Otmar Issing, who was very important in dictating the form of European Monetary Union (EMU) has issued a provocative challenge using the fiscal embarrassment of Greece within the Euro Area. He makes several statements of partial facts. His purpose is to argue that EMU’s rules are absolute and can only be flexed by European Political Union (EPU), as if to swing the Euro rules like a bat on the pivot of Greece to hit a home-run for EPU, which he argues, as he did in the 1980s, should have preceded EMU. To be fair, Issing clearly dislikes the idea of leveraging EMU to gain EPU – that it should have been the other way about, but that is how he sees matters now standing.
What are his provocations? They include that the Euro Area system is a monetary stability system that does not permit any direct or indirect transfers of aid between member states. In truth, it does permit transfers far more than would be the case if the Euro did not exist. But, these are indirect transfers between states via inter-bank loans and bond sales i.e. private to finance trade deficits between states, for which, as the credit crunch crisis has shown us, central banks and state treasuries are ultimately solvency guarantors.
Jean-Claude Trichet, ECB President, also says, however, that there can be no special cases i.e. Greece can swap assets with the ECB for short term roll-over loans, but only if the assets are rated suitably high enough by the ratings agencies. This is a Catch-22 circular argument since the ratings agencies’ sovereign ratings for Greece are influenced by Greece’s EU, EMU and OECD membership, and too by the flexibility of the ECB’s lender-of-last-resort role. To play tough and say each state must absolutely balance its books as if there are no external circumstances, effectively makes policy responses to the credit crunch and recession within the Euro Area a hostage to the ratings agencies whose models and role in the crisis, while central, are profoundly discredited.
Issing concedes there are transfers at the full EU level via the budget of the European Commission, but he avoids any references to transfers via the short term money market operations of the ECB. In the 1980s, when EMU was conceived and Issing argued EPU first, EMU second, The Jacques Delors and European Recovery plans proposed up to a trillion in bond issuance that would be self-financing to provide for a system of transfers to ease the readiness for EMU. This sensible idea was voted for by all states except UK, Germany and The Netherlands. If today’s EU majority voting system had applied back then a system of transfers would have been part of the Maastricht, EMU and Euro treaties. I would go further and say if the EU had a system of transfers similar to what operates within sovereign states (to compensate for imbalances between regions) then there would surely be far more support and impetus towards EPU within the EU by now.
Issing says European taxpayers would not stand for ‘transfers’ from states who obey the rules to those who do not. But, following the rules is not the real issue and is not simple at any one point in time. It is more a question of what follows from very different economic growth policies within the EU. In the EU Single Market transfers are inevitable either private or public, interbank lending or inter-governmental transfers. When interbank lending (and buying and selling of net financial assets such as securitised bonds) broke down, governments everywhere have had to step into the breach. Greece may be rightly accused of running a far too high annual trade deficit and external account financing (up to 18% ratio to GDP). But its credit-boom led growth, while imprudent, was not outside of the rules. Indeed, Ireland, Finland, Greece and Spain were repeatedly praised for contributing to EU growth and jobs recovery much above their weight within the EU economy.
All states cannot seek after only export-led growth! For most of my lifetime it has been the case that the world economy has accommodated only a few net exporters (e.g. Germany, Japan and OPEC). The extreme special case of the past decade was that a few credit-boom economies (mainly the USA) generated trade deficits that allowed almost everyone else to generate surpluses or get nearer to balance. The conditions that led to the credit crunch were a boon to emerging countries generally, and of course to China.
What Issing neglects to say is that when states gave up their individual currencies they also handed all their off-balance sheet short term bonds operations (treasury bills) to the European Central Bank (ECB).
It has been precisely by using treasury bills that the UK and USA have been able to generate trillions of aid for their insolvent banks at no material cost to taxpayers – no taxpayers’ money applied, aid is off-budget in assets for treasury bill repo swaps. Greece, Ireland and Spain, and others in the Euro Area when directly bailing out their banks have had to issue bonds ‘ on budget’. They would not be in such fiscal difficulties if they could have relied on the ECB for a similar scale of money market response on behalf of the whole Euro Area and Single Market without regard to who got more or less help relatively.
The unstated implication of Issing’s argument is that only political union would permit such flexibility by the ECB. This is debatable. Some argue the ECB’s inflexibility is because it is not backed by political union. Another view, my own, is that the inflexibility comes from the EU being composed of countries that followed opposite growth impulses. Germany pursues export-led growth (why its employment gains have been less than others) alongside economies who pursued USA and UK style credit-boom growth (what we used to call deficit-led growth), such as Ireland, Greece and Spain, which meant having to sustain large trade deficits by selling financial assets. These diametrically opposing growth and monetary policies stymies the ECB in its response to the credit crunch.
Greece had further to go to catch up economically with the rest of the Euro Area and the banks went further than others in pushing a mortgage-led credit boom, and did so against Central Bank of Greece advice and in years when the ECB did not express its concerns. Like banks elsewhere, Greek banks capital reserves were wiped out and Government had to pick up a bill to provide support equal to one year’s GDP. But, Greece has to accommodate much of this ‘on-budget’ and that is hard to do and keep within the Maastricht Treaty rules.
Issing says “Emu is a “no transfers” community of sovereign states”. But, if taxpayers accept aid transfers internally between regions within states and externally at a global level why not within the EU? Does the ECB constitution and treaty really forbid ‘special cases’. Statements by Trichet and EU finance ministers in December and January did not seem to think so.
“No transfers” has clearly not been a macro-economic reality since the 1930s in the world economy. The idea of states sharing the same currency is that they may trade fearlessly with each other without currency problems. But, this happy view neglected to consider how external accounts are managed and financed.
The ECB cannot claim to be a force for stability when it ignored these fundamental stability issues. The ECB needs to broaden its operations and treaty scope or it risks becoming a force for instability by religiously enforcing rules on government fiscal policy as if this is the only monetary policy factor and thereby ignore the underlying economy’s money supply as dictated by commercial banks.
NOTE:
Issing is president of the Centre for Financial Studies and former member of the board of the Deutsche Bundesbank (1990–1998) and of the Executive Board of the European Central Bank (1998–2006). He conceived the 'two pillar' approach to monetary policy decision making adopted by the ECB. His statement in the FT (15th January):
"To bail out Greece or not? The question is grabbing headlines daily. Supporters of a bail-out argue that if Greece collapses, others would follow. Financial markets have already identified the next candidates. As such, European economic and monetary union is at risk. Only financial aid and “solidarity” with highly indebted members can rescue the euro.
It is certainly true that this is a decisive moment for Emu – but for the opposite reason. Greece will continue to receive support from several European Union funds. But financial aid from other EU countries or institutions that amounted, directly or indirectly, to a bail-out would violate EU treaties and undermine the foundations of Emu. Such principles do not allow for compromise. Once Greece was helped, the dam would be broken. A bail-out for the country that broke the rules would make it impossible to deny aid to others.
It seems that quite a number of observers have forgotten what Emu is, and what it is not. The monetary union is based on two pillars. One is the stability of the euro, guaranteed by an independent central bank with a clear mandate to maintain price stability. The other is fiscal solidity, which has to be delivered by individual member states. Member countries are still sovereign. Emu does not represent a state; it is an institutional arrangement unique in history.
In the 1990s, many economists – I was among them – warned that starting monetary union without having established a political union was putting the cart before the horse. Now the question is whether monetary union can survive without such a political union. The current crisis must be handled in such a way as to produce a positive answer. The viability of the whole framework – nothing less – is at stake.
By joining Emu, a country accepts its rules. Greece, moreover, also knew that adopting a stable currency that was not controlled by its own central bank implied a total break with the past. Devaluation of the national currency and an inflationary monetary policy were no longer options. A single monetary policy is implemented by the European Central Bank and it is the responsibility of each country to adjust its economic policies so that this one size fits all.
Participation in Emu brings huge advantages. The benefits of joining a stable economic area are greatest for countries that were unable to deliver such conditions before. Thanks to the euro, Greece has enjoyed long-term interest rates at a record low. But instead of delivering on its commitment at the time of entry to reduce public debt levels, the country has wasted potential savings in a spending frenzy. The crisis with which it is now confronted is not the result of an “external shock” such as an earthquake, but the result of bad policies pursued over many years. Bailing out Greece would reward such behaviour and create moral hazard of a dimension hardly seen before.
In this context, one conclusion becomes obvious: financial assistance for countries that violated the terms of their participation in Emu would be a major blow for the credibility of the whole framework. By its construction, Emu is a “no transfers” community of sovereign states. Transferring taxpayers’ money from countries that obeyed the rules to those that violated them would create hostility towards Brussels and between euro area countries. Among ordinary people, it would undermine a badly needed sense of identification with the great project of European integration.
This moment is a turning point for Emu, and for the future of Europe. Most observers point to the high risks – which cannot be denied. However, any crisis also presents an opportunity. This is a big chance – probably the last for Greece, and others – to adapt fully to a regime of stable money and solid public finances.
For Emu, the crisis represents a final test of whether such an institutional arrangement – a monetary union without a political union – is viable for an extended period of time. Lax monitoring and compromises when it comes to observing implementation of rules have to stop. Emu is a club of states with firm rules accepted by entrants. These rules must not be changed ex-post. Governments should not forget what they promised their citizens when they gave up their national currencies."
Portugal, Spain, Italy and Greece are all in breach of 3% Maastricht crieria budget deficits and 60% national debt to GDP ratios. That is an issue currently shaking the Euro system and is being talked up as a major challenge to EU integrity - even if everyone else in the EU are also in breach of the 3% ceiling for budget deficit ratios. It is not far fetched to point to a North-South EU divide between the self-proclaimed prudent beer-swilling cold-hearted North and an imprudent impudent wine-savouring sunny South, between an iron north and a malleable south? 
Passing our Edinburgh statue to one of my great great grandfathers, The Duke of Wellington (Duke of Douro in Portugal), I was reminded in a Radio 4 discussion about the history of UK national debt, by historian Niall Ferguson that Wellington was nicknamed the Iron Duke not for his defence of Portugal or for victory at Waterloo, but for installing iron shutters on his windows at Apsley House that were regularly being stoned, almost daily, by the mob protesting about economic hardships and his opposition to the Great Reform Bill in 1831. Today the stones are being thrown for similar reasons in the so-called 'Club Med' countries, and the The Guards charging the mob, who were nicknamed the "Piccadilly Butchers", are in today's EU supposedly the Germans. 
FT's Lex looked at the Club Med countries as a group perhaps because they are currently each experiencing street protests, sometimes violent, against budget cuts imposed. some say at the behest especially of 'Iron' Germany, to make them and all other fiscal recalcitrants comply with Maastricht deficit rules, that Germany itself is marginally in breach of? Two centuries ago, to help balance its books, the French under King Joseph invaded Andalusia and began the long two and a half year long bloody siege of Cadiz! Let's not indulge economic equivalents, to traduce the idea of the EU as having kept the military peace in Europe, only to replace it with open economic-warfare. The EU runs a modest trade deficit with the rest of the world. If Germany persists in maintaining a substantial export surplus internally and externally to the EU, then it has to live with the fact that many of its EU fellow member states must run deficits and therefore Germany has to buy the deficit countries' bonds to fund the current account imbalances.
German politicians have particularly decried the profligacy of the Club Med states, no doubt mainly for domestic political consumption plus a little leverage at the loans negotiations. Athens politicians complain this is Berlin bullying and the mob and expert commentators agree. FT Lex says, "Amid a rash of strikes in Greece, Spain and Portugal, emotions are running high. Yes, Greece and the other big-spending Club Med countries must tighten their belts. They also need to increase their competitiveness. But to insist, as Berlin has done, that austerity is the only way out for these countries is both unrealistic and untrue. Germany must play a role too." I agree, except this is not yet the time for so-called 'belt tightening'. Much of the anciety is caused by the evidence of Greek sovereignty rating crisis hitting the Euro, example of tail wagging dog, or as Soros would say 'tails' given similar problems in Ireland, Portugal and Spain. 
Greece, Spain and Portugal, less so Italy, have been running large trade and current account deficits for many years. Italy, unlike the others, did not indulge in credit boom growth. In credit crunch terms, Italy has been the most prudent economy in the EU. The ECB has provided loans to support bank aid, abd as can be seen Germany and France have also received support.
Last year, these current account deficits summed to about €127bn, of which trade deficits were €100bn, half of which was due to trade within the eurozone. The 4 countries shrunk their deficits significantly in 2008 and 2009's recession. 
Germany's advocacy of fiscal austerity may be merely political grandstanding or a genuine concern that market confidence is more important than economic realities - whichever? Even germany must know that if now the four Club Med countries deflate their way to shrinking their budget deficits to 3%/GDP ratios, this means a €135bn cut, or about 7% of German output - a huge slump in demand, including for imports -see data below. 
