As the Eurozone crisis continues, John Doukas assesses the next options available to the ECB, arguing that printing more money will not solve the fundamental problems underpinning struggling European economies. Instead, the EU needs to encourage the private sector to function as a willing partner in boosting economic activity and to strengthen its trust in the Eurozone. The article concludes by suggesting that Germany should draw inspiration from its reunification experience and take the lead in facilitating a more integrated and stronger EU economy.

What has started as a fiscal policy crisis in the Eurozone has now become a monetary policy crisis that threatens the survival of the euro and makes the break-up of the Eurozone more likely. The different interest rates across the EU countries reveal another ECB weakness. That is, the ECB cannot set uniform interest rates for the EU as a whole. Of course, the underlying assumption here is that central banks have the power to control interest rates. This conventional view, however, has its limitations, which are worth addressing in another article.

While Italian banks borrow money for a year at an interest rate of 2.7 per cent and Spanish banks pay 3.8 per cent, German (and Swiss) banks borrow money at near (below) zero interest rates as money flows in these countries from the EU periphery as a result of heightened lack of trust in local bank institutions and uncertainty about the future of the Eurozone. This in turn reduces the borrowing cost of German corporations while it raises that of their competitors (if any) in the other EU countries, forcing the periphery countries into a deeper and lasting recession. This is bizarre and definitely inconsistent with what we should have expected under a single currency area with a common central bank. While we still have a single currency, the constituent components of the EU are in danger of falling apart.

European Central Bank Credit: Jim Woodward (Creative Commons BY)

The ECB, as the guardian of the euro, has failed to stop the disintegration of credit markets across the Eurozone. ECB monetary policy (price stability) should affect the entire Eurozone the same way, but as the numbers show above it does not. To put it differently, the ECB is not in control of monetary conditions across the Eurozone. The EU has not only failed to achieve the desired economic integration, as the sovereign debt crisis has shown thus far, the prevailing interest rate disparities in the EU also demonstrate a state of credit market disintegration, which were both expected to be diminished with the adoption of the single currency. It seems that investors doubt the effectiveness of ECB monetary policies and hence they are in charge of setting interest rates. Investor fears have succeeded in outweighing the ECB’s open market operations.

Should the ECB intervene more strongly to address the interest rate disparity across the EU? Well, the previous ECB injection of liquidity (December 30, 2011), in excess of one trillion euros, had little effect on reducing the borrowing cost of money. That is, this refinancing of European banks, which was expected to have a trickle down effect on the real economy (i.e. increasing lending availability to businesses), failed to produce any tangible results as economic activity continues to contract, with the rates of unemployment in Greece and Spain rising to more than 23 per cent. As I have argued before, this is mainly because commercial banks are loaded with non-performing (toxic) real estate assets and government debt (bonds). Some argue that the ECB should inject more liquidity into the system by buying short-term government bonds from the debt burdened countries of the Eurozone to help them meet their current financial needs, as markets have raised their borrowing costs to prohibitive levels. This is believed to give governments more time to restructure their economies and help them grow at a faster rate.

The question then becomes; what should the ECB do next? Whether or not the ECB increases its lending again to banks in an attempt to start lending and/or engage in government bond purchases, this entails more money printing and the world does not need more money printing. Further easing of monetary policy will not help the EU economy grow. This excessive liquidity path runs the risk of overburdening the ECB. What that means is that money printing has already stretched the world’s finances too far and we’re running the very real risk of a major blowup.

The ultimate objective of monetary (and fiscal policy) in the EU (and US) is to re-engage the private sector. The EU needs the private sector more than ever as a willing, but not necessarily equal, partner in funding and boosting its economy. This requires that EU officials realise the vital importance of the private sector to overcome the recession and provide incentives for growth through fiscal and regulatory reforms to boost economic activity and its trust in the EU project. The issue of “investor trust” has been ignored thus far. On the contrary, the noisy details of the frequent promises, such as the one to defend the euro made by Mr Draghi and other EU officials, gain unnecessary prominence which tends to undermine the single currency.

The private sector is critical for future growth in the EU. Without its involvement, a one-sided funding through state-controlled banks and central banks will ultimately lead to high debt-to-GDP ratios, risk spreads, more rating downgrades and a deeper recession. The Greek bailouts that included private sector involvement (PSI) but no official sector involvement (OSI), have signaled to the markets that similar programmes might be used in the future for Spain and Italy, causing investor anxiety and fear resulting in higher costs of borrowing for both private business and sovereign states. The lack of OSI in mitigating the debt burden of Greece has made it unsustainable and if the new coalition government fails to raise €11.5 billion this might trigger the start of the Eurozone break up.

The exit of Credit Agricole, Societe Generale, Millenium Bank, Bank of Cyprus and Cyprus Popular from the Greek banking sector, after they get recapitalized and have realised billions of losses since they moved in, is another bad omen for the Eurozone. While Greece is a small fraction of the EU, its exit from the euro has not been discounted by the markets. Unless the Greek government makes significant progress in restructuring its sickbed economy, and another bailout takes place through the OSI to make its debt sustainable, it is not unreasonable to expect the constituent parts of the Eurozone will start falling apart as the markets will ask who is next. Italy with a public-debt burden of 120 per cent of GDP, the second-highest after Greece’s in the euro area, a dismal growth record over the past decade and high unit labour costs, is most likely to depart from the euro after Greece. Given France’s strong trading and financial links with Italy, markets would fret even more, making the survival of the euro still more daunting.

If Angela Merkel, the German chancellor, wants to preserve the euro area in its current form, as she always insists, she has to convince the German politicians and voters that is worth spending another €496 billion to assist Greece (€118 billion) and PICS (€378 billion) (i.e. Portugal, Ireland, Cyprus and Spain) restructure their economies and start growth again. Otherwise, if they drop out of the Eurozone, it would cost more than €1.15 trillion of which the German share would be €385 billion (15 per cent of GDP), and have a huge impact on the world economy. The additional cost to bail-out German banks, as a result of the exit of the five periphery countries, would bring this to €496 billion. In addition, German non-financial firms and individuals would experience a loss of more than €200 billion on their claims in the five countries. This, in turn, could make it difficult for Germany to retain its triple-A credit rating.

Germans have been able to achieve unification and economic integration with Eastern Germany and despite the fact that it has been a very costly experience for West German taxpayers, Germany today is a much stronger economy. Germany can adopt a similar approach and take the lead on the European stage for the sake of a more integrated and stronger EU economy. To move in this direction, however, “Angela Merkel needs to drop the Wilhelmine pomposity in her foreign policy” to use the words of the former German Chancellor Helmut Schmidt. If Germany succeeds in doing so it would be viewed as a great and equal EU partner. If not, it would alienate its EU neighbours. This, of course, would require that the periphery debt-burden countries take the necessary and drastic measures to restructure and make their economies more efficient and competitive.

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Note:  This article gives the views of the author, and not the position of EUROPP – European Politics and Policy, nor of the London School of Economics.

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About the author

John DoukasOld Dominion University, Virginia

John Doukas is the founding and managing editor of European Financial Management (EFM), the leading journal in European finance. He is also the founder of the European Financial Management Association (EFMA). He is the William B. Spong Jr. Chair in Finance and Eminent Scholar at Old Dominion University, Virginia (United States). He is also an Associate of the Judge Business School at the University of Cambridge (United Kingdom). He earned his Ph.D. in Financial Economics at Stern School of Business, New York University.

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