The Black Hole At The Heart Of Europe

A financial warning from history. This article was written almost 18 years ago, shortly after the EU formally agreed to introduce the Euro in 1999. What foresight!

By Laurence Copeland, Professor of Finance, Cardiff Business School

At the heart of the Euro-constellation, shortly to be renamed EMU, yawns a black hole, threatening to suck in any economy which strays into its gravity field. The black hole is called insolvency.

This may, at first sight, seem an outrageous statement. Surely, only Third World governments get into such dire straits. Surely insolvency couldn’t arise in the heart of Europe? Unfortunately, it could, and all too easily. Sovereign defaults have never so far been a serious threat in the industrial world, not so much because of levels of economic development or supposedly greater fiscal responsibility. Rather, it is because most of the borrowing by Western governments has been denominated in their own domestic currencies. In contrast, Third World nations are often forced to borrow in foreign currency because their domestic capital markets are thin – and in many cases virtually non-existent – and because importers often insist on payment in “hard currency”. Default among countries with largely domestic debts is virtually impossible because the government simply prints more money.

Those who finance themselves through foreign debt don’t have that option. Now apply this to economic and monetary union. The European Central Bank in Frankfurt will have the sole prerogative of printing euros. So EMU will reduce all its member governments to the status of local authorities as far as their borrowing is concerned. All government borrowing will effectively be in foreign currency and the threat of default will hang over every member to a greater or lesser degree. Those with relatively high debt levels and a history of fiscal irresponsibility will have low credit ratings and pay high rates of interest on their loans. More responsible governments will enjoy the benefits of the finest borrowing rates.

Despite these variations in perceived credit quality, European interest rates have converged dramatically. Italian bonds are scarcely riskier than those of Germany. The reason is not a suspension of the reality of market forces but realpolitik. If an insolvent New York City was able to find a saviour even in the free market heyday of Reagan’s presidency, the capital markets are betting that the European authorities will be forced to come to the aid of Italy or Spain, let alone France or Germany, if they are in distress. The pressure to bail out a country with a weak economy – or a weak will – is bound to prove irresistible.

Suppose France suffered a funding crisis: imagine the consequences if Frankfurt ignored French pleas for funds. The air would be thick with the smell of bad blood from old wounds reopened. Ultimately, a bail-out could be the only way to prevent the EU breaking up amid mutual recriminations or worse. The “no bail-out” clause written into the Maastricht treaty with such a situation in mind would prove as expendable as the convergence criteria as economics were tossed aside for political expediency.

All this would be irrelevant if there was no danger that some in the EMU-zone might allow their fiscal affairs to deteriorate to the point of insolvency. But it cannot be ruled out. The almost ubiquitous fiscal incontinence is ominous. Even the threat of exclusion from EMU has proved unsufficient to get their fiscal houses genuinely in order. Only Luxembourg will satisfy the Maastricht borrowing conditions without cooking the books. The predicament of Belgium and Italy is probably beyond the help of statistical massage.

In the run-up to spring 1998 when those fit to join the euro will be chosen, aspiring members will have had to behave like boxers trying to make the weight for a big fight, with spending cuts and tax increases sold to voters on the implicit or even explicit promise of a post-match blow-out. After 1998, they will revert to the psychology of any sad heavyweight, willpower sapped by the lack of deadline, reliant only on self-discipline.

If countries haven’t tightened their belts with EMU as the prize, what hope is there when the prize has already been won? These are the sort of considerations that motivated the stability pact, the patently unworkable German proposal for a system of fines on profligate EMU members. The idea of some kind of European traffic cop pinning fiscal speeding tickets on offending governments strains credulity. EMU is already unpopular without telling voters that it involves sacrificing national autonomy in fiscal as well as monetary policy.

If the stability pact proves unworkable, as it almost certainly will, EMU members will face a stark choice: either to overspend, or to finance the overspending of the other member indefinitely. This is less a case of moral hazard, more like Europe’s national poverty trap.