Lord Flight is a former Shadow Chief Secretary to the Treasury who is now chairman of Flight & Partners Recovery Fund. This article was submitted 24 hours before yesterday's latest "solution" to the €urozone's debt crisis.
It is perhaps not surprising that while we have been wallowing in the escalating Murdoch crisis, coverage of the escalating Eurozone debt crisis has been mostly confined to the financial media. We have lived through the first round of the Irish, Greek and Portuguese crisis and nothing much seems yet to have affected the UK – albeit that our own position is none too rosy. But what we now have is no longer the risk of contagion to larger Eurozone economies – it has already spread to Italy and Spain. Both countries have not only experienced sharp rises in their Bond interest rates but are also now finding it hard to sell the necessary Government Bonds to finance current deficits and to refinance Bond maturities. I cannot see that the EU bailout Funds or the ECB – by the back door – and the IMF can raise the necessary funding to finance these economies’ borrowing requirements: and even if this is arranged for the short term, the problems will return speedily.
The essence of the point is that both countries need a significant currency devaluation. The Euro Zone’s financial and economic problems cannot, in my view, be resolved unless the Euro splits into 2 currencies – a hard currency for Germanic Northern Europe and a soft currency for the less competitive Southern economies. The unresolved question in this scenario is as to which way France would jump – certainly its economy would fare much better if it stayed with Southern Europe. My March ConservativeHome contribution, “Watch out for the European Financial Crisis this year”, suggested the easier solution would be for super-competitive Northern Europe to adopt a new “strong DM” leaving the rest of the Euro Zone with a competitive, weak Euro; and I believe this remains the most manageable option.
The crucial political question is as to whether or not, albeit confidentially, the EU or Germany itself is now working urgently on such a “plan B”, or are burying their heads in political sands. Clearly the break-up of the Euro would represent a major disaster for the “Europe Project” and potentially unleash effective opposition to its whole ill-conceived architecture. The only financial alternative would be the issuing of Pan EU backed Bonds to finance the vulnerable economies, with the option for investors to switch out of the “PIIGS” Bond issues at a discount; but I doubt Germany would accept this as it would imply on going German underwriting of their economies’ borrowing. Moreover, it would not solve the fundamental economic issue that they will not recover unless their competitiveness is registered.
On the economic and currency fronts the issues are blindingly obvious, as warned by those of us opposed to the “Euro Project” at its outset, a currency cannot be shared by highly efficient and competitive economies such as Germany and the less competitive, higher inflation economies of Southern Europe, without there being major transfer payments from the competitive to the less competitive. Such transfer payments, even in the more homogeneous USA, amount to over 30% of federal tax revenues. In the UK alone, transfer payments to Scotland, Northern Ireland, Wales and the North East, mostly from the more prosperous London and South East, are running at, at least, £50bn p.a. But while such major transfer payments would enable the weaker economies to stay afloat, they would have the invidious effect of locking weaker economies into poor economic performance and dependency. Even if Germany were willing to finance such major transfer payments – which after their experience with East Germany, they are clearly not willing to contemplate – they would be an unsatisfactory solution. It is clear that what these economies need is restored competitiveness via a major currency depreciation – albeit with the price that an inherently weak currency going forward will require appropriately, higher interest rates.
It is now, however, not only the EU Authorities who appear not to be facing reality. Germany does not seem to realise that it cannot “have its cake and eat it”. Its current strong economic performance is based, substantially, on having become “super-competitive” within the Euro Zone –somewhat analogous to the position of China vis a vis the rest of the world. The price it will end up paying within the Euro Zone, is either major Government to Government bail outs, or major losses by its banks, probably requiring their bail out by the Government.
The problems of Italy and Spain are, however, different. While German unit costs have risen only 5% over the last decade, those of Italy have risen by 31% and those of Spain by 27% – their economies have thus become uncompetitive and stagnant. Italy has a relatively smaller budget deficit of 4.5% of GDP, but a large debt of 129% of GDP with major refinancing needs over the coming months. Spain has an unemployment rate of 21% and similar problems to those of Ireland – low Euro interest rates triggered a massive property boom leaving 1.5m unsold properties and major banking losses, which the Spanish State will have to pick up, at least, in part. Spain’s total debt load is 300% of GDP. Belt tightening programmes for both economies to price them back into competitiveness would require a further cut in living standards in Spain of some 13% and in Italy of some 19% – This is not politically realistic.
If the Euro Zone “sleep walks” into a sovereign default crisis the impact across Europe, including the UK, would be massive, when Governments are already “maxxed out” as regards their borrowing capacities and their abilities to bail out banks. The compound impact on the banking system could be a disaster analogous to 1931.
As Germany appears to have decided it is not willing to finance transfer payments in one form or other, it is time for it to take the lead and get a move on, restoring the DM. Gossip has it that the DM note printing presses have recently been tested for good working order?