ECB’s Recommendations for Sound Fiscal Policy

Throughout the euro crisis, the European Central Bank in Frankfurt has been staunch proponent of austerity. Most recently, its president Jean-Claude Trichet urged European governments to cut spending, noting that monetary responsibility on the part of his bank cannot continue to substitute for fiscal irresponsibility on the part of individual member states.

Two recent ECB studies are no less adamant about the need to rein in public spending. In an entry at the libertarian Cato Institute’s blog, Daniel J. Mitchell cites both reports, the first of which focuses on debt reduction in European core countries.

Entitled “Major Public Debt Reductions: Lessons From The Past, Lessons For The Future,” (PDF) the report unambiguously concludes that spending restraint is the right way to reduce deficits and debt, according to Mitchell. “Tax increases, by contrast, are not successful,” he observes. The study summarizes its major findings as follows.

First, major debt reductions are mainly driven by decisive and lasting (rather than timid and short lived) fiscal consolidation efforts focused on reducing government expenditure, in particular, cuts in social benefits and public wages. Revenue based consolidations seem to have a tendency to be less successful. Second, robust real GDP growth also increases the likelihood of a major debt reduction because it helps countries to “grow their way out” of indebtedness. Here, the literature also points to a positive feedback effect with decisive expenditure based fiscal consolidation because this type of consolidation appears to foster growth, in particular in times of severe fiscal imbalances.

In other words, reducing government spending is the best method to fostering economic growth. Mitchell notes that the Obama Administration has been doing the very opposite with its stimulus policy. “The American economy would have enjoyed much better performance if the burden of spending had been reduced rather than increased,” he believes.

That assertion is supported by the ECB’s other study, “Towards Expenditure Rules And Fiscal Sanity In The Euro Area” (PDF). Its authors find that, “on the basis of real time rules, expenditure and debt ratios in 2009 for the euro area aggregate would not have been much different with neutral expenditure policies than actually experienced” — neutral expenditure meaning no excess increases in spending to affect productivity and growth.

Primary expenditure ratios would have been 2-3½ [percentage points] of GDP lower for the euro area aggregate, 3-5 pp of GDP for the euro area without Germany and up to over 10 pp of GDP lower in certain countries if expenditure policies had been neutral.

In plain English, the ECB is saying that with an annual cap in place on the growth of government spending, its burden could have been reduced by up to 10 percentage points of GDP. “To put that figure in context,” Mitchell notes that “reducing the burden of government spending by that much in the United States would balance the budget overnight.”

European Bank President Urges Budget Cuts

European Central Bank president Jean-Claude Trichet urged governments to “turn the page” and start making serious budget cuts in 2011. “Monetary policy responsibility cannot substitute for government irresponsibility,” he told a conference of conservative lawmakers from Bavaria in southern Germany yesterday.

The ECB has been a proponent of austerity throughout the euro crisis. Trichet has repeatedly called for tougher budget rules in order to avoid a repetition of the meltdown that occurred in Greece last year. In a speech before the European Parliament in June, Trichet warned that “sanctions need to be applied earlier and must be broader in scope” lest European publics lost confidence in their institutions.

The European Commission has proposed to punish budget rule breakers but in a compromise, France and Germany, the eurozone’s two largest economies, agreed that sanctions would not be automatic. That’s not enough as far as Trichet is concerned. “We should be inflexible in applying sanctions if rules are breached,” he professed. Penalties should include “fines, reduced access to EU funds and other pecuniary consequences.”

While the central banker is trying to convince embattled countries on the fringes of Europe to make cutbacks, he has to cope with a German public that is increasingly skeptical of having to come to the monetary union’s rescue time and again.

Chancellor Angela Merkel’s ruling coalition lost its majority in the upper house of parliament last May in the wake of the Greek bailout effort and German voters long for the days of the Deutsche Mark. The head of the Bundesbank, Axel Weber, who is likely to replace Trichet as president of the ECB, publicly criticized his decision to buy some €74 billion ($95 billion) worth of Greek, Irish and Portuguese government bonds over the past year in an attempt to fend off investors’ worries. Trichet is still defending the move eight months later, saying Friday that buying bonds doesn’t interfere with the bank’s mandate. “The reason for the [bond buying] decision was certainly not to finance debt laden member states, but to address some severe malfunctioning of markets,” he claimed.

Observers expect that the ECB will again need to buy large amounts of bonds in the weeks ahead as concerns persist that Portugal will be forced to accept a rescue package from the European Union and the International Monetary Fund soon. Greece and Ireland had to accept bailouts last year.

World Critical of American Monetary Policy

Countries around have criticized the Federal Reserve for its expansionary policy. Last week, the American central bank announced another multibillion dollar capital injection in the hope that it might increase liquidity in the financial system and encourage banks to ease their lending to private enterprise. Other nations believe that it amounts to a veiled attempt at driving down the exchange rate of the dollar.

The Fed plans to buy $600 billion worth of Treasury bonds over the next eight months with the aim of keeping long-term interest rates low and promote the now almost moribund recovery of the American economy. Unemployment rates in the country continue to hover around 10 percent while some of its antiquated industries are struggling to compete with companies in China, Germany and low wage countries across East and South Asia. Inflation rates have remained modest at 1.2 percent but may well increase as a result of the Federal Reserve’s second round of quantitative easing.

American treasury secretary Timothy Geithner previously blamed China and Germany for relying too much on exports to the United States. “For too long many countries oriented their economies toward producing for export,” he said last month, “rather than consuming at home — counting on the United States to import more of their goods and services than they bought of ours.” China has also come under fierce American criticism for keeping its currency undervalued which helps Chinese exporters prosper — at the cost of American competitors, according to Washington.

These both countries have been quick to blame the Americans in turn for their monetary policy. Germany sees the Fed’s move as an attempt to put it on the defense at the upcoming G20 summit in Seoul, South Korea later this week. The German finance minister, Wolfgang Schäuble, described the decision as “clueless”. “They have already pumped endless amounts of money into the economy with extremely high budget deficits,” he added. “The results have been hopeless.”

China’s vice finance minister, Zhu Guangyao, reiterated Chinese objections Monday, charging that the Fed’s latest move “did not recognize its responsibility to stabilize global markets.” Nor, he said, did the bank “think about the impact of excessive liquidity on emerging markets.”

The reason China won’t compromise on currency is the very real fear of its leadership that any slowdown in economic development risks unleashing internal forces of discontent and threaten Communist Party rule. That fear is not without reason. Unrest in the southwestern provinces of Xinjiang and Tibet continues in spite of sometimes violent attempts at oppression. Tens of thousands of protests take place across the country each year. Even in the fast growing cities along the eastern seaboard, discontent with the lack of political freedom is mounting.

With China and the United States so hopelessly deadlocked, it is little wonder that other G20 countries are worried. Brazil’s finance minister previously warned of a “currency war” among nations while South Africa’s Pravin Gordhan predicted this week that the Fed’s unilateral decision to expand the money supply could “undermine the spirit of multilateral cooperation that G20 leaders have fought so hard to maintain during the current crisis.” Russia added that the G20 should have been consulted before such a major policy were enacted.

The European Central Bank, a proponent of austerity, has refrained from commenting on the Fed’s latest decision out of courtesy but it is pursuing a very different course. President Jean-Claude Trichet declined to inject new stimulus into the eurozone despite weak recovery figures in particularly the south of Europe.

Although Trichet said that he believed the Fed’s quantitative easing wasn’t aimed at depreciating the dollar, Prime Minister Jean-Claude Juncker of Luxembourg, who also heads the group of eurozone finance ministers, complained that the dollar was undervalued and the Fed stimulus bore “risks” for the world at large. “The dollar in relation to the euro is not at the level it should be,” he told a European parliamentary committee on Monday.

French Finance Minister Christine Lagarde agreed, noting that the Federal Reserve’s expansionary policy is putting upward pressure on the euro. “The euro bears the brunt of the move,” she said in an interview Thursday. “I am not making a judgment on the America quantitative easing,” she explained. “But it shows the imperative need to rethink the international monetary system and cooperation mechanisms.”

Despite such appeals to closer cooperation, the Fed’s decision to effectively pump another $600 billion into the American economy would seem to diminish the prospect of world leaders agreeing on a unified approach at the G20 in Seoul. The broader debate between stimulus versus austerity, which currently divides the United States and Europe, remains unresolved.

Saving the Euro

Bending the rules of euro management, European leaders and finance ministers agreed to an unprecedented effort to guarantee the stability of the eurozone with loans adding up to nearly $1 trillion (or €750 billion) this weekend.

In spite of the multibillion euro rescue package previously pledged to Greece, investors continued to worry about the unsound fiscal policies of other eurozone members, including Ireland, Italy, Portugal and Spain. The value of the euro sharply decreased in recent days while protests in the streets of Athens last week shed further doubt upon the country’s chance to recover — and pay back its loans. Read more “Saving the Euro”

Euro Resentment Demands New Rules

Euroskepticism is abound anew. Where previously economist Paul Krugman argued that Greece could have weathered its fiscal crisis if it had retained its own currency, Judy Dempsey reports that Germans are increasingly nostalgic for their Deutsche Mark.

“For Germans,” writes Dempsey, “the mark was more than just currency.” It represented the country’s postwar recovery, the Wirtschaftswunder that made Germany within mere decades the strongest economy of Europe.

Should they be forced to bail out an ailing eurozone neighbor as Greece, Spain, maybe Portugal, “resentment against Europe and the common currency” would certainly intensify among most Germans.

Chancellor Angela Merkel is in a tough spot. “She knows that the euro has been good for Germany, despite the resentment.” Stable exchange rates have encouraged trade and growth. “But bailing out Greece would be terribly unpopular.” Read more “Euro Resentment Demands New Rules”

Sarkozy Strikes at the City

With France, along with Germany, leading the way of European recovery, President Nicolas Sarkozy has both the power and the prestige to launch a reinvigorated campaign against what he calls the “freewheeling Anglo-Saxon” model of finance. With his countryman Jean-Claude Trichet heading the European Central Bank and UMP-ally Michel Barnier soon to be installed as the union’s internal market commissioner, Sarkozy appears to have everything in place to make the world see “the victory of the European model, which has nothing to do with the excesses of financial capitalism.” No wonder that people are worried in the City of London.

London was quick to respond. Mayor Boris Johnson traveled to Brussels to lecture the European Parliament but his entourage of rabble-rousers and cameramen did little to persuade them. Nor was Chancellor of the Exchequer Alistair Darling’s argument that “London is New York’s only rival as a truly global financial center,” and therefore Europe should strengthen, not weaken it, well received.

Earlier, in conference with his colleagues from across the continent, Darling compromised on the creation of a European financial regulator. French finance minister Christine Lagarde praised the deal which according to Darling leaves considerable responsibility with national authorities. That is not how his counterparts sold the agreement at home.

Nevertheless, there is some truth in Darling’s statement. A European Systemic Risk Board is to be put in place to spot irregularities in the financial system that threaten to harm it. But it will have no power to leap upon banks to put any questionable practices to a halt. Rather it is supposed to issue recommendations and warnings alone.

Sarkozy has more weapons in store to bombard Paris to the world’s next financial capital however. A European Alternative Investment Directive seeks to install a framework for all alternative fund managers which in London is rather perceived as an attempt to shackle another sector of “freewheeling Anglo-Saxon” capitalism. If that were true, Paris in fact stands to gain very little: hedge funds taking a pre-emptive decision to leave London headed straight for Switzerland, not Paris or Frankfurt.

There is more reason for Londoners to be hopeful. As Ambrose Evans-Pritchard notes in the Telegraph, Barnier is actually “deeply averse to trampling on British sensitivities.” Moreover, his director-general, Jonathan Faull, is British. “Given the circumstances, the Barnier-Faull team is the best that Britain could hope for.” Whether that will stop Sarkozy remains to be seen.