Defaulting banks - where will it stop?

[Jan Klimkowski]

For your amusement, the HateMail wants to stick it up the Krauts.....

http://www.dailymail.co.uk/debate/articl...rough.html

How long can PIGS feed at the German trough?

By William Rees-Mogg
Last updated at 7:53 AM on 19th January 2009

In the early months of the current recession, it was widely assumed that the impact on Europe would be less serious than the impact on Britain and America.

It was thought the recession would vindicate the European model of integration and go against what is called the Anglo-Saxon model.

There were even calls for Britain to join the euro.

It would be difficult enough to negotiate British entry to the eurozone at the top of a boom, and quite impossible in the trough of a recession.

However, the recession is the first big test of the euro in its ten-year life. When the euro started to operate, its critics said it was a fair-weather yacht, well adapted to short cruises in sheltered waters, but dangerously vulnerable to the pressure of the high seas.

We then argued there had been several 20th Century crises that would probably have caused any single European currency to break up.

The two World Wars of 1914 and 1939 would have made it impossible to maintain a single currency between the combatants. The Great Depression of the early Thirties forced Britain to abandon the gold standard in 1931.

In 1971, President Richard Nixon’s abandonment of gold convertibility for the dollar marked the end of the Bretton Woods exchange system.

In September 1992, at the Bath conference, Germany refused to lower interest rates, which forced Britain to leave the European exchange rate mechanism (ERM).

There were, therefore, five occasions in the 20th Century in which events caused a rupture of the existing European fixed-rate exchange system.

All of these represented real economic adjustments that could not have been made inside a single currency, or political conflicts that could not be resolved.

The European powers then decided a single currency, with no provision for withdrawal, would force the weaker European countries to make other economic adjustments because the option of devaluation would have been taken away.
To devalue its currency, a country would have to withdraw from the euro, and the departure of even a small European country would create a major political and economic crisis.

The critics foresaw a gradual divergence of the different European economies: that has occurred. German productivity has risen steadily and the costs of reunification with East Germany have been absorbed.

Other European countries, including the so-called ‘PIGS’ – the four problem countries of the eurozone, Portugal, Ireland, Greece and Spain – have been much less successful in maintaining their competitiveness. We shall be hearing much more about the ‘PIGS’, in the same way as we had to learn about sub-prime mortgages.

Some people think there should be two Is or that the I really stands for Italy.

No doubt Italy will, in the end, be a bigger problem for the eurozone than Ireland. I do not like to see the emerging pattern of a North-South divide in Europe, with Italy, Spain, Greece and Portugal suffering from the pressure of an overvalued currency.

Obviously, the deeper the recession, the greater the pressure on the weaker European economies.

The critics of the creation of a single European currency also pointed to a central contradiction.

In the eurozone, the European Central Bank (ECB) is responsible for managing the currency, but the governments of the European countries are responsible for national economic policy.

This is not the same as the arrangement we have in Britain, where an independent central bank sets interest rates.

In a crisis, as we have seen, the Government and the Bank of England co-ordinate their policies. If the Bank of England has a major disagreement with the Government on a critical issue, it is the Government that prevails.
The gap between the powers of the ECB and a national government shows up in the cost of borrowing. We can, therefore, measure the risk of a country leaving the euro in market terms.

Despite the setback last week when a German bond issue was under-subscribed, Germany was able to borrow on a ten-year, euro-denominated bond at three per cent.

France, almost as good as Germany, borrows at 3.47 per cent. The weaker countries pay a higher rate – Greece 5.34 per cent, Ireland 4.73 per cent, Italy 4.40 per cent, Portugal 4.12 per cent and Spain 3.97 per cent.

If there were market confidence that each country would be honouring its commitments inside the eurozone in ten years’ time, the prices ought to be the same.

Greek bonds yield 80 per cent more than German bonds of the same nominal value.

Of course, if the Greeks were to leave the euro their cost of borrowing would be much higher. Europe will fight hard to keep the eurozone together, but the market measures its perception of the risk of default, country by country.

In this situation, almost everything turns on Germany, Europe’s strongest economy.

In 1992, the Germans failed the test. They put the concerns of the Deutsche Bank ahead of the preservation of the ERM. Now Germany’s economy is under pressure.

Germany is a major manufacturer of high-quality heavy engineering equipment. In a recession, it is normal for investment equipment to be hit late, but hard.

For the first year or two, manufacturers are still completing existing orders. Then when the orders run out, customers do not reorder. The latest Berlin report is that the German economy contracted by eight per cent in the fourth quarter of 2008.

Belatedly, the ECB has cut interest rates to two per cent, with an overnight rate of one per cent. But it takes the ECB almost as close to zero as a central bank can get. The next step after zero rates is the printing of money.

The European governments are determined the euro should survive, but they also want their own administrations to survive. If the recession calls for a further stimulus, are they going to give the ECB a printing press?

Would Jean-Claude Trichet, the ECB president, who hates inflation as the devil hates Holy water, be willing to use a printing press if he were given one?