One size fits all Eurozone is set for total failure

Allister Heath
WHAT a horrible mess. Portugal is broke and begging for a bailout, yet Jean-Claude Trichet, the European Central Bank’s (ECB) president, chose yesterday to hike interest rates by a quarter point. It hasn’t exactly been a good week for the Eurozone, which is facing a slow-motion, ever worsening existential crisis that could end up destroying it and triggering another recession. While the euro was always a flawed idea, its uncontrolled implosion would not be good news for the UK, which would get caught up in the chaos. Already, the UK government’s liabilities could hit £4bn in a Portuguese bail-out, including additional UK IMF contributions. While UK taxpayers are tightening their belts, they are now being asked to bail-out their Portuguese counterparts, who have refused to push through an austerity package. This is wrong and should be resisted.

Given the fragile state of the region, why did Trichet hike rates? Simple: the ECB’s mission is to stop inflation. The March estimate showed Eurozone prices increasing by 2.6 per cent in March, well ahead of the ECB’s inflation target. The ECB was especially worried about evidence of upward pressure on German wages.

Germany’s economy is booming, with GDP increasing 3.5 per cent in 2010. Yet the Irish economy contracted by 1.6 per cent in the final quarter of 2010 and is forecast to grow by less than one per cent this year. The outlook for Greece is worse: GDP shrunk by 3.9 per cent last year. The situation in Portugal is grim. It makes sense to hike rates in Germany. But it makes no sense to do so in Portugal or Ireland. Because of the euro’s one size fits all interest rates, the periphery countries are being sacrificed.

The creation of the euro also helped contribute to the bubble. During the noughties, the yield premium to compensate for the risk of investing in euro-denominated bonds issued by a weak country compared with those issued by a strong country kept on narrowing. Investors started to believe that there was a single European government, and that this meant than any debt denominated in euros was safe. It was thus claimed that the single currency had achieved a beautiful free lunch: lower interest rates for all countries, without damaging the credit of strong countries such as Germany. But the low rates in periphery countries, including Spain and Ireland, helped fuel property bubbles. They certainly explain most of Ireland’s problems. In the case of Portugal, as well as Italy, the issue is labour costs: those countries have priced themselves out of global markets. The only solution is to do what Germany did over the past 15 years and to tighten their belts, reduce their wage costs and boost their productivity. In the past, this could be achieved by devaluing (as the UK is doing at the present time) but membership of the euro rules that out.

The last thing we need is a temporary, bridge loan to Portugal. This would be a recipe for disaster: no conditions could credibly be imposed given the temporary nature of Portugal’s government, and it would be seen as the necessary precursor to a larger financial package. By increasing the amount of debt Portugal is taking on, it would bolster the moral hazard of the whole exercise without solving any problems. The ECB’s purchases of junk sovereign bonds to keep yields under control is equally dangerous: it has already bought €77bn but any haircut would trigger massive losses for the ECB, jeopardising its solvency and requiring additional equity from governments. This would likely trigger a constitutional crisis and force another treaty.

There is only one viable way forward. The UK should refuse to bail out Portugal. The Eurozone should acknowledge that Portugal, Greece and Ireland stand no hope of repaying all their debt. A plan should be devised to allow a controlled, gradual write-off of a large chunk of the debt. Financial institutions ought to be given time to raise more capital; in extremis, the authorities should impose compulsory debt to equity swaps, triggering bail-ins and recapitalising without requiring taxpayers’ cash. The weaker Eurozone countries should then be given a choice: either they push through radical measures to liberalise their economies, balance their budgets and boost their competitiveness – or they are kicked out of the euro. It is high time we stopped throwing good money after bad.

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