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One area where the Eurozone did manage to achieve convergence is in government borrowing costs.  The Maastricht Treaty, economists argued, had the effect of minimising currency risk premiums among future Eurozone countries over time, and effectively disappeared with the introduction of the euro.  Countries enjoyed investor faith in the euro, which was viewed as a hard currency.  If this is the case, then it stands to reason that if investors were to lose faith in the euro as a hard currency, or that economic fundamentals had not come into line sufficiently to minimise currency or default risk, then borrowing costs should rise.  Unsurprisingly, this is what happened.

Figure 1: Annual average yield on 10-year sovereign bonds, 1995-2012

Source: United Nations, Bloomberg, Europe Economics

In fact, those countries that benefitted the most from joining the euro are precisely those countries that are now seeing their yields rise.  In order, Greece, Italy, Spain, and Portugal saw their borrowing costs fall the most between 1995 and 1999.  Finland, France, Germany, and the Netherlands also witnessed yields on their sovereign debt come down, but less than the GIPS group. 

Core countries benefitted from the reduction in risk premiums brought on by the euro, but it also appears their fundamentals were more in step with what investors prefer, as yields on their debt since 2008 have fallen as well.  That, or they’re the “cleanest dirty shirts” for investors that can’t get out of their euro exposure.

GIPS countries, on the other hand, borrowed at lower rates almost exclusively due to the risk premiums effect of the euro.  As Eurozone members, they allowed their fundamentals to go haywire and drift substantially in the wrong direction away from the Eurozone average.  Now they are, literally, paying for it.

Figure 2: Change in annual average yield on 10-year sovereign bonds

Source: United Nations, Bloomberg, Europe Economics

The hope of the Maastricht Treaty was that economic management principles imposed on countries before joining the Eurozone would minimise differences among national economic structures, allowing for a well-functioning currency union.  Instead, differences persisted, but were largely papered over — by euros.  The sovereign debt crisis exposed lingering differences and began to pull yields of distressed countries towards their pre-euro levels.  Rates on GIPS sovereign debt have fallen recently, thanks in part to economic reforms, and in part to the Draghi Put.  But you can’t fight fundamentals forever.  In the long-term, distressed Eurozone sovereigns, if they wish to remain in the single currency area, will need to continue to bring their economic fundamentals in line with their non-distressed peers to borrow at affordable rates.

The UK and US labour markets have both been in a dreadful state for sometime now.  Unemployment rates on both sides of the Atlantic are nowhere near their pre-recession levels and, even though both markets are showing some signs of improvement, many commentators have become resigned to a "new normal" of higher (non-inflationary) unemployment.

One way of analysing patterns in labour market dynamics is to look at the Beveridge Curve, which plots the unemployment rate against the job vacancy rate (i.e. the number of job openings over the size of the labour force).  Beveridge Curves are typically downward-sloping.  When jobs are plentiful, unemployment tends to be low; when jobs are scarce, it’s harder to find employment.

The Great Recession pulled the UK and US labour markets from the high vacancy, low unemployment end of the Beveridge Curve to the low vacancy, high unemployment end.  The Beveridge Curve for the year June 2008 – June 2009 shows a distinct migration across unemployment-vacancy plot.

Figure 1 UK Beveridge Curve: Jan 2002 - Feb 2013

Source: Office of National Statistics, Bloomberg, Europe Economics

In the UK, higher unemployment has been associated with lower vacancies, as theory would predict.

Figure 2 US Beveridge Curve: Jan 2002 - Mar 2013

Source:  Bureau of Labor Statistics, Bloomberg, Europe Economics

In the US, however, a given level of the vacancy rate today implies a much higher unemployment rate today than it did before the recession.  For example, between January 2002 and May 2008, a vacancy rate of 2.5 per cent was associated with an unemployment rate of around 5.5 to 6 per cent.  From July 2009 onwards, that same vacancy rate was realised where unemployment sat around 8 to 8.5 per cent.  In other words, the Beveridge Curve has shifted outwards.

There are a number of reasons why this can happen, and no one reason can explain the entire shift.  One argument is that there is a structural mismatch between jobseekers and employers in the US.  It might be that the workforce simply doesn’t have the skills necessary to fill the vacant jobs.  If skills aren’t the problem, there could be a geographical separation between where the workers are and where the jobs are.  The relative illiquidity of the post-recession housing market, for instance, could inhibit labour mobility.

Alternatively, the shift could be the result of hold-outs in the labour market.  On the labour supply side, workers, who have been able to claim unemployment benefits for a longer period of time, might be holding out to find a better job.  On the labour demand side, employers could be delaying hiring decisions in hopes that a better candidate will apply or until growth expectations rise.  Workers who are chronically unemployed could find that their skills — actual or perceived — have deteriorated to such a point that employers are unwilling to give them a chance.  A Boston Fed paper argues this is what we’ve seen recently in the US, where, they argue, the Beveridge Curve has shifted outwards only for the chronically unemployed.

Estimated Beveridge Curves using data from the pre- and post-recession observed Beveridge Curves suggest that the US Beveridge Curve has indeed shifted to the right.  It also flattened, indicating additional frictions in the labour market.

Figure 3 Pre- and post-recession estimated linear UK and US Beveridge Curves

Source:  Bureau of Labor Statistics, Office of National Statistics, Bloomberg, Europe Economics

This is markedly different from what we’ve seen in the UK over a similar time period.  Instead of shifting outward, the post-recession estimated UK Beveridge Curve has actually shifted inward, which should indicate an improvement in labour market conditions.  With unemployment stubbornly lingering around the 8 per cent mark since early 2009, however, it would be hard to argue that there have been improvements.  Nevertheless, patterns in the current, post-recession relationship between unemployment and job vacancies don’t seem to have undergone the structural shift we see in the US.

Instead, the primary driver of patterns in the UK Beveridge Curve is a lack of job vacancies to absorb unemployed workers or workers returning to the labour market. 

The UK and US labour markets bottomed out in the summer of 2009.  Since then, UK job vacancies have picked up modestly, growing by roughly 15 per cent to date.  This pales in comparison to the US, which has seen job vacancies increase by around 74 per cent over the same period.

Figure 4 Job vacancies in the UK and the US, Jan 2002 - Feb 2013

Source:  Bureau of Labor Statistics, Office of National Statistics, Bloomberg, Europe Economics

So while the UK and US continue to struggle with unemployment, the underlying causes are distinct.  In the US, there are plenty of vacancies, but a breakdown between the process of matching employers with employees has kept them unfilled.  The anti-clockwise movement in the US Beveridge Curve is typical of post-recession labour market dynamics, and may even point to a future recovery.

In the UK, there has been less of a recent structural shift in labour market dynamics, though evidence suggests there has been in some sectors, notably technology.  Of course, we won’t really know if there’s been a shift in the UK Beveridge Curve until the vacancy rate begins ticking upwards, allowing for a comparison of unemployment rates for the same level of the vacancy rate.  Once this happens, we might see that matching in the UK labour market has broken down as well, as the IMF has suggested.  Nevertheless, the more immediate problem facing the UK — apart from the productivity puzzle, which demands a separate blog post — is not how to slot workers into open jobs, but how to create those job openings in the first place.

A lot of ink has been spilled in recent years on what was once an obscure back-office settlements mechanism.  TARGET2, the Eurozone’s real-time interbank payments system, has been labelled a means to finance current account deficits, a passage for capital flight, and a way for non-Eurozone banks to minimise redenomination risk in the event of a break-up of the euro.  Actually, all three are true.  Identifying the root cause of changes in TARGET2 balances requires a case-by-case analysis.

So how does TARGET2 work?  Cross-border financial flows within the Eurozone are intermediated by national central banks, whose transactions are conducted via the ECB.  TARGET2 acts as the settlement platform for these flows.  This helps maintain the balance of payments identity:

Current Account + Capital Account + Official Settlements Balance ≡ 0

Banks in countries running current account deficits find themselves short of capital due to having transferred customer deposits on its balance sheet to banks in countries with current account surpluses.  Under “normal” times, banks in current account deficit countries can recapitalise themselves by turning to the interbank lending market, effectively borrowing back the capital transferred in the deposit transaction.  This settles the balance of payments.

In times of financial distress, banks might find borrowing from the interbank market too expensive.  Furthermore, the ability to satisfy the balance of payments identity might become strained due to capital flight from distressed countries. 

This is where TARGET2 balances come in.  Banks in current account deficit countries can post collateral at their domestic central bank, which then transfers the banks cash from the ECB.  Sober Look has a simple diagram of this process.  TARGET2 liabilities come in via the “Official Settlements Balance” in the balance of payments identity.

Capital has been flowing out of peripheral European banking systems over the past year.  GIIPS bank balance sheets shrank 3.2% from March 2012 to March 2013, while Cypriot bank balance sheets were over 8% smaller.  Tellingly, in the 11 months from March 2012 to February 2013, GIIPS banking systems contracted 3.3% and Cypriot banking systems only 3.1%.  This means the Cypriot banking system diminished a full 5% — more than it had over the past 11 months — during March’s financial meltdown.  As steep a downturn as this is, the drop would likely have been far steeper without the strict capital control Cyprus imposed on investors.

Figure 1. Total size of MFI balance sheets, Mar 2012 - Mar 2013

Source: Central Bank of Cyprus, Banco de Portugal, Central Bank of Ireland, Banca d’Italia, Bank of Greece, Banco de España, Bloomberg, Europe Economics.

Given the deteriorating capital accounts of Cyprus and the GIIPS countries, their balance of payments can be settled in two ways: cutting the current account or recapitalising with TARGET2 funds.

The traditional route out of a balance of payments crisis is to slash the current account deficit.  To some extent, peripheral Europe has been taking this route.  Since the end of 2008, Spain and Portugal have taken steps to bring down their sizable current account deficits.  Relative to its peers, Italy has managed its current account deficit fairly well; its current account deficit as a per cent of GDP in the last quarter of 2012 was in line with its medium-term average.  Cyprus, however, breaks from this pattern.  True, Cyprus’ current account is nowhere near its recent peak of 20% of GDP, but its consolidation has been rocky.  Furthermore, the Cypriot current account deficit has been ticking steadily upward, both as a per cent of GDP and in raw numbers, since the middle of last year.  Before the euro, Cyprus would have had to dip into its reserves.

Figure 2. Current account deficit as a per cent of GDP, 2006 Q1 – 2012 Q4

Source: Eurostat, Europe Economics

But under the monetary union, Cyprus can instead tap the TARGET2 system, incurring liabilities to the Central Bank of Cyprus and, by extension, the Eurosystem.  Starting around the middle of last year, TARGET2 liabilities as a per cent of total banking assets began to fall in both Cyprus and the GIIPS countries.  They continued to fall in GIIPS countries in the first three months of 2013, but rose, both as a per cent of bank assets and in levels, in Cyprus.

Figure 3. TARGET2 liabilities as a per cent of MFI assets, Mar 2012 - Mar 2013

 
Source: Central Bank of Cyprus, Banco de Portugal, Central Bank of Ireland, Banca d’Italia, Bank of Greece, Banco de España, Bloomberg, Europe Economics

Over the past 9 months or so, GIIPS countries have responded to capital outflows by reducing their current account deficits, while Cyprus has become increasingly reliant on TARGET2 support to keep its banks capitalised.  That’s not to say GIIPS countries didn’t or now don't need TARGET2 largesse to keep their banking systems afloat.  They did, and do.  But patterns in their TARGET2 liabilities and current account deficits might be a template for what we can expect in Cyprus over the coming months.

One thing is certain: the Cypriot capital account is not going to surge upward any time soon.  Going forward, then, Cyprus can either reduce its current account deficit, or become more reliant on TARGET2 capital.  It’s impossible for Cyprus to adjust the current account fast enough to match the speed of capital outflows, even if capital controls will last until September.  In the short-term, I expect Cypriot TARGET2 liabilities, both in levels and as a per cent of banking assets, to continue their ascent.  Over the medium-term, barring extraordinary action from the ECB, Cyprus will probably bring down its current account, as other GIIPS countries have done since their banking crises.

This works out to around 0.03 per cent of UK GDP, so the numbers concerned aren’t enormous.

The political element of these debates overshadows the relatively small, in percentage terms, numbers.

On the one hand, net creditor countries are calling for a cut in one way or another to the European Commission’s proposed €1,025bn budget.  These countries include the UK, Austria, the Netherlands, and Sweden.  Despite calls for shrinking the proposed budget coming from these countries, they still have their own pet projects in it.  Austria, for instance, is critical of cuts to rural development subsidies it receives from the budget.  Similarly, the UK refuses to budget on the size of the rebate on its contribution.

On the other hand, net beneficiary countries, primarily from central and eastern Europe, want to maintain levels of spending.  Poland, a rising star within the EU and seen by many to be leading the “Friends of Cohesion” bloc of 15 countries arguing against cuts to the budget, has taken a particularly strong line against cuts to structural funds dedicated to help central, eastern, and (increasingly) southern Europe “catch up” to northern Europe in economic terms.

A compromise budget submitted by president of the European Council Herman Van Rompuy strikes a balance between the Commission’s budget and the UK’s proposed cuts.  Under the Van Rompuy proposal, the 2014-2020 budget would stand at €973.2bn, high than the UK’s proposed €886bn but still lower than the Commission’s request.  The Van Rompuy plan also cuts CAP spending and decreases Britain’s rebate by as much as 21 per cent.

What happens if there is a veto?

All parties have much to lose if a compromise cannot be found during the budget talks.  Contrary to some accounts, an “EU26” group cannot “circumvent” a UK veto.  Instead, if a budget cannot be approved by all 27 member states, spending in 2014 will be determined by Qualified Majority Voting (QMV). 

QMV does not require unanimous approval by member states.  Under the QMV system, expenditure would be frozen in real terms at 2013 levels (i.e. an increase of approximately 2%, in line with inflation) and EU leaders will have to renew up to 55 regulations on EU spending, which would almost certainly be an arduous affair. 

From the UK’s perspective, this situation is not ideal.  David Cameron wants to freeze EU expenditure at 2011 levels, so the QMV system would entail a larger increase in the UK’s.  This contribution would be partially offset, however, by the UK’s rebate, but other “rebates on the rebate” such as those the Swedes and the Dutch enjoy would expire.

Alternatively, the European Parliament could structure an agreement between itself and EU ministers, but this is unlikely as the Parliament is already facing criticism about democratic legitimacy, which would only get worse if they forced through an unapproved budget.

What are the chances Cameron will veto?

Cameron could certainly veto the budget.  But, given what has been discussed above, it seems unlikely.  Vetoing the budget would earn Cameron some political capital at home – he promised in the House of Commons to get a “fair deal” for Britain – but the reality of a drawn out, cumbersome QMV process may push the prime minister to come to a compromise.  Other EU leaders will also be keen to avoid spending time on QMV when more pressing issues surrounding the future of the Euro remain.

Though the Van Rompuy plan entails a cut to the UK’s cherished rebate, it may be more desirable than resorting to QMV.  Van Rompuy’s plan is also gathering some support from countries with positions close to the UK’s, such as Germany, meaning that the UK might be increasingly isolated in the group of countries demanding a budget cut.

Even if Cameron does not outright veto the budget, he can still influence its shape.  He could, for instance, demand the repatriation of structural funds so that wealthier member states can invest in poorer areas of their respective countries.  He might also push for revising down the current 7 year time span for EU budgets to a 5 year time span.  This would allow the budget to be more responsive to changes in fiscal and macroeconomic conditions.

If Cameron can agree to a budget that caps spending at a level less than the real terms freeze implied by a QMV scenario, he might be able to claim a small victory.  This is because the UK is calling for a freeze at 2011 levels while the QMV freeze would be at 2013 levels.  He could argue that he managed to cut the proposed budget in real terms compared to the last period of the current budget.

What will be the implications for the UK’s relationship with the EU?

The UK has butted heads with other EU member states repeatedly over the last year.  The budgeting process represents something of a fork in the road for UK relations with the EU.  With anti-EU sentiment growing in the UK Parliament, the budget debate acts as a way for the UK to signal its intentions regarding its future in the EU.

If the UK can be a constructive contributor to the budgeting process – advocating for its own interests while ensuring a solution can be found – then these talks can be a way to reassert the UK’s commitment to and influence in European affairs.  It can also show other member states that the UK can be a productive participant in pan-European discussions.  This could improve relations with countries such as Germany, who share many of the UK’s positions and might want allies in discussions on other European issues, such as the Euro. 

On the other hand, by pushing its position, the UK is set to anger some countries with which it has had historically good relations, such as Poland.  The UK will need to be conscious of demands from central and eastern European member states, as their power within the EU is only set to grow.

If the UK vetoes the budget they will likely face considerable scorn from the other 26 member states who will have to dedicate time and resources to the QMV process.  Perhaps more importantly, a veto could act as a signal that Britain is unwilling to compromise on long-term issues affecting the EU, leading other member states to put more faith in a sentiment expressed in the Houses of Parliament recently: maybe it’s better if Britain just leaves.  Even without resorting to this extreme, a veto would still likely move European leaders towards figuring out how to minimise UK involvement on big questions in the future.

Those Eurozone politicians who ludicrously claimed that the crisis was over (see quondam President Sarkozy, as recently as March) have been routed.  Once again the doom merchants are in the ascendancy.   Maybe the Mayans were actually predicting the end of the euro in 2012 not the end of the world.  (I imagine Mayan hieroglyphs are the devil to translate.) 

For my purposes here I will take it that the euro will continue (this is also what I expect).  I will not discuss directly issues around crisis management and short-term fixes — instead I want to focus upon those measures and changes that would be required for a more permanent solution.

The euro’s starting conditions were not thought through.  If we consider a country with relatively flexible labour markets, then any adjustment to changes in demand can be spread across employment and real wage levels even in a low inflation environment.  But if a country has rigid labour markets, then low inflation — and price stability was one of the big wins intended for the euro — is a problem: employment takes the full brunt of the adjustment necessary.  A country like this needs a high level of inflation to adjust real wages.  A major problem then for the Eurozone is continued heterogeneity of labour markets in terms of bargaining.  This also means that adjustment within the Eurozone to differing macroeconomic conditions is far from ideal.  It follows that it was extremely foolish to join inflexible economies into a currency union.  Needless to add many economies within the Eurozone still need deep structural reform. 

Factor mobility

To cope better with economic shocks, greater efficiency in national labour and capital markets is needed to aid price flexibility.  But even in the event of substantial and long overdue structural reforms within peripheral countries it may take a very long time to work their way towards the same competitive level as the more successful Eurozone states.  So, greater cross-border factor mobility is also needed: particular of labour.  This would mean substantial broadening of the recognition of professional qualifications and similar measures.  Germany should show leadership here.

However, even if successful enhanced cross-border mobility could create new problems.  If such labour flows were bilateral (not necessarily contemporaneously but over time) then this would not be a cause of concern, but it is more likely that there will be winners and losers.   Portugal could spend its resources educating its labour force only for it to spend its working life elsewhere. 

Given this perhaps a system of “transfer fees” be introduced.  This would involve the recipient country sharing tax revenues with the host.  This would not last for ever but could act as a mechanism for achieving small fiscal transfers: countries that are booming would attract labour and therefore be obliged to pay money to its exporters.  The likely consequences of this should not be overstated — I imagine that the numbers involved would be fairly small beer for most countries but may be more politically acceptable than the alternatives.

Increasing fiscal sustainability

There is a looming fiscal challenge due to the ageing of societies — and in some cases low birth rates — that puts in potential jeopardy the current basis of healthcare and pension provision.

On pensions there are a number of possible choices beyond the brute increase in retirement age (although that is likely to be necessary too). For example Sweden reformed its pensions, retaining a pay-as-you-go system — in common with much of Europe — but with features that make it akin to a notional defined contribution plan.  In particular there is an automatic stabilising mechanism, such that when liabilities exceed assets benefits are reduced.  This type of adjustment happened in 2010.  The discipline such an approach imposes upon politicians and voters would be a benefit in other countries too (although it may be that those countries likely to benefit most may be least likely to make the change).

More ambitious would be a switch towards own account pensions, with top-ups in contribution for the low paid and, subject to some conditions, non-earners.  Again this would closely define and limit the state’s role and obligations. 

Ideally this could be designed such that it would facilitate cross-border labour mobility: you, your employer and the relevant government could all contribute to your account.  This type of approach is critical to the promotion of bottom-up European integration, driven by (and limited by) the individual- and family-level decisions of its citizens.  The Institutions for Occupational Retirement Provision (IORP) Directive seeks to reduce limitations on such cross-border pensions.  This benefit has been subsumed within the (very important) debate about how prudential rules should apply.

Macro-prudential tools

Macro-prudential tools are now to be part of the arsenal for every central banker.  The case for them is, I believe, even more pressing in the Eurozone — this would be the case even in the case of political union: the Eurozone’s economies are simply too heterogeneous to do without.  The key objective would be dealing with asset bubbles, such as those experienced in the Spanish and Irish housing markets.

Conclusion

None of the above means that political or full fiscal union are required: but new policy strategies are required to stabilise the euro beyond anything done or described so far.  Given their track record to date the idea of Europe’s leaders having the audacity to do what is necessary may be a vain hope.