Fiscal Dominance Will Persist Because Banking Systems Have Not Recovered

The economic crisis is not over yet. The European Central Bank announced that some banks in the EU will incur further write-offs in 2010 and 2011, amounting to over 200 billion euro. The cleansing of bank balance sheets will obviously take a while. Furthermore, many large European banks dread the publication of stress test reports, which serve only to aggravate the lack of confidence that has seized interbank markets. During the past few weeks, banks have experienced the same syndrome that had manifested itself in the period immediately following the collapse of Lehmann Brothers — a fact also reflected in the interests on these markets. What I am particularly concerned about is the sovereign-debt crisis, as government interventions to rescue financial systems, combined with the effects of the severe economic decline (which has diminished the budget state income), have caused a significant increase of public deficits. Forecasts indicate that public debts will increase considerably during the years to come.

The history of economic crises (see also Carmen Reinharrt and Kenneth Rogoff’s book This Time Is Different, Princeton University Press, 2009) shows that crises were often followed by complex public budget issues and even bankruptcy in the case of some countries. The governments in the U.S. and Europe are obsessed with finding a way to stop economic decline (and resume economic growth), while also keeping public debt under control. There are some observations to be made in relation to the manner in which financial markets react when faced with deepening budget deficits (and increasing public debts). Thus:

• the size of budget deficits is all the more important because the financial/economic crisis is accompanied by a permanent loss in production (which, in its turn, diminishes budget incomes);

• private debts, if considerable, influence systemic risks and become targeted by the people in charge of establishing a nation’s payment capacity;

• large short-term debts worsen liquidity crises when financial markets are frozen; it matters how much of the public debt is held by non-residents (in Japan, the largest part of public debt is held by residents);

• banks’ debts are considered to be “contingent liabilities” of the public budget. This means that some countries, whose public debts are not yet overwhelming, will be watched circumspectly if their banking systems experience problems (for instance, Spain’s public debt was under 53 percent in 2010, but the problems within the banking system were related to the public budget). The fact that governments intervened in order to rescue banking systems meant that the latter received additional explicit and implicit guarantees;

• contagion effects can be very intense if mutual large exposures exist (this is the case of the German and French banks that hold many Greek bonds); the intense contagion effects do not appear only within the European Union (because of its unique markets), but also between the U.S. and the EU.

States have entered an infernal downward spiral. The most rotten financial systems have avoided collapse through state interventions, at the expense of public debts. Governments are forced to raise more money from the financial market, that is, to sell bonds to the banks they rescued. The banks, together with other components of financial markets (including hedge funds and private investment funds), sanction the increase of deficits and public debt through an increase in margin buying (reflected in the evolution of credit default swaps). Banks are an extremely profitable business: they use state bonds as collaterals in order to obtain cheap financing from central banks, while giving out credits at a much higher interest rate. It is only when central banks are buying state bonds directly (as it happened in the U.S. and Great Britain) that governments can finance their deficits cheaply. One should note that, in the EU as well, ECB operations put a stop to the excessive growth of insurance policy rates. On the one hand, governments have all the interest to see banks increase their capital so that they are able to give out credits again. On the other hand, there is tendency for banks to profit from the guarantees offered by governments in order to obtain cheap financing and acquire interests by forcing speculative market trends.

I mentioned above that states have entered an infernal downward spiral. This happened because adopting austerity measures in order to improve public finances is a very different situation from being overwhelmed by the burden of public debt and the threat of a liquidity crisis that could give way to insolvency. There are a few countries within the European monetary union that are threatened by this possibility. Hungary, Latvia and Romania found themselves in a critical situation during the autumn of 2008, although the public debts of Latvia and Romania were not a problem at the time. Economic textbooks mention “fiscal dominance,” a phenomenon that appears when the public budget faces such difficulties that it becomes necessary for the state to break various norms in order to finance the deficits. This happens when monetary policies lose their constitutional and procedural consistency and focus only on adjusting the financing of tax deficits, including by offering special facilities that are equal to printing new money. The last couple of years have been characterized by a fiscal dominance over monetary policies in the EU and the U.S. (this was unfathomable a few years before; I must add that “fiscal dominance” was one of the characteristics of the first transition years in post-communist nations).

Some notes on the functioning of monetary policies in the EU and the U.S.:

• in order to rescue banking (financial) systems, it was necessary to transfer an enormous quantity of resources out of the public sphere;

• large central banks joined the trend of fiscal transfers, which was reflected in their growing balance sheets (the money supply increased everywhere);

• all the attention required by the systemic risk, as well as the need for financial stability, created new roles for central banks (irony has it that if liquidity injections are not absorbed in time, then the seeds are planted for further moments of instability);

• large liquidity injections were boldly made into national economic systems, dominated by a high demand for money (the so-called “liquidity trap” identified by Keynes).

Fiscal dominance will persist, in my opinion, because banking systems have not recovered yet and central banks do not want to raise interest rates before the economic recession has been overcome in a sustainable manner.

There are two levels of fiscal dominance. The first is dictated by the state of the public budget and the relationship between the fiscal policy and the monetary policy. The second level is concerned with the effects that the measures adopted in order to diminish budget deficits have on budget expenses and their structure. If the austerity continues and the economic recovery is fragile, the need for extensive fiscal consolidation measures might entail a massive cutting of public expenses, including investments. For a country like Romania, a dramatic increase of the coefficient of absorption of European funds and a diminution of the squandering and leaking of public money are valid means of reducing the intensity of fiscal dominance on both levels. Generally, if one takes into account the contagion effects and the logic of vicious circles, it becomes essential to capitalize on the economic growth factors that operate from within during this economic crisis.

Daniel Dăianu is an economics professor, former member of the European parliament and Minister of Finances.