The ‘Fiscal Compact’ Has Not Solved the Euro Crisis

Philip Arestis and Malcolm Sawyer

The Triple Crisis Blog is pleased to welcome Philip Arestis and Malcolm Sawyer as regular contributors. Philip Arestis is the Director of Research at the Cambridge Centre for Economic & Public Policy and Senior Fellow in the Department of Land Economy at the University of Cambridge, UK, and Professor of Economics at the University of the Basque Country, Spain. Malcolm Sawyer is Professor of Economics at the University of Leeds, UK.

In a recent post (19th December 2011) we argue that the recent ‘fiscal compact’ agreed upon by the European Union (EU)/European Monetary Union (EMU) at their meeting of 8th/9th December 2011 would not deliver. Now that further details have emerged, it is clear that the situation is even far worse than what appeared to be in the first instance. It is now clear that neither the governments of the EMU countries nor the European Central Bank (ECB) have committed themselves to doing enough let alone satisfactorily. The ECB is not prepared to perform the proper role of any central bank, namely the ‘lender of last resort’ function. EMU governments have not made progress on the ‘eurobond’ idea, whereby the EMU members would share the troubled economies burden of debt.

The markets had been behaving in an encouraging manner in the run-up to the 8th/9th  December summit; yields on long-term Italian and Spanish bonds fell – two big euro area countries whose yields had already reached levels not seen since the formation of the euro. Since then, yields on these bonds increased initially and fell again after the ECB’s intervention on 21st December 2011, whereby 489.2 billion euros were injected into the euro-area banking system in the form of bank borrowing. This was undertaken through the Long Term Refinancing Operation (LTRO), one of the ECB mechanisms. There were more than 523 banks involved, encouraged by the policymakers of the region, who borrowed the 489.2 billion euros in three-year loans, equivalent to 5 per cent of the euro area GDP; actually a much bigger take-up than had been expected. It is the largest amount provided in a single ECB operation so far. However, this amount is not as big as it might appear since the ECB switched funds from shorter-term facilities; in fact the amount of ‘fresh’ liquidity was only about 190 billion euros. The euro and equities also surged as a result. It was expected that the excess liquidity just mentioned would be used to finance purchases of peripheral euro-area higher yielding government debt, thereby helping to ease their debt crisis. Such optimism, however, never materialised!

The initial enthusiasm of the markets soon waned – Italian and Spanish government-bond yields rose and equities as well as the euro retreated (as soon as the ECB intervened as suggested above). This is not surprising, though, for such measures only help to address the liquidity shortage in the euro-area banking sector, but do not provide new loans to the private sector since banks shed assets in an attempt to abide by the new capital rules expected to commence in June 2012.

There is also the more serious problem that the weak economic performance of most euro-area countries would not allow the necessary demand for credit by both business and consumers to materialise. The relevant experience of the period since August 2007 is very telling on this score; it suggests that banks are expected to hoard the cash, especially so in view of the looming refinancing needs in the first quarter of 2012 and also the gloomy expectations for the year 2012 and beyond. In fact, banks in the euro area had deposited 452 billion euros with the ECB by Tuesday 27th December 2011 (Financial Times, 28th December, 2011), the week after the LTRO operation. Still it is expected that those countries where the economic difficulties emerged from their troubled banking sector, such as Spain and Ireland, would get some help out of this operation.

Interestingly enough, on Wednesday 28th December 2011, 9 billion euros of six-month Italian bonds were sold at 3.25 per cent, down from the euro area record of 6.5 per cent reached in November 2011. Only for the yield to return to its original level on the same day once it became known of the 452 billion bank euro-deposits with the ECB. On the 29^th of December the overall demand for the ten-year Italian bonds was low with the sale only raising 7 billion euros rather than the targeted 8.5 billion euros. As a result the interest demanded by investors on these bonds was above the critical 7 per cent level, which is viewed as unsustainable by the markets, after the auction. But here again the ECB is not prepared to act as a ‘lender of last resort’, thereby does not intervene in government bond markets. This would be an illegal act according to the President of the ECB (see, for example, The Economist, 17 December 2011).

The pledge of 200 billion euros to the IMF by the EMU country-members to deal with the crisis is clearly not enough, but the hope is that other countries outside the euro area would follow. Further, the European Stability Mechanism (ESM) is accelerated into entry as soon as it is ratified by 90 per cent of the member states with capital commitments to it. The objective is now for the ESM to come into operation in June 2012, sooner than what had been planned,  January 2013. The increase, in addition to the 500 billion euros already planned for the ESM, will be examined in March 2012. It is widely recognised that the amounts just referred to would not be enough to cover the borrowing needs of Italy and Spain, if required, over the near future.

Clearly the ‘fiscal compact’ package, as demonstrated in the 19^th of December blog post and the current one, is not promising at all. Under the current economic circumstances, it is economic policies to promote growth that are vital. The ‘fiscal compact’ contains nothing of the required economic policies.

Read this post in Portuguese at INESC.