Sunday, May 13, 2012

Eurozone - the real issue of half baked integration

As the Greeks contemplate exiting the Euro and the Spanish continue to suffer from not only increased unemployment but also the constant spectre of loss of access to bond markets, one tends to forget some obvious macro features of Eurozone that make it financially no worse than US. And yet, bond investors are piling on US government debt at negative real yields (with murmers of the government looking for ideas to introduce negative nominal yields too!) and shunning most of the Eurozone debt.
They are not wrong!
For one, Greece did default and did it with quite a large margin (nearly half of the face value of the bonds) and nobody "rescued" the bond buyers (other than of course the european banks - which got doles from ECB). Secondly, there is a fundamental problem with Eurozone economies which differentiates them from US.
This is the problem of half-baked integration of the economies. The Euro area is a common currency zone but there is no fiscal integration of the sort seen in a single country. If currency is same but bonds are different for a group of countries, it is likely to produce some difficulties which will not exist for a single currency country.

The obvious remedy to any massive unemployment is not available to Spain or Greece - or for that matter to Germany either. This is the remedy of very loose fiscal policy for a controlled period of time. It needs to be accompanied by domestic banks buying large amounts of government debt and a parallel incentive for everyone to spend rather than save - at least through the crisis. Counter-intuitive as it may sound, this obviously props up aggregate demand and keeps the government funding domestic - thereby reducing dependence on global bond markets. (One reason that i maintain that India's rating by S&P and Moody's etc is utterly useless is that Indian government has no foreign debt to speak of and almost all of its debt is domestically funded, ditto for Japan.)

Eurozone countries' fiscal independence is a mirage though. As shown by North Europe's insistence on the "fiscal compact", any help from north is contingent on austerity - exactly at the time when it hurts the most.

How is US different? For one, it has a single federal government that runs most of its budgets and deficits thus issuing bonds. Also unlike individual Eurozone countries, most of its debt is also funded domestically - and the part that is not i.e. Chinese and other East Asian reserves invested in US GSecs is held for safety and not returns. Lastly, US being a single country can follow the policy of fiscal loosening to prop up demand - without say Nevada or California claiming that they are getting a raw deal in the process (which as a matter of fact some states might be getting - but nobody knows or analyses that). In Europe fiscall quasi independent governements do not want to "fund" some other country's "profligacy" and thus want to control fiscal loosening.

The crux of the matter is - how much will Germany succeed in fiscal austerity imposition before pushing through the fiscal integration. The balance - through inflation and currency depreciation - would be the effective funding the north europeans would have done for the south europeans.