Simon Tilford / Nov 2018
Giuseppe Conte. Photo: European Union
What does the political stand-off between Italy and the European Commission over the country’s proposed 2019 budget deficit tell us about the chances of the euro ever challenging the dominance of the US dollar? After all, for many euro advocates, ending the dollar’s ‘exorbitant privilege’ was one of the original objectives of the single currency. And is especially relevant now, given the deepening trans-Atlantic rift over a raft of issues from trade to Iran.
There has been borderline hysteria in some quarters about the proposed deficit of 2.4% of GDP, with talk of how it poses an ‘existential’ threat to the eurozone. There are certainly reasons to object to this budget. There are too many giveaways to groups who do not need or deserve them and not enough investment, for example. But a deficit of this magnitude in an economy that is barely growing is hardly outlandish.
And it needs to be seen in context. Italy has been running among the tightest fiscal policies in the eurozone for many years, contributing to the country’s economic stagnation and low inflation, and in turn, to its high stock of public debt relative to GDP. It is very hard to bring down debt unless an economy is growing and inflation is rising at a decent pace. In short, Italy needs some fiscal stimulus. And providing some should not pose an existential threat to the currency union.
If it does, there is a problem with how the eurozone has been set up as much as with Italy’s public finances. The main reason why Italian borrowing costs have ballooned in recent weeks is because investors fear that the European Central Bank will not be able to stand behind Italian debt, not because investors are concerned per se about Italy breaching the currency union’s fiscal rules. And the rise in borrowing costs risks bringing about precisely the kind of crisis the eurozone wants to avoid by rendering Italy’s debt burden unsustainable, forcing the country into renewed austerity, weakening its economy and worsening its debt dynamics. In short, it risks repeating a pattern familiar from Greece.
Rules are important, but they are no substitute for institutions; that is, a central bank that investors know will, not might, stand behind sovereign debt. And rules are not apolitical and technocratic. Those which the European Commission chooses to enforce reflect where political power lies within the eurozone. There is plenty of sound and fury about eurozone members’ fiscal positions but next to no action on trade imbalances. Yet it is a moot point what has done more damage to the eurozone: fiscal ill-discipline or trade surpluses and the huge excess savings they reflect.
Which brings us on to the question of the international role of the euro. Many Europeans would like the euro to supplant the dollar as the world’s most-used currency. That is, to challenge the sovereignty that the dollar affords the US. The dominance of the dollar enables the US government and private sector to borrow very cheaply in their own currency and to lend long-term abroad, for example through foreign direct investments. Borrowing cheap and lending long (and hence at high rates of return) enables the US to permanently ‘live beyond its means’ without running up too much debt.
Resentment at this privilege is understandable. But many eurozone policy-makers fail to understand why the dollar is so dominant. The US economy is no bigger than the eurozone one. And the eurozone does more trade with the rest of the world than the US. But the US provides the liquid safe assets – in the form of Treasuries and other dollar-denominated assets – that the world wants. Supplying these safe assets means the US running a large current-account deficit with the rest of the world.
If the euro is to rival the dollar, Europe needs far more safe assets and it needs to provide as many of them as the rest of the world wants. But this would require big changes to the structure of the eurozone economy and to eurozone governance.
First, there is currently an acute shortage of eurozone safe assets. One reason is restrictive fiscal policies, as all member-states have targeted reduced indebtedness. Another is the failure to pool sovereign debt risk. The volume of eurozone sovereign safe assets has fallen steeply since 2007. Before the financial crisis, the sovereign debts of all members of the euro were basically seen as safe by regulators, and the outstanding volume was around €4.8 trillion.
Now that eurozone members unable to raise funds on the markets will have to default and restructure their debts, the volume of actual safe assets has fallen to around €4 trillion: that is, the debts of Germany, the Netherlands, Luxembourg, and the slightly less safe ones France, Finland and Austria. Moreover, the ECB has bought over a billion of this outstanding €4 billion as part of its programme of quantitative easing.
Second, being the world’s source of safe assets means being a capital importer, which means running a current account deficit. At present the eurozone is running a surplus of around 3% of GDP, easily the biggest in the world in absolute terms. Put another way, it is exporting an unprecedented amount of capital. The German economy is striking in this regard. It has been growing a decent pace now for several years, yet its current account surplus is stuck at about 8% of GDP. Part of the reason for the size of the country’s external deficit lies with the governments large budget surplus, part is down to the huge savings of the corporate sector and part of it reflects high household savings.
Bringing the eurozone into current account surplus wouldn’t just require major change in Germany, but also an end to every member of the eurozone trying to be a creditor: an end to every country targeting a current account surplus. In some ways, the legacy of the eurozone crisis is similar to that of the Asian crisis: every country wants to be a creditor country. This is unsurprising given how the eurozone crisis was handled. In short order, the debtors made the creditors whole, making it risky to be a debtor. Unless member-states are confident that any future crisis will be handled differently, they will strive to become creditors.
Changing this requires institutions – completing the banking union with a fully-fledged European system of deposit insurance and some pooling of sovereign risks, perhaps through the provision of a supranational guarantee of public debt through the European Stability Mechanism. But this is not going to happen, at least not for the foreseeable future. Indeed, the fact that it is a populist Italian government that is pushing for change makes it even less likely that progress will be made.
Donald Trump or no Donald Trump, the dollar will continue to reign supreme. For the euro to challenge it would require fundamental change to the way eurozone economies and the eurozone are run. Politics will not allow that.