risk.

Although Greece only amounts to 2% of combined Eurozone GDP, the impact of contagion from the inevitable devaluation of any New Drachma will also, inevitably, depress global confidence and hinder growth.

Conversely, Standard Chartered's Peter Sands comments that the Eurosummit failed to provide the leadership on growth and this is actually hardening market opinion that the probability of Greek withdrawl is increasing, adding "ultimately, the current structure and shape and scope of the eurozone only works if the market believes it's worth supporting."

It is, he says, "a path-dependent problem."

With financiers gleefully pouring scorn on the confidence of politicians, a fresh battle is in the offing. If Greece does depart, traders will place their bets in turn "to test the resolve to defend the positions of Portugal, Spain, Italy and, ultimately, France." How much are tax-payers prepared to back the house?

So obviously the start of January marks the beginning of a new campaign of rhetoric between the anti-Europeans and the pro-Europeans. Can the Euro become the world's reserve currency? or can it even survive?

As is typical of these debates, Iceland, Noway and Switzerland are brought into the equation as counterweights to show how independent currencies can prosper within the European Economic Area but outside the Eurozone, nevertheless overlooking the question of real versus perceived sovereignty and the cultural difference between these prospering 'northern' countries and the 'southern' countries under threat.

Competitiveness and productivity are interlinked questions, so the answer you arrive at will depend on the premise you start with - is market power stronger than political will? do hundreds of millions of individual decisions outweigh the decisions of hundreds of millions of individuals?

For me, this is is a destructive question which helps nobody, and neither the future of the Euro nor the future prosperity of Europeans will be solved by asking it.

Previously, I examined this question in greater detail, noting that sovereignty and territorial integrity are a dual-principle - each demands the other in a mutually-dependent relationship. This is absolutely relevant for the issue of the Euro.

By tradition and history Greece has been isolated territorially, not only on the periphery, but also with no land border to the rest of the union (until Bulgaria became an EU member in 2007). For political integration such isolation can be overcome up to the point at which economic considerations take effect and the realisation that the transfer of fiscal competencies is made impractical by the impossibility of free trade while transiting additional borders and the inflexibility of centrally-designed rules undermine both growth and stability. This is the point we've reached - geography is proving an immovable object to overweening ambition.

Yet the concept of territorial integrity also offers a prospect of a real and lasting solution.

Bulgaria and Romania joined the EU in 2007, Croatia concluded negotiations in 2011 and is expected to accede on 1st July 2013. Of the remaining Balkan countries only Bosnia has not yet applied formally (though it would be fasttracked) - Serbia, Bosnia, Montenego, Kosovo and Albania could all join as early as 2015. Due to it's sizeable population and position neighbouring the Middle-east Turkey is a more difficult proposition, while Iceland looks to be heading for a referendum over full membership in the next few years.

Each new member is required by the Maastricht Treaty to accept legal obligations requiring the country to seek to join monetary union, upon the condition of meeting the defined criteria. These involve restrictions on government deficits and total debt, on interest rates and inflation, as well as on currency convergence.

Following the collapse of the ERM on Black Wednesday on 16 September 1992 a new mechanism for currency convergence was drawn up, officially coming into place at the end of 1998 - unimaginatively, it was called ERM 2.

Instead of the ERM's artificially restrictive 2.25% fluctuation rate (except Italy, for whom it was set at 6%) ERM 2 accepted the new reality that had been in effect since 1993 and allowed currencies to vary by plus or minus 15% compared to a rate fixed upon entry. This limit was set primarily to account for the Franc's volatility against the Deutschmark, and save them the embarassing losses created during the Bank of England's failed intervention to prop up Sterling which led to Black Wednesday and the ousting of Margaret Thatcher, just at the same time as European currency regulations were being liberalised to encourage the same types of speculation which gave rise to the practises of high-volume hedge funds.

When Greece was accepted into the Euro in 2001 only Denmark was left within this convergence group, but has since been joined by Latvia and Lithuania. Of the remaining members Poland, Czech Republic, Hungary, Romania, Bulgaria and Sweden have accepted the obligation to join the Euro upon meeting the convergence criteria and provided they have completed two-years participation within ERM 2.

As the result of conflicting referenda in 1993 and 2004 Sweden chose for political reasons to stay out of ERM 2 in order to resist membership of the Euro. For newer members of the EU the ECB has indicated this is not an option and these countries are part-way along fulfillment of the requirements.

So looking forward to the end of Greek austerity in ten year's time the whole of Eastern Europe and the Balkans should expect to be Eurozone members - barring any further economic calamity.

Sweden, Denmark and Iceland have given themselves the option to join the Euro, the UK has the option not to do so, leaving just Noway, Switzerland and the countries of the former Soviet Union. It should be no surprise that the level of commitment to the process is directly related to the sense of a nation being integral to it.

But Sweden also went beyond simply meeting the convergence criteria to help promote them as the sensible economic rules which formed the basis of the same European Growth and Stability Pact that is now unravelling because they weren't applied to Greece.

Given that Greece leaving the Euro would be the cause of that economic calamity what steps can be taken in the next ten years to avoid it?

Well, here it's time to get a little bit imaginative and support calls for an equally-unimaginatively named ERM 3.
This would be designed specifically to introduce regional convergence as the stepping-stone to continental convergence - adding a gearing system to the currently stratified 'multi-speed' Europe to provide the capacity for acceleration and braking and sufficient flexibility to move policy without either causing any new market shocks or becoming subject to them.

ERM 3 would allow Athens to become a Balkan leader, speeding up integration with it's neighbours and softening any damage to continental unity caused by withdrawl from full monetary union, thereby reducing the social pressure created when politics and economics are pitted against each other. Instead of resurrecting the Drachma and failing to prevent the chaos caused by the volatility of a free-floating currency, setting up a pan-Balkan currency able to vary by up to 25%, or even 50%, would provide a more flexible resolution to innumerable conflicts.

The Balkans didn't give birth to the phrase 'Balkanisation' for no reason - in remembering that the European project was originally about ensuring Germany and France never go to war again, we should be inspired by their example and relate this lesson to more recent wars in Bosnia and Kosovo to understand that integrating individual parts of Europe such as the Balkan peninsular must be the stepping stone towards unifying Europe.


NB The Vickers Commission suggests it might also be worth the EU and IMF having a look at the endemic culture of corporate tax evasion among northern European nations via opaque systems of dividend arbitrage. This $100bn share-dealing market is designed with the 'central purpose' of avoiding taxes.

No comments: