The EU End Game: “Sixth Set”

Despite Wimbledon week, the main centre court contest that many economists are watching is that between the German government and the ECB, now entering the sixth set of the European endgame.

“A default – however sugar-coated – is still a default.”

George Irvin

As the contestants at Wimbledon enters Center Court to end this years tournament, the EU leaders are entering the final stage of the European end game. And – just as in the tennis game – there are no obvious favorites. Who will win? Who will lose?

An abbreviated summary of the action so far is as follows:

The German Finance Minister, Herr Schäuble, initially appeared to gain the advantage by admitting that the Greek situation is so perilous that they should be allowed in effect to default – the phrase he used was “voluntary restructuring.”

Monsieur Trichet then fought back hard arguing that a Greek default would be catastrophic and implying that euro zone governments (not the ECB) should continue lending.

The ECB even threatened to stop accepting Greek Eurobonds as collateral for its continued lending to the Greek central bank, a move that would effectively pull the plug on the Greek banking system.

Who will prevail?

Well, Professor of Economics and European expert, George Irvin, have just posted the following analysis on his blogsite at the :

On the face of it, Herr Schäuble has a strong case, albeit rendered more palatable to his critics by such sweeteners as having Greece sell off public assets, voluntarily ‘reprofile’ its sovereign debt and so forth.

The real case for default, though, is that the retrenchment medicine is not working and risks killing the patient. Instead of extracting a vengeful levy entirely from ordinary Greeks, German and French banks should be made to pay their fair share – a ‘haircut’ variously estimated as between 35% and 70% of the bonds they hold.

Indeed, given the dramatic turn of events in Athens in recent days, default now looks almost certain.

But here is the rub. A default – however sugar-coated – is still a default.

The ECB argument is that if Greece is allowed to do so, other highly indebted members will follow suit and, as contagion spreads, the markets will cease buying members’ sovereign debt altogether.

The ECB would be left to bail out not just the small peripheral economies, but probably Spain and Italy too.

That would spell the end of the euro.

That is partly why Jean-Claude Trichet will be replaced in October by another tough conservative, Italy’s Mario Draghi who famously prefaced an interview with the Financial Times by the phrase “The euro is not in question.”

On the face of it, then, the first set of the match will almost certainly end in a nail-biting tie break.

But whoever wins, the match will be far from over.

To borrow Wolfgang Münchau’s phrase, the existing union is too weak to function properly, but too strong to blow up.

Assuming the euro zone does not blow up, how might it be strengthened?

The central pillar of a new economic architecture for the euro zone would be the creation of a Treasury Secretary with a secretariat; ie, an embryonic euro zone Treasury (Ministry of Finance).

Indeed, the idea was floated earlier in June by Monsieur Trichet himself who added that such a Ministry would also carry out “all the typical responsibilities of the executive branches as regards the union’s integrated financial sector, so as to accompany the full integration of financial services, and third, the representation of the union confederation in international financial institutions.”.

The key points to retain are, first, that such a Ministry would have real power (ie, it could override national bickering in the Council); and secondly, that the euro zone would have a single banking system.

Another pillar would be fiscal-financial. Like its US counterpart, a euro zone Treasury would need to be able to emit E-bonds jointly guaranteed by all members.

Not only would this enable the euro zone to supersede the now-discredited system of relying on national Eurobonds, it would greatly strengthen the euro as a reserve currency since euro-assets would be far more desirable (and available) to hold.

Additionally, a Euro-Treasury might start by improved ‘co-ordination’ of member-states’ fiscal policy, but it would soon need to raise significant amounts of revenue.

A useful mechanism would be to follow up on a suggestion by Spain a decade ago that a tax on member-states (ie, a share of their VAT receipts) be levied progressively in proportion to their per capita income.

The third pillar would be political.

The euro zone cannot survive unless its citizens benefit from its existence.

And here is where serious political courage is needed – the courage to set up a euro zone unemployment benefit scheme, and/or for that matter, a euro zone pension scheme.

Initially such schemes would complement the national schemes already in place, but as they grew in size, they would come to play the same macroeconomic stabilisation and redistributive functions as the US Treasury.

How do these proposals relate to the current contest between the Germans and the ECB?

The answer is straightforward.

Although the Greeks, the Irish and other countries at risk will doubtless be offered further loans, at the end of the day what we are witnessing is a slow-motion default.

Why? Because ‘internal devaluation’ and the fiscal straightjacket imposed upon the weakest members means they can never repay.

Ultimately, Germany, France et al will have to bail out their own banks.

If slow-motion default leads to another major financial crisis, we shall all pay.

In truth, euro zone member states already live in a ‘transfer union’, and the sooner members realise it and adopt a common macro-economic framework, the better.

The practical details may take a long time, but one thing is certain: the gruelling match on Centre Court is far from over.

By George Irvin

I guess that means we can look forward to another entertaining weekend in Europe…

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