Europe in crisis: acknowledge accountability and keep forging ahead
In this second article on Europe, we look back at the institutional origins of the latest economic and financial crisis. Which, although it originated in the US, has exposed the imbalances specific to Europe in general and to the eurozone in particular.
Under the treaty establishing Economic and Monetary Union (EMU), management of monetary policy is delegated entirely to a central, federal authority, the European Central Bank, which has a mandate to maintain price stability. By contrast, fiscal policy is still the preserve of the member states, which nevertheless have to abide by the rules laid down in the EMU treaty and in the Stability and Growth Pact (SGP). The SGP’s rules were designed to ensure that, once in the eurozone, European countries would pursue policies of fiscal restraint, albeit on a decentralised basis. Further, strict rules governing fiscal policy were established to mitigate the risk of harmful repercussions – so-called negative externalities – from policies that were unsuitable and/or that did not take sufficient account of the costs imposed on the union’s partners. This is important because a government belonging to a monetary union might be tempted to adopt an expansionary fiscal policy, knowing that the resulting costs would be shared among the members. For that reason, fiscal discipline was to be the bond that ensured an appropriate eurozone-wide budgetary stance and sustainable debt paths, on the same basis as the protection of private creditors and the irreversibility of the currency area. This construct, designed to limit moral hazard and hence insolvency, was predicated on the fundamental agreement that a member state could not be bailed out by its peers. But the system was flawed because it omitted a mechanism for resolving a possible debt crisis. Accordingly, one could assume that a bailout was possible, notwithstanding the various treaties, and that a member state’s taxpayers could be on the hook, instead of private creditors. With this implied message the policy created a kind of subsidy, with risk premia converging on sovereign yields and destroying the discipline that markets, too, ought to have enforced. Something else missing from the original construct was an awareness of the risks posed by private-sector debt to public finances.
These arrangements might have been tolerable in an equilibrium situation where all countries enjoyed healthy government finances. But the model was undermined by its original imbalances and limited leeway, making it highly vulnerable to shocks. In the event of a symmetrical shock hitting the entire eurozone, monetary policy could be relied on to stabilise the area, whereas any asymmetrical shocks were to be dealt with at national level, with absolutely no solidarity mechanisms. One key element was missing from this political agreement, namely determining the macroeconomic conditions (growth, inflation and interest rates) for making certain that debts would be sustainable and the non-bailout agreement respected. A core function to ensure macroeconomic stabilisation would have been needed in order to cope, among other things, with common shocks. The ECB is unable to fulfil that role because it is not permitted to stabilise economic activity unless price stability is in jeopardy.
Having been built on these shaky foundations, the eurozone has a history of inertia and complacency. Prior to the crisis, the issue of its unfinished institutional blueprint was never raised. In 2003, when countries were mired in low growth due to the implosion of the internet bubble and Germany was embarking on internal devaluation to cope with the inflationary shock sparked by unification, these rules were seen as a straitjacket. So France and Germany sidestepped them, impinging on the authority of the European Commission and making the supervisory process less effective. This paved the way for an era of fiscal nonchalance, where the windfalls generated by renewed growth concealed a structural deterioration in the public accounts. At the same time, national oversight of banking systems failed to curb a credit cycle fuelled by a common monetary policy that was too accommodative for countries with faster-than-average inflation. The liquidity crisis that followed the collapse of Lehman Brothers in autumn 2008 merely pointed up the limits of the EMU construct. The time bomb eventually exploded, laying bare both the unsustainable imbalances that had built up within the eurozone and the fact that multilateral supervision could do only so much to avoid sovereign insolvencies. It also revealed the absence of alternative adjustment mechanisms capable of supplementing monetary policy and cushioning the effects of this kind of shock. The sole response to the crisis and the debt problem was fiscal retrenchment. This turned out to be ineffective and counterproductive, and had to be backstopped by financial assistance among member states, debt restructuring and a more expansive and interventionist monetary policy.
Significant but partial progress
The initial responses were belated, muddled, piecemeal and uncoordinated. In addition, they modified the initial EMU configuration and thus created uncertainty about how to interpret the treaties. The decision not to allow a member state to default on private creditors, save in exceptional circumstances, meant implicitly that sovereign default was a last resort. But no clear-cut process for bailout or declaration of default was worked out, aside from official assistance coupled with austerity. The uncertainty arising from this blurred framework generated deep mistrust among private-sector creditors and triggered a sharp rise in risk premia on distressed sovereign bonds, thus making the crisis worse. In the case of Greece, it was initially claimed that the country’s sovereign debt was sustainable, and official aid was provided to ensure that private-sector creditors were paid, then to tap the remaining private creditors and ultimately to ease the terms of official aid.
In 2012, for the first time, the European Council addressed EMU’s shortcomings more systematically and coherently. It shunned emergency measures and came up with a comprehensive programme based on four strands: banking union, fiscal union, economic union and political union.
- Banking union provides for single European supervision by the ECB, a single resolution mechanism and fund, and ultimately a deposit guarantee scheme.
- Fiscal union entails tighter budgetary rules, with greater room for manoeuvre in case of cyclical weakness and closer attention paid to public debt paths. Moreover, financial assistance is to be extended through the European Stability Mechanism (ESM), which enjoys preferred creditor status along with additional capital and guarantees from member states. The interest rate on financial assistance under the EMS would be sufficient to cover risk, ensure fiscal discipline and send a signal that the money is a loan and the borrower country still has to meet its obligations. The EMS was designed with the aim of managing financial crises with a limited endowment; for that reason, it should not be seen as a cast-iron safety net that will guarantee the stability of the eurozone. Nevertheless the entire responsibly for reasserting the no-bailout principle rests upon its shoulders. The fiscal union project, like its banking union counterpart, is not fully accomplished but nonetheless represents a big step forward.
- By contrast, progress on economic union and political union has been tardier. The former, which entails recognising the importance of growth, had its first expression in the Juncker plan to kickstart public investment; the latter, which requires more democratically legitimate decision-making, has yet to translate into practical measures.
So, will these developments be a solid rampart against a forthcoming crisis? Not really. If the ECB had not maintained an active presence in the markets, investors would have meted out even harsher punishment for the inadequacies of the EMU project. When political and sovereign risks eventually resurface, those investors will seize the first opportunity to demand either a well-ordered debt restructuring or a guarantee that the environment is favourable to debt sustainability, something that can be achieved only through a centralised mechanism for macroeconomic stabilisation. It is all-important that the technical success of the euro should be turned into an economic and social success. Mario Draghi said last Thursday that the euro was the prerequisite to the single market, without which the EU could not exist. Guaranteeing that growth environment is also the fair answer owed to the citizens of those countries that made major and painful adjustments in the wake of the crisis and equally to people in the countries that have committed resources to enable the eurozone to stabilise. The euro will not be truly irreversible until politicians tackle transparently and responsibly the issue of unfinished EMU.
Paola Monperrus-Veroni, Crédit Agricole S.A. Economic Research Department