Monday, 20th September 2010
The Rt Hon. John Redwood MP
Gabriel Stein
John Redwood MP discussed the threat to the City of London from the EU's AIFM Directive. Also at this event the respected economic commentator Gabriel Stein talked on the current economic outlook/problems for the euro area, including looking at the history of previous monetary unions and the technicalities involved in leaving the euro
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Rt Hon. JOHN REDWOOD, MP
John Redwood was appointed to the Cabinet in May 1993 when he became Secretary of State for Wales. In 1995 he challenged John Major for the Conservative Party leadership.
In opposition he has acted as Shadow Secretary of State for Trade and Industry (1997-1999) Shadow Secretary of State for the Environment, Transport and the Regions (1999-2000) and Shadow Secretary of State for Deregulation (2004-2005).
He has written widely on Eurosceptic issues, free enterprise and democracy. His publications include; Our Currency Our Country, Stars and Strife: The coming conflict between Europe and America and The Death of Britain?
GABRIEL STEIN
Gabriel Stein is a respected economic commentator and a Director of Lombard Street Research, a leading provider of independent macroeconomic research.
He joined Lombard Street Research in 1991 and together with Brian Reading set up the World Service. He became a Director in 1995. He has written a dictionary of economic and financial terms. His research follows all global trends and Gabriel’s current areas of specialisation are the eurozone, Germany, Poland, Sweden, Mexico, Australia and also the US.
Chairman, ladies and gentlemen. The Capital Gains Tax proposals originally Mr Chairman from the Liberal Democrats were going to be 50% Capital Gains Tax across the board and a lowered threshold from £10,000 to £2,000.
So I think with the help of many people from around the country who wrote in at my suggestion and the suggestion of others to the Treasury, with thanks to those newspapers who soon saw a good campaign and leaped aboard, we managed to alter the proposals, so we kept the £10,000+ tax free threshold, which I think is most welcome. The Government introduced the entrepreneurs’ relief so that you can still set up a business, work very hard and then, when you wish to pass it on to others, keep much more of the hard work you’ve put into it and of course the final rate was 28% rather than 50%.
We also heard the Chancellor of the Exchequer say something which no previous Chancellor has ever admitted, and this is most important for future years when we can revisit this issue. And the Chancellor himself said that he had decided on reflection not to put the rate up above 28% because he did now believe that if you put the rate up too high you would collect less revenue.
So I will be probing and pushing quite hard to try and find out what that optimum rate is because I believe the optimum rate, the inflection point, is nearer 15% than 28% and I think we need to get the Treasury to do a little bit more research and thinking about this in the spirit of the Chancellor’s statement because it would be such a pity not to maximise the revenue from Capital Gains, particularly if maximising it meant taking the rate down again to something that was more generally friendly to investment.
Chairman, I was invited here to talk about the broader picture of Britain’s relationship with the European Union and the impact of European Union legislation upon our economies, our jobs, our incomes, our savings and our prosperity. Time permits only a few comments from this rich and difficult tapestry that has been woven between the United Kingdom and the European Union and I think we need a little bit of perspective coming out of the dreadful credit crunch which dominated our lives and the news media in the period 2008-2009.
If you listen to many of the so called experts and politicians on the continent of Europe, they would tell you that the credit crunch was an Anglo-Saxon phenomenon; it shows you how dangerous capitalism is. To them it illustrated that it wasn’t regulated and that the answer is to them very simple, you need less Anglo-Saxon capitalism and you need to regulate what there is much more stringently and intrusively.
And they went further, there was the bizarre situation where the shares of leading banks were tumbling for the very simple reason that the banks were extremely distressed and would not be able to pay dividends. Some people feared for the very futures of some of those banks, so it was not surprising that a large number of shareholders who had bought bank shares in better times expecting good dividends and safe profits went out and sold them.
But the cognoscenti in the European Union lighted upon people in hedge funds and other more aggressive and active investment management houses, who’d they’d seen selling some bank shares short, and said if they could stop the selling short there would be no problem and the bank shares would go up again or they would stabilise and the problem would go away.
It’s quite difficult arguing with people like that, I mean how can they believe something so transparently foolish. The bank shares were mainly going down because the holders were not getting what they wanted, they were terrified out of their wits, many of them were small savers or the representatives of small savers who needed to sell those shares because they were no longer doing what they wanted, providing stable dividends for their income for their retirement for their nest egg.
But that is the way that some of these people look at the problem. I think some of them probably do understand that there were some people selling bank shares who actually owned the shares and that that was the main reason why bank shares fell and they might even understand that people were selling them for perfectly good reasons at the time.
What I think they were doing is using it as an opportunity, because if you dislike Anglo-Saxon capitalism you particularly dislike hedge funds, private equity, anything that makes people rich and can make people substantial sums of money through financial activities and they saw this as a heaven sent opportunity to say we will now regulate these things more, we will get even with these people, we will bring them down a peg or three.
I think we need to mount a different explanation of why we had that grave and serious banking crisis. Now Tim Congdon is in the room, he’s done a great deal to explain it to people. I’ve done my bit to explain it to people with a daily blog on my website www.johnredwood.com throughout the crisis period and beyond, often talking about aspects of the banking crisis.
And both from Tim’s work and from what I’ve been writing, I think there is one very important common theme which you never pick up from the luminaries in the European Union and the European Government that is this, that this crisis happened in a very regulated industry, not in an unregulated industry and that the crisis happened at least partly because of the actions of the regulators themselves, it wasn’t just the banks and bankers that made mistakes, it was also the regulators and the central bankers.
If you could make a single change to try and prevent such a crisis happening again in the future, I think the change would be to the conduct of central banking, it was the central bankers in America, in Britain and elsewhere who lurched from presiding over the most phenomenal expansion of credit and banking balance sheets we’ve ever seen to the opposite, the most severe deceleration or destruction of banking balance sheets and deposits we’ve ever seen since the 1930s.
And they still don’t seem to understand that they made these mistakes. Even the most insightful of them who now accept that they contributed to mistakes of the bankers in the credit boom, they still don’t accept that they made a mistake the other way by taking the banks down too quickly, by throttling the system of money by keeping interest rates too high, by helping precipitate the very crash they said they were trying to stave off or they feared.
Unfortunately the majority opinion still is informed by the notion that the crisis was brought on by bad bankers, by wicked hedge fund managers, by wrongful private equity specialists and that the answer, the means to prevent any such future crisis must lie in taxing and regulating the aforesaid villains.
And so we are now well into their extensive programme of taxation and regulation across the European Union, some of it being pursued independently by Member State Governments, they’re doing so because they think its popular to attack bankers and politicians always like to find people who are even less popular than they are as a class and it’s a great advantage that bankers apparently poll less well than politicians despite the low poll ratings for politicians, and so this has been an incentive to them to do this. But we also see now at European level the opportunity not being missed, ‘never waste a good crisis’ is often the motto of successful bureaucrats and they see the opportunity post the crisis to come out with a whole raft of new proposals and regulations.
I think Eurosceptics often underestimate the strength of this movement, the tenacity of this movement, how far it has already gone, how complex it now is, how much power now rests behind it and all of this power has been granted to these institutions in the European Union by democratically elected governments throughout the Union and in quite a number of cases by plebiscite of the people themselves.
The British people after all voted yes in 1975. Now I happened to vote no because I took the precaution of reading the Treaty of Rome and the Treaty of Rome was very clearly a document heralding a long journey to political union, which I did not want, and I did not believe those politicians who assured me on platforms that it wasn’t about political union it was just about a common market.
Ever since 1975 I have taken the view as a good democrat must that the British people wanted to be in a common market, that was why they voted for it, and I’ve always argued publicly and privately to try and limit what the European Union is doing to that minimum of things that you need to do to cooperate in a common market and to head off, certainly for our country, the United Kingdom, that much wider range of things you need to do in order to create a more fully integrated European State and Government.
But with the single exception of us winning the battle of the currency we’ve had a lot of reverses on the way and one of the reasons for this is that the British people are not sufficiently exercised about the growing and increasing power of the European Union to vote in any kind of election in a way which would prevent that happening.
We have seen that time and time again, the tribulations have been added to because the Eurosceptic side, confident and cocky that it has a majority, always conspires to run against itself in such a way that it never has a majority. So I’ve had to watch in Parliament for almost 20 years now, where there has been no effective Eurosceptic majority in Parliament to express the view of what may be a Eurosceptic people.
And so we need to be honest with ourselves, this is why we are where we are, lots of people have different remedies for this, lots of people will blame different people for it. I’ve got beyond that, I’m just this evening being a commentator explaining to you where we are and why we are where we are.
If we look at the ambitions of the European Union in this wide ranging area of banking and financial services, I think we should step back a little and realise that the job is now almost completed. The European Union does now regulate all collective investment schemes, does now regulate banks both for their conduct of business and for their solvency, it does regulate insurance companies for their conduct and their solvency, it is about to regulate alternative investments as they are called, hedge funds and private equity and I think they will reach an agreement on that erelong. There will be alleged compromises and victories and sacrifices but there will be regulation because that is clearly the will of the qualified majority, which is all it needs in the European Union on an issue like that to assert power over this particular area of investment activity.
The list of directives covering financial services now covers about three pages and it’s now too long for me to remember them all by name but we all have to make sure that our businesses operate under them.
I’m worried about this multiplication of regulation. Now I am often caricatured and often particularly unfairly caricatured as someone who doesn’t wish to see a regulated banking or financial services industry. That is quite untrue, I’ve always been very clearly on the side of those who believe for example that if a business takes your money or mine and places it on deposit and it co-mingles your money or my money with the bank’s money generally, we do need to have some external regulation to make sure that should you or I want to get our money back again we can get our money back again.
I think it is important to recognise that that is an added level of trust compared with other private sector contracts that we enter into and that it is no bad thing to have some external person or group making some judgements just to lay down some rules of the road.
So I’ve always favoured regulation of cash and capital. The bank does need to have enough cash so that if a lot of us turn up on the same day to get our money back they’re not embarrassed, they can pay out the £10 notes and we can have our money. And they do need to have enough capital so that if they lost quite a bit of money on lending to various categories of people or against various assets, it doesn’t wipe the bank out, that they can use some of their own capital to pay the losses so that they can still pay the depositors back. So I’m quite happy that we should have cash and capital regulation.
What is extraordinary is that at a time when there has been this huge increase in the number of regulators and the levels of regulation, that there is now global cash and capital regulation through the Basel agreements, there is European Union level cash and capital regulation through their directives and other devices and there is very clearly British cash and capital regulation through the FSA set up by Mr Gordon Brown when he was Chancellor of the Exchequer.
But despite these three layers of regulation, most sensible people looking at the state of the banks in 2007 would have said the regulators have fallen down on the job, these banks don’t have enough cash and capital and I think people looking at the situation in 2009 should have looked at the banks and said the regulators have now lurched too far the other way given the situation we’re in, and they are being too touch too soon and they should be tougher when things have started to recover.
So the evidence seems to be ladies and gentlemen, that the more regulators you have involved and the more layers of regulation you have and the more wise men and women who meet to settle these things the worse the regulatory achievement becomes.
Deciding, in the case of the United Kingdom, that maybe four or five banks had collectively overcooked it a bit in 2007, could have been a judgement of one able man, maybe the Governor of the Bank of England would have been a suitable person to do it for example who was in receipt of information and thought about these things but it wouldn’t even have been a full time job.
You didn’t have to read many bank balance sheets to work out whether the British banking system was overcooked or undercooked but very few people read bank balance sheets and sometimes you wonder how many regulators read and understand the high level message of bank balance sheets because they do seem to have missed the main point of these bank balance sheets for about five years running now, which is a matter of some concern.
I remember when Mr Gordon Brown got himself into a position where he thought he should take over some of these banks in the United Kingdom, not something that I think was either desirable or necessary, there were other ways of keeping them going. I think I was the only Member of Parliament who pointed out that in the case of RBS that we would be nationalising a bank whose balance sheet was larger than the national income for a year.
And I could hear the intake of breath from some of my Parliamentary colleagues when I made this point and their first reaction was that John Redwood must be wrong and then their second reaction when they saw I was quite serious and was quoting the numbers was that unfortunately maybe John Redwood was right. And they looked hesitantly towards the Treasury Bench and you could see the Ministers on the Treasury Bench looking down at their toes wishing that I wasn’t making these points and there was no answer forthcoming from the Treasury Bench about why this was a good idea or how we got into this mess or why they thought it was feasible given the very large deficit the state was already running on its own account.
What the Government has now done, mainly the last Government, is to preside over the biggest collapse of a main bank balance sheet I’ve ever seen and the corporate plan agreed with Mr Brown and Mr Darling for RBS, was to take the balance sheet down from 2.2 trillion, that’s 2,200 billion or one and a third times our national income – one and a half times our national income now – to 1.2 trillion in the space of a couple of years. So they decided to halve this bank balance sheet.
And I kept asking the regulators and the Government of the day, the previous Government, what impact they thought this might have on the UK economy and why we were debating the odd billion or two of public spending when surely what mattered was this enormous 1 trillion contraction in the balance sheet of the nation’s biggest asset, the ownership of RBS – not strictly true its our biggest asset because its also got a lot of liabilities to net off but gross it was our biggest asset. And of course there was no answer because they’d stumbled into this as a result of bad central banking and bad regulation.
So what do we do next? Well I think all we can do, those of us who believe that too much regulation and too much tax is destructive of prosperity and enterprise, is to keep renewing our arguments in the sharpest possible terms. I am trying to establish that there is a maximum level, not just for Capital Gains but also for income tax, and that if you go about that maximum level the revenue starts to fall off rather than to increase or that the proportions are no longer as favourable. I want them to try and hit the sweet spot, which I think would be at a lower rate than they are currently set for the highest rates of tax.
We need to come up with the simple phrases that do the job. Remember when we were fighting the battle of the currency, our one successful battle in all of this. The way I used to put it to audiences was very simple; I used to say joining a single currency is like taking out a bank account with the neighbours. I used to go onto say, I don’t know about you but I get on quite well with my neighbours and I invite them around for a drink occasionally, we do the odd neighbourly thing for each other but I’m just not ready to share a bank account with them.
Call me old fashioned or worried but I just had that feeling that if I shared a bank account with the neighbours and I put some savings in it they might go and spend it and I just get the feeling that when I want to put the extension on my house I’d be told that we were already up against our overdraft limit and that we couldn’t borrow anymore and I’d miss my turn to build the extension.
Now the opponents of Euroscepticism who did want and some still want us to be in the Euro, found this a very difficult argument to tackle and they made the wonderful mistake of helping give it credence by trying different attacks upon it. They thought it was an imperfect analogy but the more they tried to prove it was an imperfect analogy the more it lodged it in the popular press and to some extent in the public mind.
And of course it turns out to be a pretty good analogy because when we hit the first phase of the Euro crisis earlier this year we saw exactly how it is sharing a bank account with the neighbours. And the Germans of course still want to believe its not sharing a bank account with the neighbours.
The Germans are still saying we don’t mind that our Greek neighbours and our Spanish neighbours and our Portuguese neighbours borrow too much money and we don’t mind that our Irish neighbours have committed their economy to supporting some large banks relative to the size of their economy, that’s nothing to do with us. Germany doesn’t borrow too much, German credit is very good, these other countries have just got to get closer to German standards, as Gabriel was reminding us.
But of course it isn’t going to work ladies and gentlemen, because if you join a single currency it is one for all and all for one, they are all in it together to coin a more modern British phrase. And we see that that is what is happening.
Now I think Gabriel, it may be that they muddle through for longer because I think the pressure points have already given way and one of the ways that members of the European Union monetary union are now standing behind the weaker members is that they have allowed their European Central Bank now to buy in the bonds of the weaker members, to buy in the loans outstanding for the weaker member governments to try and stop them falling too much. And as soon as you accept that proposition, the European Central Bank belongs to all the members, they are all responsible for it, they now have on their collective balance sheet government debt from around the Union including government debt from the weaker countries.
So they are surreptitiously and gradually being locked into a system where German taxpayers have an interest in making sure that Greek debt doesn’t plunge too far, in making sure that the Greeks are not thrown out of the Euro by market forces and recreate a devalued drachma.
They are also very aware that their banking systems are quite intertwined now and that a lot of their commercial banks own a lot of each other’s so called sovereign debt, the government debt of these countries. And so again the Germans are well aware that up to a point they have to help a rescue for the weaker countries because if they don’t there could be undue pressure on the German banking system.
There is also the point, as Gabriel said, that quite a lot of German thinking now believes that one of the advantages for Germany of the system is a pretty good internal market which they can export to and they probably wouldn’t welcome too many countries pulling out and devaluing even by say 20%, which could make it rather more difficult for Germany.
So ladies and gentlemen, they are just some thoughts on where we currently are. I think we have a big argument to conduct to demonstrate that we were not in an unregulated world when the crisis struck, to demonstrate that the regulators and central bankers have played a big role in the problems that came up, that spontaneously reaching for the legislative cheque book and deciding that more rules and regulations is the way to stave off future problems is not the right approach.
You need a limited amount of effective regulation, not much more clumsy, expensive and sometimes self-defeating regulation and that we still have problems within the Euro area but I think the stronger countries are now up to their necks in it as well as the weaker countries and that we should assume that they’re going to put a lot of political effort into trying to make it work.
And in a way it is in Britain’s interest that it works because it would not help Britain at all if there were a major and disruptive explosion of currencies and finances on the continent of Europe, it could be very disruptive to us as well as being very unpleasant for our neighbours.
So they are just some thoughts to get the questions going.
Thank you very much for a very kind introduction; it’s a pleasure to be here. I don’t think I’ve been to a Bruges Group meeting since I heard Norman Lamont in late 1990 explain where Lady Thatcher, which she then wasn’t yet, was going to remain Prime Minister and it’s a shame that his forecasting abilities there were not perhaps up to scratch.
Let me start perhaps with the bottom line that means that any one of you who wishes to doze off can do so. Europe, the Euro area is headed for a sharp slowdown in economic output. Part of that, not all of it, but part of it is in fact the fault of Germany. Germany is depressing growth in the Euro area because it insists on exporting what is actually a fairly flawed model of growth to the other countries. And part of that problem is also that the Euro area is flawed in its setup.
It will come as no surprise to hear me say that, what you may perhaps be more surprised to hear is that its perfectly possible for countries to leave the Euro area, its perfectly possible for countries in the Euro area to default and if you really want or if one I suppose I should say, really wants the Euro to survive, well its no surprise that you need to move towards a fiscal union, but whatever rules you have you need to stick to them whether they make sense or not. The idea that you can have some countries that are too big to fine is of course a ridiculous one but ultimately the Euro area has to fuse or split and I think its going to fuse but only after it has split, that is to say the countries who never should have been there from the start will leave. So that’s the bottom line.
Now I mentioned that the Euro area is headed for a growth slowdown, it doesn’t necessarily have to be a double dip but the problem with many of the Euro area countries is that their growth rate, their long term sustainable growth rate is so low that they if they don’t achieve that their economy shrinks almost by default. That certainly is the case for Italy and probably for Germany as well.
But why would the Euro area slow down, after all we’ve seen quite strong growth in the last couple of quarters and we get crowing from various Euro area spokesmen about how fantastic they are. And it really boils down to one of the reasons why we were in this crisis in the first place. The world was divided into savers and spenders, or as someone said to me just a couple of hours ago, into ants and grasshoppers. That’s not necessarily wrong, the world is always divided into savers and spenders and the savers ship money off to the spenders who then spend it.
Now we then had a problem in these international capital flows in that in the first year of globalisation, the one that was so rudely interrupted by World War I, international capital flows were based on equity, people invested in other countries. In this time they were based on debt, people borrowed. That was inherently unsustainable because there is no limit to how much you may wish to save but there is of course a very clear limit to how much you can borrow and that limit was probably exceeded in a number of countries.
Now the solution to this is in theory perfectly simple, if the spenders have overspent then they need to start to save and ideally the savers should start to spend. The problem is that the spenders have indeed started to save but the savers have not begun to spend and part of the problem there is that the savers, and in Europe that is Germany and its hinterland, they deeply and sincerely believe that saving is virtuous and spending is sinful. Of course that’s complete rubbish. There is nothing inherently virtuous about either and in fact I would go further and say that the German economic model, which is based almost exclusively on export-led growth in the belief that saving is virtuous, is deeply deeply flawed.
In fact the German growth performance over the past ten years is absolutely abysmal, the German economy has grown by less than about 0.4% per annum on average, which doesn’t really strike me or I would guess anyone in this room as something that we immediately have to imitate.
The other point that needs to be made is that in this division between the ants and the grasshoppers, its not necessarily the decision to spend that was the driver, it wasn’t the case that wastrel Americans or Brits or Irish or Spaniards or Australians etc, lived above their means and therefore needed money to be shipped from the rest of the world, it’s the other way around. The rest of the world or to be specific, Germany, China, Japan and their respective hinterlands decided to pursue a saving surplus and therefore we had to spend it otherwise the world would slump. So they should really be grateful to us rather than lecture us about our wastrel behaviour because if we didn’t spend their savings they would have no growth at all, little though it has been as it is.
Now we overspent, fine, what’s then happened since we’ve decided or since the savers decided not to spend, is that instead the public sector has gone into a deficit, that’s fine, in some countries that has been a massive deficit depending on how well or badly they’ve treated their public sector finances. But it isn’t necessarily a problem. The problem comes when no one wants to spend anymore and that’s where we are at the moment. Everyone is trying to save, that is the same thing as to say everyone is trying to export and exporting by everyone doesn’t actually work, somebody has to do the importing.
You can also ask yourself questions like what’s the point of exporting at all and the answer is there is no point except a very crucial one of earning the money to buy something that someone else produces better or cheaper or that you can’t produce at all. Whereas the German idea is that exports are good in themselves, as if they save the money in a piggybank, but in the real world things don’t really work like that.
The problem is not only this, everyone is trying to save, the problem is also that Germany very much is trying to export to the rest of the Euro area, not just German products but also the German model of fiscal rectitude. But as I mentioned, the German growth record is really not so stellar and the German idea that the public sector should have a surplus means that either, if the private sector also has a surplus, then the country as a whole has one and so you save more than you spend and you have a current account surplus, or the private sector in a country where the public sector has a surplus has to go into deficit. The reason is that saving and investment have to equal.
So far so good, but the problem is the Germans mainly export to the rest of the Euro area, so that means that when the Germans tell the rest of the Euro area you have to imitate our fiscal behaviour, the subtext is but you can’t imitate our export behaviour. So it’s very much a question that Germany is depressing growth in the other Euro area countries.
To put it differently and without all the technical jargon that I’ve been trying to dazzle you with for the past five minutes, Germany’s choice in the Euro area is this, either you buy the products of the other Euro area countries or you bail them out when they have fiscal problems. And the German answer to that has been a resounding neither of the above.
And this brings me over to the issues of the inherent flaws in EMU because this is one of them. Now we all know that EMU aims at political union and I sometimes encounter the question, is the hidden agenda behind EMU a political union and the answer is its not a hidden agenda at all, its perfectly open. E as we all know stands for economic, not European, and Economic and Monetary Union ultimately does mean a fiscal union. it is in fact in my opinion a very honourable aim, I just happen to disagree violently with it and in contrast to the rest of you I have been able to express my disagreement because my own country, Sweden, has had a referendum on EMU and decided not to join as you know.
That doesn’t stop the political parties from saying that we still have to enter the monetary union just before yesterday’s elections which were historic in Sweden. The Liberal Party Leader said that Sweden must join EMU as quickly as possible; we can’t have a banana currency like the Swedish crown. That was said the day before the Swedish crown reached an all time high against the Euro. Oh well.
Now moving towards a fiscal and ultimately a political union, its not only the desire within EMU, actually the history of monetary unions tells us that unless a monetary union is composed of a minnow and a whale – Luxembourg and Belgium, Ireland and the UK from the 1920s to the 70s, Panama and the United States – then ultimately they must move towards a political union because otherwise they do not survive.
There have been previous attempts at monetary union in Europe; there was the Latin monetary union in the 19th century, that broke up. It will come as a great surprise to you that there were inherent flaws from the start, namely the fact that first the pontifical states and then Italy cheated massively under the few rules they had.
There was the Scandinavian monetary union which was more of a true monetary union and which lasted reasonably well but was broken up by World War I. There have been other attempts as well, who remembers the Czechoslovakia after the break-up, the Czechs and the Slovaks in 1993 I think, attempted to maintain a monetary union; I believe it lasted for six weeks although Tim might tell me that I’m wrong on that one.
And so the past is littered with attempts at monetary unions and as I said, unless it’s a whale and a minnow they have to move to a political union and also the history of past monetary unions tells us a few other things. You do need the supranational authority to deal with shocks otherwise the leadership is taken up by the strongest country, which may lack the will or resources to exercise that leadership there(is a clear failure on this issue in EMU.
You need rules, in a way it doesn’t matter what the rules are, I mean the Maastricht criteria make absolutely no sense except that they were invented to keep Italy out and they didn’t work. But whatever rules you have they have to be hard and fast with 100% commitment, once you start cheating on the rules because you’re too big to fine, nobody will obey them anymore, again a clear failure in EMU.
History of monetary unions further tells us that sub-units can default and finally, what is crucial is you must be able to leave, and even more importantly than being able to leave, you must be able to expel countries. This is of course a failure so far in EMU because EMU is presented as the fore ordained path to the future, sort of like the victory of socialism, but fortunately on that score things are changing. What we saw in the spring was very much a German feeling that there might be a crisis but it’s also a god given opportunity to correct the state of affairs that should never have been allowed to happen in the first place, namely the membership of Greece and also Spain, Portugal and Italy in the monetary union.
And so I return to the fact, I think EMU has to fuse if it is going to survive, but there is of course absolutely no way that the German voter taxpayer is going to be prepared to take on the liabilities of Greece let alone Italy. And so ultimately, unless Germany leaves, which is a possibility but unlikely, a number of countries have to leave first. And really the countries that have to leave, as I said, are Greece, Spain, Portugal and Italy and Italy is the prize one. Once that has happened the Euro area may well go forward to political union, if they do good luck to them as long as they don’t ask anyone else to join or rather press anyone else to join, that’s absolutely fine.
However, having talked about what ought to happen perhaps I should spend a couple of minutes on can it actually happen because one of the things we are also told is that this wont happen, its impossible as I said to leave EMU, technically of course its perfectly possible to do so. There are a few hurdles, quite a few technical hurdles of course, but first of all ultimately who is going to stop you if as a country you decide to re-establish your own currency, it is not going to be the Belgium Army elite corps of hairdressers that will be sent to stop you. I’m not joking; they have hairdressers there that are employed by the army.
You do need a few things to happen though. The first is you do need a debate in a country saying should we really remain in the Euro area and you don’t have that really in any Euro country today. The only countries where you have a debate on Euro membership are the ones where people don’t want to join, Denmark, Sweden and Britain.
I don’t think you will see any country voluntarily leave the Euro area as opposed to being expelled in the case of Greece for instance when they default, no country is voluntarily going to leave the Euro area until you have at least a senior serious mainstream politician whose membership in the government of this colour is unavoidable saying we need to discuss if this is in our interest or not. The closest you have to this is in Italy where the Northern League is pretty Eurosceptic but perhaps more importantly, where even Silvio Berlusconi from time to time has been making noises about this.
But conversely, once you get this debate starting, the end game has already begun, you can’t really start to say, well should we or should we not remain in the Euro, that is entirely equivalent or exactly the equivalent of saying in a fixed exchange rate system, we need to discuss whether we should have a devaluation or not. The moment you say that the process starts automatically and one of the reasons for that boils down to some technical issues. If you live in Greece and you hear politicians saying we need to discuss Euro membership, the first thing you’re going to do is withdraw all you money from any Greek bank account you have and deposit it in a non-Greek bank outside Greece. Now what that means is one person can do that but when everyone does that it means that money supply in the country collapses.
Now that needs to be replaced because if banks’ liabilities, deposits, disappear then their assets have to adjust and that would mean calling in all loans for instance which would collapse business. So rather than do that you need somehow to shore up the liabilities and the easiest way to do that is if the government says well we’ll borrow in Central Bank and deposit the money we borrow in the banking system and that shores up the liabilities of the banking system and that’s fine. But in the case of Greece that would involve increasing public debt by about 50% and its already more than 100% of GDP and in the case of Italy you increase public debt by about one third, from 120% odd to close to 160% of GDP. So once you start having this discussion, you’d better move very very quickly.
There’s also another point I wish to mention, this is a bit of jumping from one point to another because time is limited, but why would the other countries in EMU let you leave? Well part of it is as I mentioned, they might actually want to get rid of you. To repeat, Germany never wanted a monetary union that included the Southern European countries and given sufficient guarantees they might be very happy to see them go. Of course it does mean that countries like Greece or Italy leaving would devalue their currencies very sharply, probably by up to 50% and if they do that they might as it were, threaten German competitiveness.
That’s possibly the case, what’s worse is that they would threaten German investors who bought Italian and Greek bonds, but that can be dealt with by having the country in question, Greece, Italy whatever, take the exchange rate risk and promise to honour Euro denominated liabilities and to roll over.
There are other technical issues you need to deal with; you need to switch back to national notes and coins. Personally if I travel anywhere in the Euro area now, when I get change having paid something, I make sure that I don’t get Greek Euros. You can all do the same if you want, look at the coins they will show Greek text on them if they are Greek and look at the bank notes, if the letter Y appears in the serial number tell them you would like another one. By the way if anyone wants to know, K is the serial letter for British Euro notes when we join as they confidently believe we will.
I realise I’ve been spending a lot of time on technicalities but really the long and the short of it can actually be summarised in a few words and I’ve said them once before. Monetary unions to survive need to move to fiscal union. There is no way, and I think we can all sympathise here with the German taxpayer voter, there is no way that the German taxpayer voter will agree to this as long as the Southern European countries are in EMU. So the choice is perfectly simple, either those countries leave and then eventually you can have a monetary union, or ultimately after limping along perhaps for quite a while, EMU will break up.
For those of us who are sceptical about the whole exercise, what is preferable? Well funnily enough I think it would be preferable if you get rid of a few countries and the rest can unite simply because that involves the least amount of turmoil, the least amount of hassle, the least amount of problems in financial markets. And frankly, if they do want to unite, if they do want to proceed to a political union, if they don’t pressure us to join why on earth should we care about it, they are going to lose by it out economically anyway so they are welcome to it, we will benefit.
Thank you very much for inviting me and I hope that this very cursory overview was of some interest to you. Thank you very much.