The world was looking for a watershed in Europe. There was one at the European summit last week, but not the one expected: Britain’s isolation on treaty reform was a defining event for the future of Europe, but the agreement to rescue the euro fell short of setting the foundations for stability and growth in the euro area.
Let us begin by acknowledging two positives in the euro decisions. First, there will be significant ammunition at the disposal of the firefighters: the swifter introduction of the European Stability Mechanism (ESM), its temporary coupling with the financial facility (EFSF) already in place, and new resources to the IMF (which are certainly going to be matched by contributions from the emerging world) add up to a serious intervention power. Markets are likely to take notice. Second, there is new emphasis on a more decentralised approach to budgetary responsibility, with national rules and procedures of the ‘golden rule’ kind. If properly designed and seriously implemented, tailor-made provisions for fiscal discipline are likely to be more effective than micromanagement from Brussels. The new set-up may gradually change the role of the EU, from an intrusive yet ineffective watchdog to a guardian of the consistency of national rules. All this is welcome.
There is a snag, however: the questionable premise that strict enforcement of the disciplines of the Stability Pact is the key remedy to the euro area’s problems.
No one can argue about the need to correct the faulty implementation of the Pact and to prevent a repetition of what occurred in 2003 when France and Germany combined forces to block the procedure. But these reforms have already been decided and will enter into force in January. Returning once more and underlining the importance of the three-percent limit and automatic sanctions resembles the famous ‘streetlamp syndrome’, whereby one looks for lost house keys in the light of the lamp rather than elsewhere where it is dark. For three reasons.
The first is that the Stability Pact suffered from design faults as much as faulty implementation. In 2007 Ireland had a balanced budget and Spain had a significant surplus. Four years later, at the end of 2011, Ireland’s debt has risen from 25 percent to 108 percent of GDP, and that of Spain from 40 percent to 70 percent. Tax receipts artificially swollen by the domestic demand boom made the situation appear healthy but they evaporated as soon as the bubble burst. And governments have had to refloat the banks, at a cost estimated at 40 percent of GDP for Ireland. No amount of automaticity will prevent damage such as this in the future. On the contrary, what is needed is a more economic, rather than legal, and a more discretionary approach.
The second reason is related to the perverse interaction between the sovereign and bank crises. In some case, such as Ireland, it is the collapse of the banks which brought the country to its knees. In others, as in Greece, it is the failure of the state which is threatening the banks. The same vicious circle applies everywhere: sovereigns and banks are weakening each other because the banks’ balance-sheets are loaded with the debt of their own government and the government alone bears the burden of any rescue of financial institutions. In the US banks hold little government debt, and when they do it is federal debt. And it is also to the federal level, not New York state level, that Wall Street banks would look for rescue.
In order to put a stop to this interplay which is making the whole of the eurozone fragile, banks must be required to diversify their risk, or be offered paper representing the whole of the euro area (the famous Eurobonds). Responsibility must also be switched to euro-area level for supervising big banks and the burden of cash injections partially mutualised, or the area must be endowed with fiscal powers to this end. However, nothing serious has been done here, other than scaring banks by asking them to mark government bonds to market, in other words to mark down all southern European paper. The upshot is that banks are offloading these bonds in a hurry, which is knocking even more value off them.
The third reason is that the euro is suffering as much from a balance-of-payments crisis as from a budgetary crisis, as Hans-Werner Sinn and others have emphasised. Since 2007 private capital has gradually stopped financing southern European countries and central banks have had to step in instead. This situation is dangerous. It was believed that the difference in balance of payments would disappear between euro countries, but they still exist because mobility is weak and banks remain national. To resolve this problem at its root calls for deeper economic integration. This is not the path being adopted.
If the drug works, it will be because the dose is massive. But the leaders’ prescription is no precision medicine, to say the least.
A version of this column was also published in Le Monde and Handelsblatt.