One of the most striking moments in the euro crisis saga was when European elites forced Silvio Berlusconi to leave office in favour of unelected Mario Monti. This was possible because Italy is a member of the euro area, and is therefore uniquely vulnerable to capital flight and bank runs.
At first blush, the bloodless coup in Italy seems like a good reason to stay out of the monetary union, for those who still have the choice. But we recently attended a fascinating conference hosted by the Centre for European Reform where some argued the European Central Bank’s veto over elected politicians is a feature, rather than a bug.
In this line of thinking, the ECB is a constitutional safeguard that could have prevented the kind of creeping authoritarianism that’s taking place in Hungary and Poland. Countries committed to remaining outside the euro, including Hungary and Poland (but not Sweden, for some reason?), have therefore declared themselves “rogue states”, according to this view.
If this were true, it would be an intriguing justification for the single currency: the euro doesn’t promote economic integration and it shrinks the supply of safe assets, but it does protect freedom. Unfortunately, this defence doesn’t work. For better and for worse, monetary union and sovereignty can be perfectly compatible for any government determined to maintaining an independent course.
The ECB’s power over member states comes from two essential features of the monetary union:
- National governments no longer issue safe assets
- Bank accounts in foreign countries can be just as good, if not better, than bank accounts in your home country
In countries with their own currencies, such as New Zealand, residents are more or less captive buyers of central government debt and local bank deposits. This is because most people’s spending and borrowing are denominated in local currency. Even though Kiwis import a lot from Australia and China, they would still prefer to have most of their savings in New Zealand dollars. One advantage of this system is that the government’s cost of capital moves inversely with the private sector’s, which makes it relatively easy, in principle, for the state to offset changes in household and corporate behaviour.
People will put up with this arrangement as long as the fiscal and monetary authorities in these countries keep inflation under control and prevent defaults on all assets perceived as “safe”. If governments fail to uphold their end of the bargain, people might move money into foreign currencies or alternative assets, such as gold, but in general the combination of good governance and monetary independence works well.
The euro was created in part because some people in countries such as Italy and Spain didn’t trust their governments to control inflation. They deliberately sacrificed monetary independence in the hope this would compensate for what they believed to be bad governance at the national and local level. Or, put another way, they hoped foreign elites would do a better job running their countries than elected politicians.
Control would be imposed by the threat of capital flight. In the old days, that threat would end with currency devaluation. People who got their money out early would be fine and everyone else would have to swallow some inflation. This wasn’t pleasant, but it didn’t cause Great-Depression-level collapses in employment and output, either. Under the single currency, however… well, that wasn’t agreed in advance. (If there had been clear agreement in advance, there wouldn’t have been a crisis.)
The danger is clear. If you live in Spain, for example, you earn money in euros, you borrow in euros, and you spend in euros. Most of your imports come from other euro area countries. Spaniards therefore have good reason to hold euros in bank deposits and euro-denominated bonds as their safe asset, but have literally no reason to hold Spanish bank deposits or Spanish government bonds. At any moment, euro-area creditors could decide they no longer wish to finance a country’s banks and its government. This arrangement is inherently unstable.
The job of a normal central bank faced with this situation is to be the lender of last resort. But the ECB was deliberately constructed to be different from normal central banks. Rather than directly providing emergency loans to banks desperate to replace fleeing deposits, it authorises national central banks to make emergency loans on a case-by-case basis. The ECB has also shown it has little appetite for limiting sovereign credit spreads unless the governing council believes that problems in a particular country threaten outright deflation across the monetary union.
These features give wide discretion for the ECB to provide — or withhold — support on the basis of political considerations. Thus Silvio Berlusconi believes, not unreasonably, that Italian parliamentarians were told his ouster was the precondition for further support for Italian bond prices and banks in late 2011. In mid-2015, Greek politicians found out what happens when ECB policymakers take a position on bailout negotiations. So the discipline and punishment system exists, at least in certain circumstances.
The problem with the idea that the ECB could have stood up for liberalism in Hungary, for example, is that the punishment system can be avoided by a government committed to “self-insurance” with a combination of current account surpluses, fiscal discipline, and bank regulation that would make any country essentially invulnerable to pressure from Frankfurt.
In fact, the Hungarian government already does the things you would expect it would do if it were a member of the euro and keen on preserving its independence from foreign “interference”. Presumably, if it had actually been in the euro, the difference would be one of degree rather than kind.
Since 2010 Hungary has been running ever-increasing current account surpluses:
This wasn’t just because of shifts in private preferences: “macroprudential” regulations played a role. In 2006, about 37 per cent of Hungarian bank liabilities were denominated in foreign currency. By the end of 2016, the share had dropped to 29 per cent, despite the depreciation of the forint against the euro and Swiss franc.
In addition to curtailing FX borrowing, Hungarian regulators also encouraged much higher bank equity capital ratios:
The Hungarian government doesn’t yet run a budget surplus, but it is quite close to doing so. Since 2012, the general government deficit has averaged about 2.3 per cent of GDP, and has been even tighter more recently.
Poland could move in a similar direction, it seems. While the largest Visegrad country doesn’t have a Hungarian-style current account surplus, it has nevertheless moved from a stable pre-and-post crisis deficit of about -5 of GDP to about 0 per cent since 2015. The Polish government has also trimmed its net borrowing sharply. The government there has been in power for less time, but there is no clear reason to think it wouldn’t use similar techniques to “self-insure” against external pressure.
There are good reasons for Hungary and Poland to avoid joining the euro. There may also be reasons why Hungarians and Poles would want to become a member of the single currency. The prospect of political interference from Frankfurt, however, shouldn’t be what swings the decision.
[Update: Adam Tooze points us to this paper from 2014, which makes similar points about how Hungary insulated itself from international pressue through financial regulation and orthodox macro policies.]
Related links:
European leaders seem determined to remake the “global savings glut” on a massive scale — FT Alphaville
Target2 balances reflect euro area’s potential to be better than traditional exchange rate peg regime — FT Alphaville
Greece shows ECB’s stress tests were nonsense — FT Alphaville
