Gianpaolo Rossini - 03/ 2010

The opening months of 2010 have given us a fresh crisis in Greece, as well as the fallout from the crisis in Iceland in 2008. In a referendum on 7 March 2010, Icelanders refused to pay back debt accumulated with Great Britain, the Netherlands and other countries. The result has had repercussions, and puts a distance between the island and European integration, which only two years ago seemed just around the corner. In Greece, the Papandreou government is tackling the placement of state bonds which have registered a loss of trust and are yielding interest rates that are 3% higher than their German equivalents. Rich rewards for risks being taken by investors, most of whom are foreign. It is a heavy further drain on an already difficult situation with public accounts and hefty foreign debts, and one that showcases the flaws inherent in the Economic and Monetary Union (EMU). Greece and Iceland may be distant geographically, but are in fact closer than they seem. Iceland wants into the euro and the EU. Culturally European, it is a tributary of the Greek culture which shaped our thought and material life. But the similarities run deeper, due also to the global financial downturn. In 2008, Iceland's public accounts glow in the light of Maastricht and the country is a model economy seeking admission to the EU and feeling more virtuous than many who are already part of the game, such as the south-shore PIGS. In a report published at the end of 2006, Columbia University's Frederick Mishkin and the University of Iceland's Tryggvi Herbertsson sung the praises of the Viking island. Gross public debt at just under 10% GDP and “a situation that other European countries would be thrilled to have [...]. [Iceland] has a fully funded pension system. The United States, Japan and the countries in the EU would all love to be in Iceland's shoes. [...] Although we believe that the banks' reliance on external financing poses the biggest risk to the system at the moment, we firmly believe that Iceland will not be the next credit event”. Superficial comments from someone who had a brush with the Nobel prize, comments which are to ring false in 2008 when the storm breaks and Iceland sinks. It is saddled with foreign debt three times its GDP, debt which unstable markets refuse to hold because it is not sustainable. The spectacular collapse engulfs Icelandic banks, whose liquid assets evaporate overnight to the point that cash is no longer available from the ATM machines. Economists failed to spot Iceland's financial fragility, blinded as they were by its Maastrichtian virtues. Yet, over the last twenty years there have been repeated systemic upheavals invariably linked to weaknesses in foreign accounts. From the Tequila crisis in 1994, to Asia 1997, Russia 1998, Brazil 1999, Argentina and Turkey 2001, foreign accounts have been a fuse sparking successive explosions that have rocked currency exchange, the banking system and public accounts. While a meltdown originating in public accounts has been seen just after global wars. Let's try to understand more clearly. A country has negative foreign accounts and builds up foreign debt when it spends more than it produces, and therefore accumulates debt with the rest of the world. A negative balance in public accounts happens when the public sector revenues are smaller than public expenditure. Japan and Iceland are two useful examples. The former has had a foreign surplus for decades and is the second largest holder of US bonds, despite a public debt which is almost twice the GDP. The descendants of the samurai are compulsive savers. Not only do they finance their own enormous public debt, but also part of the USA's, and can enjoy substantial foreign credit. If they decide to cut public debt, no sacrifices will be needed because although each Japanese person carries the equivalent of two years' pay in public debt, she also owns the same amount in Japanese state bonds. Thus she will simply use her treasury bills to pay for new taxes aimed at reducing public debt, with no cut of her standard of living. Iceland is at the opposite extreme, with a public sector which is almost debtless. Unfortunately, the whole country, i.e., the private sector, banks, companies and households, has an enormous burden with respect to the rest of the world, because it produces less than it buys. There is no comfortable way out to pay back foreign debt. Slashing standards of living are needed as three years' worth of pay has to be handed over to the British and the Dutch. An unsustainable sacrifice, as the outcome of the referendum indicates. Iceland is a clear example of why Maastricht rules are partial and must be consigned to history. Focusing on public accounts without even mentioning foreign accounts makes no sense whatsoever. Unfortunately, Maastricht is still a watchword for many economists, and continues to reap victims. The latest victim is Greece, which finds itself in the eye of the storm as a result of its financial weakness. Here are the figures: public debt 1.1 times GDP; foreign debt 1.7 times GDP, just half of Iceland's. The press and European officials are focusing on public accounts and the threat posed to Greece by a soaring public deficit (around 13% GDP) in 2009, as well as public debt. But do the threats really come from public accounts? In fact, foreign accounts are far more frightening and they, unfortunately they call for two remedies. The first, which is hard for Greece, is that the country must reduce its standard of living if the international markets become frantic and want their money back. The second, which does not go down well East of the Rhine, is that Germany must increase public and/or private spending in order to reduce its enormous foreign surplus, which is the counterpart of the foreign deficit in Greece, Spain and other countries in the EMU. Greece could in fact get off more lightly than Iceland, given that its financial situation is less dire. However, Greece belongs to the EMU. Iceland doesn't, and therefore can devalue its currency. The advantages of the euro, resulting from smoother finances (a market that is bigger and therefore is more liquid) and lower interest rates, count for nothing in Greece's case because the ECB does not intervene in sovereign bonds markets to eliminate the spread of rates between states. If Greece were to decide whether to enter the euro today, it would opt to stay out. Leaving the euro has exorbitant costs and would trigger a financial crisis in the whole South-East of Europe, affecting Austria, Italy and even mighty Germany itself. As does the Icelandic crisis, the Greek crisis throws into sharp relief the failings of the EMU and the EU. No country will leave the euro for the moment. But if some are regretting having joined, it means that something is not working. But what? Firstly, there is a lack of foreign accounts discipline among EMU countries, in terms of both deficit and persistent surplus. Germany is proposing a European Monetary Fund (FME) to safeguard the orthodoxy of Maastricht, which is however entirely blind to imbalances on the foreign front. It would be a caricature of the IMF, which was created in 1944 to deal with foreign accounts, and has always done so. A continent-wide IMF would demand of Germany that it increase rather than lower its public spending, as it has a foreign credit which is 27% of its GDP and a GDP surplus that is greater even than China's, which is criticised daily by the USA for imbalances in exchange rates and foreign accounts. If it reduces public spending, as the German parliament decided to do on 5 March 2010, in yet another genuflection to the sad philosophy of Maastricht, the weaker countries will have to endure growing and unsustainable financial imbalances, which will affect the healthier economies by chain reaction. Germany's banks may help Greece with one hand, but with the other the German parliament is making adjustment more difficult not only for Greece but also for the whole of Europe. Secondly, the emphasis on public accounts and the urgency to cut public deficit are unwarranted. Spending must continue to be pushed to avoid economic depression destroying further human and physical capital. Lastly, ECB policy is too rigid. It does not touch the state bond markets. However, it did purchase low quality bonds in 2008 and 2009. Now it is allowing spreads between euroland member bonds to grow, making adjustment a Sisyphean task for Greece and other countries. Furthermore, it causes the euro to become overvalued, Europe to become deindustrialised and imbalances inside and outside the EMU to spiral, as they become sustainable only in Germany and the Netherlands. The ways to restoring some lustre to Europe's institutions are many. Maastricht discriminates between saints and sinners on erroneous grounds that lead to dramatic situations like Iceland's. One hopes that Greece does not become the next victim of mistakes that get repeated.

Gianpaolo Rossini (University of Bologna)