Once again EU leaders are meeting in an emergency session to stave off impending disaster.
- The Eurozone economy is in recession overall with the economies on the southern periphery plummeting.
- Doubts are growing about sovereign debts sustainability – driven by the vicious spiral of deteriorating bank balance sheets, ballooning potential liabilities from banking rescues, and widening spreads on government borrowings.
The sovereign debt crisis in the periphery has now turned into a fully fledged banking crisis (Padoan 2012).
While all this sounds familiar, the situation this summer is much more precarious than it was in the summer of 2011, and Figure 1 shows; the constellation 10-year government bond yields (spreads over German bonds) is wider now than it was before monetary union.
- It is as if financial markets have already anticipated and discounted Eurozone breakup.
- Temporary respites, as notably in the early part of 2012, have not interrupted a trend of increasing divergence.
These facts are already undermining the credibility of adjustment efforts under way.
Figure 1. Eurozone bonds back to pre-euro levels (10-year government bonds interest rate, %)
Note: Monthly data.
Surely there must be a way to get Europe away from the precipice. In a recent CEPS Policy Brief (Micossi 2012), I discuss the main elements of a realistic and yet incisive policy package, capable of reassuring financial markets and a bewildered public.
A renewed growth initiative
Hope for the future must be restored; a stern and credible announcement that stronger economic growth is a shared goal is paramount. The European Council and member states must tell their citizens that they are ready to take measures to stem the fall in activity and raise aggregate demand. Exclusive emphasis on the supply side, as in the European Council March statement, simply will not suffice.
- Activity is falling more rapidly than expected in countries undertaking tough adjustment programmes;
- This is also dragging down previously healthy ‘core’ economies and pushing the entire Eurozone into recession.
This downward spiral is coming from unexpectedly large austerity-linked recessionary effects stemming from the collective application of policies that might individually be harmless as well as the investment-dampening impact of the spreading banking crisis.
Moreover, one should not forget that a substantial deterioration in competitive positions with respect to Germany was also experienced by all other members of the Eurozone, which remains as a source of deflationary pressures throughout the Eurozone. Adjustment, moreover, has not been facilitated by the strength of the euro, in turn a result of a monetary policy stance by the ECB that is systematically more cautious than that of the US Federal Reserve.
My recommendations include the following:
- To step up implementation of the internal market in energy, transport, and communications (notably broadband);1
- To mobilise all available funds at Community level in support of infrastructure investment for the internal market.2
- To clarify and announce that budgetary deficits due to larger-than-expected drops in economic activity needn’t be offset by further restrictions, as permitted by the revised Stability and Growth Pact.
- In the case of Greece and Spain, in view of the dismal output and employment performance, the Council should ease budgetary targets, which under current economic circumstances are simply unfeasible.
In this context, a greater share of the adjustment burden must fall on Germany through ‘internal revaluation’ and stronger stimulus to domestic demand, lest the correction of imbalances adds further to the deflationary forces already present in the Eurozone.3
Recent fairly generous wage agreements in Germany will help but are not enough; there is also a need to step up support of domestic demand. More aggressive liberalisation of the bloated banking system, network services, especially in energy and transport, and public procurement may provide over time a significant contribution to raising domestic investment and incomes.
All this should not be seen as a concession but must be recognised as part of the obligations undertaken by Eurozone governments with the new procedure for excessive imbalances, although so far the Commission has somewhat shirked its responsibility to apply it even-handedly (European Commission 2012).
Support from the ECB
The growth initiative badly needs the ECB’s support.
- A weakening of the euro-dollar rate into the 1.10 region would be welcome news for Eurozone exporters and economic activity.
Meanwhile, inflation in the Eurozone is receding to the 2% target and is widely expected to fall below it around year end. Thus, strong reasons support the view that:
- The ECB should lower their policy rates to zero and start quantitative easing through purchases of long-term sovereigns.
This action should aim explicitly at capping interest rate spreads as a bridge to calmer financial-market conditions.
Monetary policy matters are not for the European Council to decide; they could, however, be discussed with the ECB President Mario Draghi. The ECB would no doubt feel freer to act, were it less subject to political pressure to exercise restraint from its German and Northern European members.
Bank restructuring and banking union
The immediate cause, as cross-border interbank flows between creditor and debtor countries have shrunk to a trickle, has been the growing concentration of sovereign debt with national banks in crisis countries – facilitated by carry trade operations that banks undertook in a large-scale with ECB LTRO funds to repair their damaged balance sheets.
The vicious spiral between sovereign debt and banking crisis has been compounded by the decision, first taken in Europe by Ireland, and later followed in Spain’s Bankia crisis, to make good all banks’ private creditors and shift the burden of rescues onto the public budget.
A better alternative would have been to use the European Financial Stability Facility (EFSF) residual funds – which are in excess of €200 billion directly to inject capital into Bankia and, if need be, into other Spanish banks running into trouble.
This would have effectively severed the pernicious spiral between the government and banking solvency crises, with immediate beneficial effects on confidence. A non-negligible benefit of using the EFSF would be to avoid creating a new class of super-senior claims on the Spanish Treasury, which would inevitably accelerate the flight to safety of junior creditors.
This approach requires two further conditions.
- Conditionality imposed on banks requiring help should be negotiated directly by the EFSF, with the assistance of the ECB. The ECB should be given full supervisory powers to ascertain their true conditions, verify compliance with agreed restructuring measures and, in case of non-compliance, resolve the bank.
- The shareholders and creditors of banks seeking assistance should take their share of emerging losses.
Managing the debt overhang
The Eurozone’s average debt-to-GDP ratio is no higher than that in other advanced countries, and consolidation efforts have started earlier resulting in a much lower deficit-to-GDP ratio. Despite this, the Eurozone is mired in a unique crisis of confidence. As demonstrated by Paul De Grauwe, this points to a systemic dimension of the crisis that cannot be reduced to profligate behaviour by budgetary sinners but also has roots in flawed institutions of the monetary union itself (De Grauwe 2011).
In synthesis, three main flaws have been made evident by developments since the Greek financial crisis started:
- The system lacked effective safeguards against divergent budgetary policies.
- The single monetary policy has entailed low real interest rates in high-inflation countries and high real interest rates in low-inflation countries, encouraging excessive government deficits and credit growth to the private sector in the former countries and depressing investment in the latter, and financing economic divergences.
- Once the crisis hit, leading to a re-pricing of risks in financial markets, the disconnection between monetary (centralised) and fiscal (decentralised) powers has created a vacuum de facto impeding full use of monetary instruments to meet monetary and financial shocks, and leaving individual members of the Eurozone exposed to brutal pressure by financial markets.
By now it is clear that there will be no lasting remedy to the crisis of confidence, unless all three problems are dealt with simultaneously.
History indicates that a fully functioning monetary union requires a mutualisation of government debts and centralised taxation powers to back up the central bank in case of large financial shocks; an effective balance budget obligation and no-bail-out rule constraining ‘sub-federal’ levels of government; and a central bank free to act as required to confront liquidity and confidence shocks (Bordo et al. 2011).
Not all of this is on the cards today; it can only be achieved within the context of a full federal union, as German Chancellor Merkel is right to point out (and Mr. Hollande would be wise to heed, with full understanding of the implied surrender of sovereignty).
What to do while waiting for political integration
The question determining whether the Eurozone will survive is whether, while setting explicitly for itself the ultimate goal of federal union – which so far has not happened – the European Council can put together intermediate arrangements capable of halting the crisis and restoring trust among its members, as a bridge towards the ultimate goal.
Ultimately, the ECB will act. When push comes to shove, it will have little choice but to intervene as required to stop contagion and the melting down of sovereign and banking markets. However, its task will be haphazard and exposed to enormous risks if it is not able to count on solid agreement between the member states on how to deal with the excessive build-up of sovereign debts.
Thus another keystone in an effective transitional arrangement should be made up by the new economic governance arrangements and the Fiscal Compact. Ratification and full bona-fide implementation of the Compact is an essential component for rebuilding mutual trust within the Eurozone, and therefore should be pursued as a matter of the highest priority and urgency.
The final keystone is some kind of mutualisation of sovereign debts. This is necessary for two reasons: there is an urgent need to narrow Eurozone yield spreads as these are leading to a dynamic of instability, and political support for painful and protracted adjustment programmes cannot survive without stronger signs that sacrifices will bear fruits.
A cursory look at Figure 2 confirms that the issue of economic and political sustainability is a serious one. According to IMF estimates, under current growth and interest rate scenarios, by 2016 the debt-to-GDP ratios of most Eurozone countries will basically not diminish or only do so marginally. The exception is Germany, but even its debt will remain above the 60% ratio inscribed in Eurozone rules. For the others, the average debt-to-GDP ratio for the Eurozone will actually increase. (Greece’s decline is due to its debt restructuring.)
Figure 2. Public debt in selected countries, 2011 and 2016 (% of GDP)
Source: IMF WEO, April 2012.
Limited debt mutualisation: The German Council of Economic Experts’ proposal
This is the most difficult issue since German taxpayers must be convinced that they are not asked to make good the debts incurred by others. The good news is that a proposal that meets this requirement exists, namely the proposal for a debt redemption fund put forth by the German Council of Economic Experts (2011).4
The idea is straightforward. The Eurozone finds itself in an unusual situation due to unusual shocks and unexpected consequences of conventional policy measures. This suggests that the key is to get the Eurozone back to the usual range of debt-to-GDP ratios. We do not need debt mutualisation now and forever; a one-off arrangement could put governments back in control of their fates. Specifically, the proposal is for all sovereign debt in excess of the 60% to be placed in a redemption fund (the debt of nations in bailout programmes would be left out). This ‘mutual fund’ of Eurozone bonds would be bought with 25-year debentures that were jointly guaranteed by all Eurozone members. As the Eurozone’s debt is not, on average, a problem, removing default uncertainty with the joint guarantee would provide an immediate and substantial interest rate relief for the most indebted countries.5 It would also surely be much appreciated by Europe’s prudential savers who are now suffering from seemingly external uncertainty and a risk of large capital losses.
Each country participating in the scheme would continue to service its own debt, pro-quota, until full redemption. To this end, it would have to segregate a specific revenue source from its national budget, under appropriate irrevocable arrangements. After 25 years, all the debt would be paid out and all countries would have a debt-to-GDP ratio at or below the 60% target.
Under this scheme, Germany would shoulder some of the risks of sovereign debt in the periphery – and pay an interest premium for this – but would be fairly secure that it will not have to repay debt incurred by others. The redemption fund would be a temporary device. Capital markets would in all likelihood very much like the debentures issued by the fund, leading to the creation of a liquid and deep market for Eurozone paper. Over time, with progress towards federal union, these securities could be substituted by jointly issued Union bonds of the federation – without any need for debt substitution whereby some countries would be asked to take over the accumulated obligations of others.
Once again the European Council is meeting next week in a make-or-break situation. Playing for time will never provide a solution – things have gone too far for the usual economic self-balancing forces to work. This crisis will not go away until the heads of state and government show a solid consensus on a policy framework capable of:
- Reconciling austerity with growth;
- Dealing with the debt overhang; and
- Ensuring the ECB can provide adequate liquidity support without endangering its balance sheet and independence.
This is not impossible. The package of proposal I have suggested have a good chance of restoring confidence and normal conditions in financial markets.
Bofinger, P, LP Feld, W Franz, CM Schmidt, and B Weder di Mauro (2011), “A European Redemption Pact”, VoxEU.org, 9 November.
Bordo, MD, A Markiewicz, and L Jonung (2011), “A fiscal union for the euro: Some lessons from history”, NBER Working Paper No. 17380.
De Grauwe, Paul (2011), “The Governance of a Fragile Eurozone”, CEPS Working Document No. 346, May.
De Grauwe, Paul (2012), “In search of symmetry in the Eurozone”, CEPS Policy Brief No. 268, May.
Doluca, H, A Hϋbner, D Rumpf, and B Weigert (2012), “The European redemption Pact: An Illustrative Guide”, German Council of Economic Experts, Working Paper 02/2012, February.
European Commission (2012), Report from the Commission, “Alert Mechanism Report. Report prepared in accordance with Articles 3 and 4 of the Regulation on the prevention and correction of macro-economic imbalances”, COM(2012) 68 final of 14.2.2012.
German Council of Economic Experts (2011), Euro Area in crisis”, Annual Report 2011/12, Third Chapter, Wiesbaden, November.
Micossi, Stefano (2012), “An Agenda for the European Council. Feasible Steps to Bring the Eurozone Back from the Precipice”, CEPS Policy Brief No. 274, Brussels.
Padoan, Pier Carlo, Urban Sila, Paul van den Noord (2011), “The euro’s future begins now: Escaping debt traps and moving towards sustainable growth”, VoxEU.org, 19 June.
1An influential strand of thought maintains that infrastructure investment does not improve productivity, mainly based on the US experience of strong growth with poor road and rail networks and dismal public utility services. The European variant has it that Europe already has all the infrastructure that it needs and that further investment would be wasted. This view seems unconvincing. For instance, recent research on a large sample of countries reported in VoxEU (“Fiscal spending and growth: More patterns” by C. Carrière and J. de Melo, 17 May 2012) finds that a shift in discretionary expenditures towards transport and communications “was only observed for fiscal events followed by growth events” (p .2). In many an EU country, including Italy and Germany, over the past decade public investment has been low, sometimes below what was needed solely for depreciation and maintenance. Moreover, the creation of a functioning market for gas and electricity and for digital services requires large, and surely profitable, investment to establish the connections between segmented national markets – investment that was held back by national monopolists and that is a source not only of higher prices and lost productivity gains, but in the case of gas also of a dangerous concentration of supply with a politically unreliable partner such as Russia.
I would add that the European Council should make the member states’ obligations in this area part of the broad economic policy guidelines procedure of Art. 121 of TFEU, with attendant sanctions for failed implementation.
2This should include the immediate start the project bond pilot phase, and raising substantially – by at least €20 billion, which is double the Commission proposal – the paid-in capital of the EIB, thus greatly enhancing its lending capacity for worthy Community priorities.
3In 1999-2007, Germany engineered a significant ‘internal’ devaluation that contributed to its economic recovery and the build-up of its external surplus; subsequently, there has been little change in relative competitive positions within the Eurozone, with the sole exception of Greece and Ireland, as was recalled (see. De Grauwe 2012).
4See also Bofinger et al. 2011 and Doluca et al. 2012.
5The swap of bundled bonds for jointly guaranteed debentures would take place over a transitional, ‘roll in’ period of 3-4 years.