Summer 2011 will be remembered as a turning point in the financial and economic crisis that has engulfed the world economy since 2008.
- The US government has lost its AAA rating;
- The Eurozone credibility crisis has spread to Italy and Spain;
- France's credit rating has come under suspicion from markets; and
- The world’s advanced economies seem braced for a new recession.
Within the Eurozone, the visible sign of failure is the trend of widening interest rate spreads that sovereign debtors must pay over the German bunds (Gros 2011). The ban on short selling introduced last week by four Eurozone countries is but the nth sign of a defensive approach that is failing to halt the spreading confidence crisis.
Pressure from the markets
Not surprisingly, financial market pressure has lent strength to German demands that all Eurozone countries put their fiscal house in order. Tough budgetary adjustment programmes are now in place in Greece (with GDP currently falling by 6%), Ireland, Italy, Portugal, and Spain—and even France is moving to tighten its budget.
Structural reform has made progress in all distressed countries, albeit unevenly, but its positive effects on growth will come about at a slow pace—insufficient to offset the impact of deflationary budgetary policies. Meanwhile the ECB has already signalled its intention to revert to a more neutral stance of monetary policy—although recent events have convinced it to put on hold its planned interest rate rise and have now forced the Bank to buy more distressed sovereign paper.
Growth will not help
With all these headwinds, growth is not likely to help much in restoring debt sustainability. This raises the prospect of more requests for official assistance and a further straining of the means of the Eurozone rescue fund—the European Financial Stability Facility (EFSF). Currently it has effectively €250 billion at hand and a cumbersome procedure to raise this to €440 billion. The growth problem has found belated recognition in the recent revision of the Greek assistance programme but, once again, as an exceptional response concerning a single country.
Crisis management has suffered even more from this piecemeal approach and, while broadly moving in the right direction, has continued to run after events rather than take the lead.
The German obsession with sound finance has led to financial assistance based on bilateral loans (as in the Greek package), later turned into loans by the EFSF with funds raised in capital markets but separately guaranteed pro-quota by creditors countries (as in the Irish and Portuguese packages).
The problem with this is that all financial assistance has become creditors’ public debt, and the policy debates on assistance and adjustment programmes have become national debates as if they entailed fiscal transfers—even in cases where this was not true. Unsustainable conditions were imposed on distressed debtors to appease disgruntled taxpayers in creditor countries while financial markets were kept unsure whether sufficient money would be available to roll over distressed sovereign debt. Later on, these unsustainable conditions had to be eased after doing immeasurable damage to the credibility of the rescue operations.
German insistence wreaks havoc
This flawed approach turned disastrous following the German request to establish and write in the rulebook a general principle whereby private creditors would share the losses of debt restructuring. Of course, the principle was never in question. However, it is one thing to manage debt restructuring as the need arises in specific situations, as in IMF practice, and another one to declare in advance that that all financial assistance may entail losses for private creditors. Public discussion of private sector haircuts has prompted large scale sovereign debt sales by investors, pushing up interest rate spreads and extending contagion. In the end, Germany has settled for much less, i.e. the cumbersome arrangements for private sector participation in the new Greek package.
This is where we are: Our leaders have met emerging challenges piecemeal with ever stronger measures that do go in the right direction, but are still unable or unwilling to take the measures needed to stop the avalanche.
The way forward
The solution—assuming we are still on time—boils down to the need to build credible defences around the sovereign debt of the entire Eurozone. In order to succeed, our leaders must make full use of our common currency, the euro.
- The ECB must be empowered to purchase distressed sovereign debt as the need arises, and for as long as needed to bring back stable market conditions.
- To preserve ECB independence and its ability to control monetary conditions, the EFSF must issue Union-bonds on the scale required to relieve the ECB from these purchases when they cannot be reversed in the market. It should also undertake—through an ECB account supported by adequate liquidity lines—all the operations already authorised by the Eurozone Council last July, including debt swaps, secondary market purchases, and loans to member states for bank recapitalisation.
- Its securities must be backed by the several and joint guarantee of all Eurozone member states, thus severing the individual linkages between single loans and national public debt.
By endowing the EFSF with adequate capital and applying tough conditionality to the assistance loans, the chances that the national budget will have to bear losses on assistance loans would be minimal. Tough conditionality also addresses the objection that this will aggravate moral hazard; we can also count on financial markets to prove stricter enforcers of discipline that the European Council has proven in the past.
As unpleasant as all this may sound to German ears, we should consider the alternative. Already in my Vox commentary last December (“The Eurozone in bad need of a psychiatrist”, Micossi 2010) I argued that under the current approach all of Eurozone sovereign debt was bound to become German public debt. Recent developments are confirming that anticipation.
Fiscal union is inevitable
We can no longer avoid some kind of fiscal union if we want the Eurozone to survive. We can do it by reason and with limited impact by turning the EFSF into a full-fledged European Monetary Fund—as Daniel Gros and myself had advocated already in September 2008—or we can do it under duress in a sequence of ever graver crises.
And we must be aware that even all this will not suffice unless we manage to overcome anaemic growth. The European Council has identified the main ingredients of a growth strategy that may work—including the liberalisation of services and enhanced spending in infrastructure for the internal market. They should push forward operational decisions under a fast track procedure capable of signalling to financial markets the renewed determination to lift growth, which they have so far failed to do.
Gros, Daniel (2011), “August 2011: The euro crisis reaches the core”, VoxEU.org, 11 August.
Micossi, Stefano (2010), “The Eurozone in bad need of a psychiatrist”, VoxEU.org, 10 December.