ECONOMY:COUNTRIES LIKE Greece and Spain are experiencing difficulties which are being exaggerated by financial markets. We now know to our cost after the banking fiasco that financial markets are not efficient and do not always lead to equilibrium prices. We also know that they live off volatility; they make their money by churning underlying markets. The original Friedman dictum that markets were inherently stabilising has repeatedly been shown to be false.
Financial market participants would love to destabilise the euro zone because if they could split the euro back into its component national currencies then there would be much greater scope for volatility and speculation. Many years ago Nobel Prize winning economist, James Tobin, proposed a tax on the turnover of foreign exchange traders. The idea behind the Tobin tax was to cool the ardour of the markets and reduce the degree to which they cause damaging volatility.
The idea fell on deaf ears because the largest countries in the world happen to have the largest financial markets – New York, Tokyo, Frankfurt, London, Paris – and these markets account for a substantial proportion of the GDP of those countries. They also provide lucrative employment and consultancy opportunities, especially for members of the establishment. It would require someone with the courage and foresight of Barack Obama to clip the wings of the financial markets; he is one of the few leaders who seems to put Main Street ahead of Wall Street.
Not so long ago these markets were targeting the US because of its twin deficit problem. Now they have turned their attention to the euro zone. At times foreign exchange traders are influenced by interest rate differentials; at other times they seem to believe that real growth rates are all-important in determining whether exchange rates are undervalued or overvalued. They are capricious to say the least. George Soros destabilised sterling in 1992 (Black Wednesday). A handful of London banks forced a devaluation of the Irish pound in early 1993. In these, and many other cases, if the markets are prepared to throw enough money around they will force the underlying asset to fall – or rise – in price. Thus, profit is virtually guaranteed.
Markets are penalising Greece by increasing the spread it must pay on borrowing. But who can really say whether the spread of three or four percentage points above Germany for 10-year bonds is the correct measure of the risk differential? There is no way of quantifying this scientifically. It is quite likely that the markets are attaching a higher weight to the left-wing hue of the Greek government than to its fiscal deficit. In recent years the retail credit markets tried to measure the risk of sub-prime mortgage lending and look at the unholy mess they made of that.
If this were the 1980s and Greece had exactly the same problems, the Greek government would be able to borrow on much better terms. Why? Because there was ample liquidity (petro-dollars) sloshing about the international system back then. In that period 1,400 banks lent to Mexico without doing any risk analysis whatsoever. Banks were queuing up to lend to countries which were in far worse shape than Greece.
Part of the problem today is that, having got it so stunningly wrong in the dot.com boom and again in the banking melt down of 2008, the financial markets are now at pains to show how rigorous they are in their assessment of risk. It is a pity they weren’t as rigorous when it counted.
These markets display an even greater degree of superficiality when they compare Ireland with Greece. Ireland has already taken strong fiscal correction measures equivalent to almost 8 per cent of GDP over the last year and a half. While this may have a deflationary impact on the economy, it is not something the markets worry about. The EU is satisfied with our medium-term fiscal targets. Long-term projections of debt-to-GDP ratios show Ireland in a far better light.
The NTMA has its ducks in a row. It even has a war chest – and is not facing major imminent refinancing of debt. The maturity profile of Irish debt is satisfactory.
Ireland does not have a very large balance of payments deficit and is not therefore in the “twin deficit” bind that Greece finds itself in. Our exports have held up well because of the pharmaceutical sector and our imports have been modest because of the fall in purchasing power. Nor has Ireland engaged in creative accounting; over the years our system of checks and balances has prevented this. There are at least four agencies in Ireland that would immediately question any attempted deviation from best practice.
The Irish government is a right-of-centre one and believes that virtually every section of society should bear the pain of adjustment. They also believe that bank share-holders should be protected as much as possible at the expense of tax-payers. This right-wing approach usually impresses markets.
It is unlikely that there will be riots in the streets in Ireland. In the first place the private sector is no longer unionised to any great degree and the fear of job losses will tend to suppress militant urges. As far as the public sector is concerned there may be work-to-rule practices, but outright strikes seem unlikely. One reason is because a high proportion of public officials are already finding it hard to meet their mortgage repayments; strikes could cause serious financial hardship.
There is absolutely no risk of Ireland defaulting on debt, yet the financial markets see fit to apply a substantial risk premium to Irish bonds. This is wrong-headed. As I argued on a previous occasion ( Innovation, February 2010) the business of sovereign credit-rating should be transferred to a responsible body like the IMF.
Are the financial markets right in their contention that cracks are beginning to appear in the EMU as a whole? It is no secret that there are design flaws in EMU. The single currency was a symbol of political unity and it was brought in for political reasons by Germany and France. Perhaps the more-or-less successful reunification of Germany has lessened this political motivation. If the financial markets believe this to be the case then they will have greater reason to target the weaker countries in the hope of destabilising EMU. This may be the last chance they will have to pick at the cracks because over the years ahead it is likely that the euro zone will move closer to the ideal of an optimal currency union.
The markets may also target the euro currency as it stands but it seems unlikely that they could push it below its equilibrium level for any sustained period of time. Hedge funds can dominate small currencies, but the market in euro is a large one. If ordinary speculators sell euro where do they reinvest? The dollar is hardly an inspiring currency at the moment; neither is the Yen or sterling.
George Soros and others have advocated a euro treasury. Every country has a treasury and a central bank. Now that we have an EMU central bank (the ECB) it makes some kind of sense to have a centralised treasury as well. Soros believes that guaranteeing or injecting equity into banks is a treasury function. He also seems to believe that a centralised treasury could issue bonds which would not have risk differentials because the subscribers would not know whether the money was going to be passed on to a strong or weak member country. While there is something in these arguments, they are not entirely convincing.
In my view the main function of a central treasury would be to transfer resources to members in recession, eg unemployment and social welfare payments. It is this sort of real fiscal federalism that holds the monetary union of the US together. If this system were in place now the weaker EMU countries would not have such high fiscal deficits and the financial markets would have no reason to question the durability of the EMU system as a whole.
If fiscal federalism is not introduced – and it would raise the spectre of a “United States of Europe” – then the euro zone countries may, at some stage, have to allow its weaker members apply to the IMF. Alternatively, the euro zone could organise its own version of the IMF. In a way this has been done on an informal basis before and it seems likely that it will be repeated soon for the Greek economy. Indeed, one can argue that it has already been done in an ad hoc way for the Irish economy. A more formalised approach would have advantages however, including a permanent defence against disorderly financial markets. The latter should also be controlled by improved regulation, a Tobin tax and a more responsible credit-rating system.
