The Anglo-Saxon world is feeling smug this weekend. UK and US policymakers are counting their blessings they’re not directly embroiled in the historic debacle that is the single currency. This euro-crisis is obviously very seriously undermining global investor sentiment. The negative impact on growth, both in Britain and the States, is clear. It is axiomatic that the financial chaos stemming from a fully-blown, market-induced “euroquake” would cause deep aftershocks everywhere, not least across the rest of the Western world.
There is palpable relief, though, in London and Washington, that attention is now squarely on the eurozone’s woes. That makes life easier for the deeply-indebted Anglo-Saxon governments – which is particularly welcome for Chancellor George Osborne, given that he’s about to give his Autumn Statement. Osborne’s speech writers will, no doubt, make much of the fact that UK government bond yields last week went below those of their German counterparts. That happened, though, not because the coalition’s debt-reduction plan became more credible. On the contrary, the upending of the UK’s growth assumptions has made it even less likely that Britain’s fiscal numbers will add up.
It is essential, despite political temptations, that Osborne doesn’t use Tuesday’s statement to misrepresent this recent gilt-yield respite. The UK’s deep fiscal problems remain. It’s just that, for now, the bond market vigilantes are focused on the eurozone – which isn’t surprising. For the single currency’s difficulties are compounding by the day.
The longer this eurozone crisis continues, the more likely it becomes that “contagion” threatens the fiscal stability of Germany itself, the region’s economic powerhouse. Anyone who doubted that received a stern wake-up call last week, when an auction of 10-year German sovereign bonds was seriously under-subscribed, with investors buying just €3.9bn of a €6bn offer. Bund yields spiked across the board, taking them above those in the UK.
Many observers seem to think such market pressure means Angela Merkel will “relent”. With Berlin’s own credit-worthiness being openly questioned, the German Chancellor is now apparently more likely to launch a massive “bail-out” fund for the eurozone laggards, while sanctioning overt QE “money-printing” by the European Central Bank.
I’d venture a different view. However much one particular branch of the German elite wants “the European project” to succeed, the vast majority of the German public are appalled at the idea of financing the rest of Europe. They resent not only the cost, but also (rightly) worry that one eurozone bail-out inevitably leads to another.
I reckon that surging bund yields make it less likely that Germany will agree to fund a bail-out, while letting the ECB let rip. German voters, and the country’s powerful Parliament, will see rising borrowing costs as further proof of the harm the euro, in its current form, is doing. Merkel must answer to both.
Germany stood by and watched back in the 1990s, as the Exchange Rate Mechanism collapsed under the weight of its own incoherence. Since then, life has become much tougher for the big industrialized Western economies. While still head and shoulders above the rest of Europe, even Germany is now on the back foot. The country’s bellwether Manufacturing PMI Index fell from 49.1 to 47.9 this month, indicating a sharp economic contraction. Germany would be unlikely to entertain money-printing and paying for a eurozone bail-out at the best of times. Under current circumstances, the chances are even slimmer.
I also think that those foreseeing “fiscal union” are also deeply misguided. We’re told that this is what Germany will insist upon as a quid pro quo for financially back-stopping Europe’s southern states. Really? Merkel last week blasted the European Commission’s proposed eurobond, the issuing of sovereign debt in the name of all eurozone members but ultimately backed by Germany, labeling the idea “extremely worrying and inappropriate”.
There is clearly no hope of German stumping up any more bail-out cash without tighter controls on the “Club Med” countries’ purse strings. Such controls may be put in place. But that’s not “fiscal union”. The only way a single currency can work in the long-term is by pooling a large share of total tax revenues and having intra-regional fiscal transfers, as in the US. Yet that will never happen in Western Europe.
Anything less, though, a souped-up Stability and Growth Pact for instance, would be too weak to succeed. When it came to the crunch, spending rules set at the European level will always be broken by politicians answerable to their own domestic electorates.
The notion that “fiscal union” of some kind is workable, and that Germany wants it, has gained ground because that is the only way certain financial analysts can keep predicting that “Merkel will print” and the end-of-year market rally will come. The same deluded analysts also claimed the euro-crisis was easing last week because the spread between French and German government bonds yields had narrowed, while failing to mention that was only because German borrowing costs had gone up.
Portuguese debt has just been down-graded to “junk” status. Short-term Italian debt is now trading above 8pc, deep into bail-out territory. While the eurozone endgame is impossible to know, I still think the most likely outcome is that several of the peripheral nations will leave, re-denominating their debts in pre-euro currencies, so allowing the core countries to stabilize. This, I believe, is what Germany really wants.
Scaling-back monetary union would take us to a better place, with the big eurozone economies no longer seemingly on the hook for everyone else’s debts. A down-sizing would also be far more implementable, logistically and from a banking point of view, than dismantling the entire edifice. Attempting to do that, I fear, would end in financial chaos. It would also sow the seeds of recrimination and potential conflict across Europe for decades to come.
American TV pundits were gloating last week, as US Treasury yields fell to a six-week low. “Just goes to show the underlying strength of the good old American economy,” the mantra went. The US has big fiscal problems of its own, of course, not least a $14,000bn debt burden, set to reach $18,000bn by 2016. The failure of the so-called “Super-Committee” to agree on a bi-partisan deficit-reduction package highlights that America’s institutions have their own dysfunctional aspects. But, for now, Europe’s dysfunction is even worse, to the benefit of US bonds.
Yet Britain isn’t America. The pound isn’t the world’s reserve currency. The UK’s demography is far less favorable to fiscal retrenchment than that of the States. While Washington can probably keep thumbing its nose at its creditors for some time, that doesn’t apply to London.
Back in March, the Office for Budget Responsibility predicted that Britain would grow 1.7pc in 2011, and that the government could “eliminate the structural deficit” by 2014-15. It’s now clear the UK will do well to grow by 1pc this year. While we’ve seen some progress, Britain’s fiscal stance, for all the rhetoric to the contrary, remains incredibly loose. Central government spending was higher in October than the same month last year. Public sector net debt was £966.6bn last month, up from £836.8bn in October 2010 – an astonishing 15pc rise, and that doesn’t include the bank bail-outs. And we’re told this is “fiscal austerity”.
Be clear, Mr Osborne, as you put the finishing touches to your Autumn Statement, the markets don’t think the UK is out of the fiscal woods. Not by a long chalk. It’s just that, for now, the vigilantes’ sights are set elsewhere.