Giving Discipline The Right Cost

marco giuliAfter two years of muddling through, the Eurozone has taken some decisive steps in order to prevent the sovereign debt crisis from leading towards the collapse of the Eurozone. Measures have ranged from a slow path towards a banking union aimed at breaking up the feedback loop between banks and sovereigns, to the Outright Monetary Transactions (OMT) which commit the ECB to taking the ultimate responsibility for the integrity of the EMU, to the launch of the European Stability Mechanism (ESM), the permanent rescue mechanism aimed at restoring market access for distressed countries. However, taking a reduction of the spreads as the only indicator that the crisis is over does not properly portray the complexity of a political, economic and social divide that is widening between the core and the periphery of the Eurozone, especially regarding the perceptions of the respective public opinions on who is bearing the bulk of the burden. The aim of this paper is to point out that a recessive conditionality was imposed at no cost for the core, therefore creating an appetite for infinite austerity and putting the public opinion’s perception of integrity at risk despite the financial resilience.

According to claims in Helsinki or Athens, both the surplus and deficit sides have suffered the cost of the adjustment. But this is not what happened. The Northern countries’ interpretation of the crisis only refers to the peripheral countries’ inadequate implementation of the Stability and Growth Pact with regard to public finance. The solution, according to this view, is to place the blame entirely on the “sinners” – regardless of the fact that before the crisis,- ignited in Ireland and Spain by the private sector -, some of the PIIGS’ public finance management had a remarkable record. This led to the belief that austerity must lie at the core of the adjustment policies, and if adjustment fails, more austerity is needed. In other words, the Northern perception is that a spiral of infinite austerity in the South – which is the inspiration for the Fiscal Compact’s approach to debt reduction – is possible. This belief is enforced by the fact that the surplus countries have not internalised the cost of this infinite austerity. So far, in contrary to what is often told to the Northern public opinion,  conditionality was imposed at a very cheap price. What does this mean?

In fact, there are two ways through which the Northern taxpayers – and the citizens in general – could be directly hit by helping the distressed countries. On the fiscal side, if rescue mechanisms were actually transfer mechanisms; and on the monetary side, if monetary expansions to buy the Southern countries’ sovereign securities were to lead to inflation.

None of this is the case.

On the fiscal side, very little of movements in the core EMU countries when it comes to public finance can be linked to the interventions helping distressed countries cope with their debt maturities. The reason for this is that therescue mechanisms established in the Eurozone do not rely upon fiscal transfer, but rather on fiscal guarantee. The ESM endowment serves as collateral whilst funds are raised in the markets. So far, the extra-Eurozone investor base of the temporary rescue mechanism, the European Financial Stability Facility (EFSF), accounts for 51%, whilst the funds collected among the private sector account for 69%. As such, losses for the Northern taxpayers will incur only in the case of default. This also explains the growing animosity between Germany and the IMF over a partial giving-up of sovereign seniority over the Greek debt.

On the monetary side, the price increase experienced by some of the core countries, especially as far as property prices are concerned, has very little to do with the ECB monetary interventions. Even if the employment boom has pushed salaries upwards in the respective countries, there is no evidence that expectations have been transferred to prices. The sharp real estate price increase experienced over the last years in Germany – 20% in metropolises between 2009 and 2011, according to the Bundesbank – has been significantly influenced by capital inflows, and it is not attributable to low interest rates and credit growth. Target2 claims in Germany – a crisis barometer that logs capital flows within the Eurozone – are almost all held by distressed EMU countries,[1] with investment flowing especially from Italy and Spain to large German towns, as the taxation risk in Southern countries is making foreign real estate assets increasingly attractive.

This means that the AAA countries are buying low-cost conditionality. In many ways, they end up turning out to profit Negative interest rates are the most evident, as any other countries’ request for help favours a capital flight to safety allowing the Northern countries to gain from the issuance of their own bonds. But there are other long-term advantages that the core EMU countries might be collecting on the microeconomic side, such as asset-stripping opportunities and a brain drain of the periphery.

Since 2012, the inflation-adjusted yield curve for German sovereign bonds is negative. Mechanisms work in such a way that if a country asks for help, top-rated countries experience a decrease of their borrowing costs, free-riding on markets’ expectations. The transition from the EFSF to the ESM did not change the picture. When a country asks for assistance from the ESM, there is an immediate lowering of borrowing costs for the whole EMU-area, letting the countries that do not ask for help to benefit from the increased market confidence without paying the political cost of requesting assistance. In other words, the  ESM effects adds to the natural flight to safety that already keeps the Northern countries’ interest rates at such a historically low level.

Asset-stripping opportunities arising from large-scale privatisations in countries under adjustment are not new. Many developing countries have experienced this while under IMF assistance programmes. However, it is extremely problematic to track whether this scheme is being replicated today within the Eurozone. The AAA EMU countries are not the only ones benefitting from the periphery’s privatisation programmes. The Greek programme, for instance, aimed at raising 50bn USD through the sale of public assets by 2015, has attracted a large number of foreign investors from China, India, the UK and the Gulf countries. However, the progressive sale of 40% of the Greek telecom firm OTE from the Greek government to the German company Deutsche Telekom had a controversial effect on public opinion.[2]

In Italy, despite the fact that the country is not under external assistance, large-scale privatisations – including the government’s stake in Enel, in which the German energy giant E.ON has demonstrated a long-standing interest – are on the table as part of the annual debt reduction of around 40bn EUR, requested according to the Fiscal Compact. Obviously, this is not evidence of a malicious behaviour on the side of the surplus countries. One can see it as a long-awaited trend of cross-border takeovers in network industries which should be normal practice in a single market. However, cross-border takeovers are supposed to happen on the basis of the consensual fall of legal barriers, not on the exploitation of large-scale privatisation programmes supported by the bidders’countries. Especially in light of the fact that large-scale privatisation of profitable assets helps raising short-term cash in order to cope with looming maturities, but it reduces the idle privatisation capacities of governments in the future, raising fears regarding the future capabilities of raising money. Also, selling profitable assets when they are underpriced due to bad market conditions is a behaviour that no private investor would undertake, so requiring it in the form of conditionality has the serious potential of alienating public opinion in the Southern countries vis-à-vis the European integration discourse.

Furthermore, the intra-Eurozone brain drain is not necessarily a bad thing, especially if it is the expression of increased labour mobility, which is one of the main conditions for an optimal currency area. However, today’s human capital flows and increase of mobility from the periphery to the core is associated with a conditionality that imposes fast and indiscriminate cuts often affecting the education system. Since the beginning of the crisis, the spending reviews have led to 30% cuts to higher education spending in Greece, 20% in Italy and between 5 and 10% in Ireland. Outside the Eurozone, the largest cuts took place in the Baltics, with Latvia cutting public funds to education by 66%. In contrast, Germany raised its public support to higher education both at the federal and local level.[3] These asymmetries are likely to accelerate the brain drain from peripheral Eurozone to the core, widening the long-term productivity and innovation gaps that the imposed structural measures are supposed to eliminate.

If conditionality can be imposed at no cost – and maybe extracting a profit –, the adjustment efforts of peripheral countries are not properly valued Only one side is internalising the costs of discipline, creating incentives for an austerity bulimia in the North. In other words, if the price of discipline is nil for those who impose it, then the demand for austerity might have no natural limits. This goes against common sense since at some point, if GDP continues to fall in peripheral countries (and depending on multipliers this seems a likely scenario), an adjustment larger than the size of GDP will eventually be requested.

To conclude, mechanisms should be corrected in order not to provide incentives for infinite austerity. A proper mutualisation of liabilities would reveal the right value of discipline, by properly spreading the cost throughout the whole Eurozone. In contrary to what happens today with the ESM, no country would profit from other countries requesting assistance , as interest rates would reflect – theoretically at least – a weighted average of the refinancing costs for the whole area. Another possibility, if there is hostility towards the implicit intergovernmentalism of a proposal calling for pooled responsibility for national debts, is a common unemployment insurance relying upon a federal budget, which would replace the government to government solidarity (mutualisation of government liabilities) with a citizen to citizen solidarity (unemployment insurance), effectively correcting the burden-sharing of a recessive conditionality. Essentially, if top-rated countries do actually pay a proper price for demanding conditionality, they would gain credibility and legitimacy in the eyes of the public opinion of distressed countries, who would then more easily accept the burden of an adjustment so far interpreted as imposed by an alien world rather than a common house. Giving the monetary union a common purpose, and not just the capacity for resilience, would be an investment..

[1] Deutsche Bank Research (2012), “The German Housing Market: Risk of a Bubble until 2020?”, 28 September 2012,;jsessionid=8A2BCE4360CFF8955FB99EA8810CE658.srv-loc-dbr-com

[2] “Greek PM calls for consensus on privatisation”, Financial Times, 14 March 2011.

[3] Source : European University Association