BRUGES GROUP, Wednesday, 14th July 2010

Is the eurozone breaking up?

Douglas Carswell MP
Professor Tim Congdon

The leading economist Professor Tim Congdon discussed the crisis in the eurozone and whether or not it will break-up. Also addressing this event was the prominent campaigner for democratic reform, Douglas Carswell MP who talked about why we need an in or out referendum.

Click here to view Professor Congdon's power point presentation

Speech by Tim Congdon

I’m going to be telling everyone I told you so and the older one is that most people remember what one said you know think of what you said in your 30s and your 40s because such pearls of wisdom they’ll remember you 20 years later but they don’t. So I’m going to recall some things that I said in 1998.

But in fact the central topic is really this question, can a monetary union where you have several countries, several governments sharing one currency, can that work without movement towards political union, meaning one government, one parliament, one set of laws and so on.

This was always the core question with this experiment, Europhiles called it the European construction, this was always the key issue.

Many Eurosceptics said that it couldn’t work without political union, so did many enthusiasts for the project including such people as President Mitterrand and Councillor Cole and they saw monetary union as something that would act to bring in political union over time.

There were some other people actually who said this can go on forever without proper political union and for quite a long time now they’ve appeared to be right. What I think there was never any question about was that with full political union monetary union was feasible.

And I wanted to say this for a couple of reasons, one was that in the 1990s there was obviously none of this, there’d just been German monetary union and political union, in fact monetary union I think was just before the political union and at any rate they basically went together and although it was a rather messy process it is clearly there for good and everyone’s announced that it can work.

But there was also centralisation of taxing, all centralisation in taxes in Germany applied to all of the Lander and the whole of the country and there’s also enforced centralisation of much of government spending.

So there was never any question about that and the second thing I want to say is that I did say right up 1997, I didn’t think this thing was going to happen because I thought frankly that they were like bills and they kind of have a vision, have a façade you know local columns and they were political but they hadn’t sorted out the plumbing. And you know after a good time it will start to smell and then it’s no good.

Anyhow it’s been there now for over a decade, effectively it started on January 1st 1999 and you know there was this façade and much signs of of working and it wasn’t smelling actually plumbing fixed the old problem.

But let me assure you ladies and gentlemen the plumbing isn’t working, there is a smell and in terms of the question of this thing it’s about to break up and if I’m asked for a timetable I will say the next three to six months and I’m going to try and justify that conclusion in the next few minutes.

Before I do that I’m going to be just a little bit self-indulgent and go through some things that I said and some aspects of the whole process.

When you’ve got a government, a single government, single countries and government usual monetary jurisdiction, the government can borrow from the central bank a great deal of money and if this is on excessive scale you get inflation.

When you’ve got a standard monetary jurisdiction, one government, one central bank, one money, one legal system etc etc, its very clear what the cause of the problem is, its government borrowing from the central bank, that government is to blame, that central bank is to blame so its clear what’s going on.

But the monetary union when you’ve got 16 governments, if each government borrows too much from the central bank is that government to blame for excessive inflation? I don’t think so it’s too small.

So all governments and have got an incentive as far as they can to borrow from the central bank, to be in that sense financially responsible and you’ve got a sort of free value problem.

Now that problem could be anticipated and it was anticipated by a treaty agreement on the size of budget deficits and also a prohibition on government borrowing from central bank as the 1992 Maastricht Treaty but for a number of reasons this Treaty was never really credible and I wasn’t the only person to make these points, but if governments had an excessive deficit, a deficit that breached what’s called the Stability and Growth Pact, also known as the Stagnation and Grief Pact, if there had been excessive deficits then they would be obliged to lodge sums of money which would receive no interest and there would be a fine imposed. The fine would increase the budget deficit actually paid by the government that was responsible.

But the extreme, suppose the government took no effective actions, would the Union instil these from the monetary union as was always the trend. The Treaty said nothing about the mechanics of expulsion.

Then what happens if a number of European countries with excessive deficits, they’ve all got excessive deficits, you have a blocking amendment a blocking majority on Ecofin but also by the way the government announced a VCV so that the countries can put together a vote to outvote well Germany in practice.

In the extreme the high deficit countries might outnumber the low deficit countries so the financial delinquents control Ecofin or the governing council of the ECB. In that event the incentive of every European government is straight forward, cheat on the public finances, maximise the deficit and to hell with the inflation risk.

The answer, there has to be a single federal government, there has to be a centralised treasury and so on and then monetary union has led to political union.

The central bankers are very powerful people; they need to be kept in check. So by the way are commercial banks, they’re also very powerful people and banking is a very political industry and so there has to be some accountability to the legislature, maybe the executive, maybe some combination of the two but in the eurozone you’ve got these 16 governments, you’ve got this Treaty, you’ve got this rather weird structure of the European Central Bank and the euro system with actually 16 central bank members and its very clear that the ECB is not accountable to any national government. Its true enough that Trichet is prepared, to refuse an invitation to talk to the French Parliament, its true enough that he does give evidence in the European Parliaments but that there may still be massive questions about the status of the European Parliament relative to the national Parliaments and also of course the national governments and so on.

So again we’re going to be in crisis, what is likely to happen is that the Maastricht Treaty would have to be revised, there would be new powers of European Parliament to discipline the European Central Bank political and monetary policies etc etc and by the way that’s more or less what’s happened. There is the Lisbon Treaty that has given more powers to the European Parliament and clearly intended by some people that the European Parliament is a kind of proto-parliament for the entire Union, in other words a monetary union has again led to a political union, another argument that has the same conclusion.

The cost of printing these things is a fraction of the £20 that its worth. The difference between the two is called seigniorage. Now the central banks also make profits, it may surprise you that they do actually, the banking institution is profitable but they make profits.

Who owns these profits? Who owns the seigniorage? Who owns these central bank profits?

Well in Britain there is a single Government, there is a single Parliament, there is a single set of laws governing this particular subject and there is a single central bank. So there’s no two ways about it, ultimately if the Bank of England make a huge amount of profit, that actually benefits the British Government and the British taxpayer.

Again however there is in the eurozone 16 governments, 16 central banks, they of course, their seigniorage there is also interbank profits and losses, sometimes these profits and losses are arise because of businesses in Greece or in France or in Italy, but actually how much business in Greece, in France, in Italy, how do we distribute this between the different nations?

So again you get this pressure for some federalisation, some cooling, some political union to follow monetary union.

And then another argument, you see all these arguments have the same conclusion. In America in the Great Depression the people lost a lot of money in keeping money in supposedly a very safe place, in the banks, bank deposits did not pay out 100 cents in the dollar. Since then its been accepted across the industrial world and everywhere really that public policy should be organised to ensure that the depositors receive back 100 cents in the dollar, 100 pence in the pound and so on.

Now this doesn’t occur by magic, these public deposits are protected in the first instance by the assets of the banks but suppose that something goes wrong with the banks and then you have a chain of security, there’s the capital of the banks themselves that officially deposit, capital of RBS and Barclays and so on in our country, if something goes wrong with that with one bank another bank may move in and buy it so the capital of the whole banking system is relevant. We also nowadays tend to have in Britain we have got it depositor insurance fund into which the banks contribute so if something goes wrong in a small building society, which has happened, then this fund is tapped to make sure depositors get back 100 pence in the pound.

Then all these are being exhausted, the capital bank is being exhausted, the other banks don’t want to take over the bank in trouble, the deposit insurance agencies is also passed all its funds, then the central bank can help, it will take on a big risk getting involved in a situation like this but its there but when all of these have gone all that’s left is the government. So the ultimate guarantor of the 100 pence in the pound, the 100 cents in the dollar is in fact the government.

Here it’s fairly clear, you’re a citizen of the UK, you have a deposit in a British bank, you’re protected by all of these elements and all of these links in the chain, the chain of security, Eurozone.

You have maybe it’s a French bank with operations in Spain, by the way if its actually a German individual that has got an account with this French bank in Spain and something goes wrong with this French bank in Spain or maybe it goes wrong with the Spanish bank but anyway where is the chain of security and which central bank or which government, which deposit insurance agents?

And so you get pressure for a unification of the whole area. The banking system is in crisis, resources of the commercial bank, the deposit insurance agency and central bank had been swept away by a tidal wave of global losses the answer of course the government.

The tax raising powers that support the banking systems is theoretically simple. In the final analysis the government would make sure the bank deposits were repaid in full but this obligation is not without limits crucially the government would in a particular nation is most comfortable when it protects deposits made by citizens of that nation and quite bluntly think about our Government and depositors of Icelandic banks, think about our Government and depositors with VCCI, yeah and the Government wanted to help them but the truth of the situation was that they were the responsibility of you know the Emirates in the case of VCCI, Iceland in the case of the Icelandic banks. And then this is across the entire Eurozone, huge pressure for political union to support monetary union.

So we’ve got here, and they are these issues which were kind of dormant for a decade are now are now live issues. The story of exactly how we got to where we are today is a fascinating one but I have got a finite amount of time even though Douglas Carswell isn’t here yet, and so I’m going to just focus on some particular aspects of the unsustainability of the current situation.

I may be rather technical and I apologise for that. What you need to understand is this idea of a central bank which central banks they issue the notes that are used all over the eurozone, they also have got banks as customers and the banks settle their own imbalances between themselves through accounts at the European Central Bank. The euro system is actually a Central Bank of Ireland, the Bank of Spain and so on but they’re all part of the ECB and they settle their imbalances through accounts of the ECB. So the Central Bank, like any other bank, has got the most holders and it’s got depositors in the form of banks with it.

And then on the other side of the balance sheet it holds various amounts of assets but in particular for current purposes it lends to some banks and it also holds Government securities. Now I know it’s not supposed to hold Government securities under the terms of the Maastricht Treaty, it’s really complicated and I’m going to ignore that for the moment and just say it has both loans to banks and holds Government securities.

Now I’m going to cut a long story short and I’m going to simplify radically but I want to get this over to you. I’m going to say, this is evidently true but that the principle note holders and the principle depositors are French and German, maybe Dutch, they’re North European and they believe in certain things sound finance and all the rest of it and the assets are Greek Government securities, Portuguese Government securities, Spanish Government securities, loans to Italian banks, loans to Portuguese banks, loans to Irish banks.

Now I’m simplifying but what I see here is the nature of the forces that currently might be about to rupture the system. That’s simplified and it’s the guts of what’s now going on.

It is the recognised job of the Central Bank to help banks that have difficulties funding their assets, it’s supposed to do that, the Bank of England was supposed to have done that job in 2007/2008, it did in the end but it did it very badly. That is the job of the ECB and it is doing it.

To some extent also the Central Bank should be bankers to the Government, there is also part of it despite the Maastricht Treaty and there are German problems with this but lets look at this.

The big problem with large amount of public debts is as follows. You know Britain had a public debt that’s as high as the GDP, high as its national output in 1815 after the Napoleonic wars, in 1918 after the First World War and in 1945 after the Second World War but in all cases the interest rate was around about 3% so the interest payments on the debt were about 6% of GDP. That’s quite a lot of money but actually people were prepared to pay the taxes to pay the interest on the debt. That’s 6% GDP.

In the case of Greece, the public debt has risen, rising all through the last 10 or 15 years, risen to about 120% of GDP. Now until the last few months they’ve been cheating, they weren’t disclosing that it was 120% and they were saying it was more like 80/90/100% and the interest rate on Greek Government debt was a bit higher than that and the German Government debt was not much.

So you had a debt that was supposed to be 100% GDP and the interest payments say were about 4/4½%, so the interest payments were about 4/4½% of GDP. So people paying taxes to pay the bond holders and so on. 4% GDP it’s alright.

Now the truth was that the debt was 120% of GDP and they had a huge budget deficit. The deficit was in fact about 12% GDP when they said it was about 6. So this thing was 120% and moving up to 140/150%.

What do you do if you’re holding Greek Government debt, you sell it and the price goes down and the yield rises and this is the story of the yield on 10 year Greek Government debt in the last six to nine months. You see it started off about 4½% and these monthly averages, it was 9% in May; it actually for one or two days went up to over 12%. So imagine, you’ve got a trajectory where the public debt is going to be 150% of GDP and the interest rate is 12% so the interest payments on the debt are 18% of GDP.

In other words you the Greek taxpayer are required to pay taxes equal to a fifth of everything you produce in order to service the national debt. You’ve got to pay all the pensioners, you know you’ve got to pay everything else, all the subsidies, everything else the Greek Government does and this debt is rising, completely unsustainable.

Now the only way of stopping this, a genuine Government economist to slash Government spending, get the deficit down or some help, get that bond yield down. And what happened over the weekend of the 8th and 9th May was that Sarkozy threatened Merkel... actually it was three Frenchmen, it was Sarkozy, it was Trichet and Strauss-Kahn behind it they threatened Merkel and said if you don’t agree to this France is going to leave the eurozone so Merkel gave in. She agrees that on the morning of the 10th May, the ECB could buy Greek Government Bonds, completely breaching the Maastricht Treaty.

The Bond yield fell 8%, crippling. What is the Bond yield today, well by the way there was a Greek Government deal that raised some money where it raised some six month money which was actually oversubscribed as a bit under 5% and there was all this spiel about relieve the markets, the Greek Government raises six month money at 5%.

Please you can’t have... you’ve got your whole debt that size at six months, so they have actually got some money in the bank now to see them through the next few weeks and months given to them by the EU.

What is the yield on tending Government debt at the moment, it was over 10%, it’s gone back up from after a fall from 12 to 8 to 10 and Trichet said we can’t keep on buying Greek Government bonds.

It’s clearly finite they can’t keep on buying this stuff bit by bit. And it is just a matter of weeks and months. I mean if there really are even more convincing cuts in Greek Government spending and all the rest of it and the Bond yield holds isn’t too high, I don’t think so, it’s over. And if you’re simply talking about weeks and months it’s not very long.

Now Spain is actually in some ways a much sadder case because the Spanish did actually have strong public finances right through until 2008. What was happening in the Spanish case was they had a banking system, remember there was a long boom in the property market in Spain, people having holidays there, people going to live there or emigrating into Spain from North Africa, increasing population, building new hotels, new houses, new second homes and so on.

This boom was financed largely by Spanish banks and other banks operating in Spain which in turn were borrowing from the international banking system in practice in fact largely from Asian banks. Spain was running a large current account deficit and you can see this line it just goes up and up you know like that alright and that is Spanish banks’ external borrowings.

We then get to the middle of 2007 and this international wholesale market closed. So the Spanish banks had got to either find other sources of funding or reduce their assets and get some of the developers to repay the loans, sell off the houses, sell off the office blocks, sell off the hotels and repay the loans or find some other source of funding.

Now there were various sources they might go to and to some extent those were Spanish public, Spanish Government but actually the lender of last resort is the central bank which is none other than the European Central Bank in the particular from of the Bank of Spain.

Well since the middle of 2007 you can see that line has gone sideways. Spain in fact at the end of last year, the Spanish banks were not that heavily indebted to the ECB, they had managed to source other kinds of funding more or less, they weren’t growing their businesses in the same way and the Spanish economy was growing but in the last three months they had been borrowing the only place they can borrow is from the European Central Bank.

The European authorities are in a bind. Ireland went through a very similar process.

Ireland, the same story basically but an even more dramatic turn, to some extent the UK is in the same situation, in the Irish case, there’s the Irish banks also borrowing heavily from the inside wholesale market.

They really were completely stuffed, the banks were completely bust and they had to borrow from there to get the Irish Government to come in to bring some capital in and the Irish banks, half of Irish banks’ funding, half of Irish banks’ liabilities funding from the European Central Bank, liabilities to the European Central Bank. The Irish banking system is about the same size as national output, the European Central Bank’s lending to Irish banks is equal to half of Ireland’s national output.

That can’t go on and Spain similarly is in this situation, not to the same degree but the last few weeks the Spanish banks’ borrowing from the European Central Bank has been rising steadily because they’ve got this funding problem, they’re trying to persuade investors that the Spanish banks has got capital etc. etc. Maybe it will work, it hasn’t really worked up until now, watch this space.

The European Central Bank can’t keep on buying the Government securities of the Greece, Ireland, Italy, Portugal, Spain; it can’t keep on making loans to the banking systems of these countries. When it says no these countries have got an unenviable set of choices but really they are in effect being expelled from this union because I don’t see, since prices are finite, this wonderful thing that economists say the process is unsustainable, it will stop and this will stop. I think we’re talking about the next three to six months.

The other possible way this thing breaks up is actually that Germany, because the Maastricht Treaty has been breached, and I gather there is another case going to the German Constitutional Court, I will be very surprised if the German Constitutional Court just gives in the way that Merkel did and that also is another mechanism by which the eurozone might break up.

Well thank you very much for listening to me. I can assure you that 12 years from now I will again be telling you I told you so but I’m not quite sure what will be the topic but thank you very much.

PROFESSOR TIM CONGDON, CBE
Professor Tim Congdon is one of Britain’s leading economic commentators. He was a member of the Treasury Panel of Independent Forecasters between 1992 and 1997, which advised the Chancellor of the Exchequer on economic policy. He founded Lombard Street Research, the City of London’s leading economic research and forecasting consultancy, in 1989. Currently he is the founder and Chief Executive, International Monetary Research Ltd, which analyses the trends in money and banking.

Professor Congdon has written a number of books on monetary policy, contributes widely to the financial press, and makes frequent radio and television appearances.

He is also the author of the Bruges Group papers, Will the EU’s Constitution Rescue its Currency? And, The City of London Under Threat: The EU and its attack on Britain’s most successful industry. He was awarded the CBE for services to economic debate in 1997. Professor Congdon is a member of the Bruges Group’s Academic Advisory Council.