BERLIN (MNI) – European Central Bank Governing Council member Yves
Mersch said Wednesday that markets are irrationally pessimistic about
the fiscal state of the Eurozone.

“Today, markets seem to be irrationally pessimistic,” Mersch said
in a draft of a speech to be delivered at the European Institute in
Florence. “Even wealthy states with sound economic fundamentals are in
trouble to refinance themselves at reasonable conditions,” he remarked.

Mersch noted that recently Italian sovereign funding costs had been
driven above 5%. The UK by contrast funds itself at 1.6%, although Italy
and the UK are two countries of roughly the same size, wealth and
income, he remarked.

While the Italian public debt, at 119% of GDP, is larger than that
of the UK — at 80% — the Italian private sector has much stronger
balance sheets than the UK private sector, the Luxembourg central bank
governor said.

“This means that the Italian government has stronger private wealth
for potential future taxation than the UK,” he reasoned. “Moreover, the
consolidation plans of the Italian government are far more ambitious
than the British ones.”

On an aggregate basis, public finances in the Eurozone are in much
better shape than in the US, the Governing Council member noted. He said
that the Eurozone as a whole will run a budget deficit of about 4.5% of
GDP this year while the IMF expects a US budget shortfall of about 10%
of GDP in 2011.

Mersch acknowledged that some countries in the Eurozone face a
combination of high levels of indebtedness, budget deficits and weak to
no growth.

“Amid market attacks and the risk of contagion, an increasing
number of economists have already announced the unavoidable breakup of
the euro area. These predictions often share an anti-Euro sentiment and
seem to be in accordance with the naysayers who were taking potshots at
the euro even before its inception in 1999. But they are wrong,” he
said.

Still, the central banker conceded that there is a risk embedded in
the constellation of the Eurozone. “Moral hazard can arise when fiscal
profligacy of one single member state is averaged out by the virtuous
behavior of the majority of the other countries,” he remarked.

“Such an incentive structure would be flawed because it could lead
to unsustainable fiscal policies of individual member states which in
turn would generate negative spillover effects to the monetary union as
a whole,” Mersch said.

“With hindsight, we have to acknowledge that in some countries
fiscal profligacy, weaknesses in the banking sector and deteriorating
competitiveness have been observed. The institutional setup could
neither prevent nor resolve a severe crisis of the magnitude that we are
currently experiencing. Where the instruments and procedures were
available, they were not implemented, were ignored, or watered down.”

Mersch cautioned that “there is a clear risk that the well-founded
desire for improved regulation [of financial markets as a whole] leads
to a too tight corset that ultimately might strangle market dynamics.”

It would be misleading to assume that partial market or regulatory
failure in the past means that the government would always provide
superior solutions, he argued.

–Berlin bureau: +49-30-22 62 05 80; email: twidder@marketnews.com

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