With the rise of the government bond spread to Germany of AAA-rated euro-area members (Austria, Finland, France and the Netherlands), the euro crisis has moved to a new stage. The issue now is not just if Greece will default, but if there will be a chain of government defaults in several countries and a consequent meltdown of the euro-area financial system, including in Germany. Let me state beforehand: in my view the euro will survive and the crisis will even result in highly beneficial governance changes. But the risk of a disorderly outcome has increased, and finding the right way forward will require far-reaching changes to the euro area – and thus political agreement.
We first need to understand the problems before discussing the cures. Problems were revealed in the pre-crisis period and during the crisis.
The pre-crisis flaws can be summarised as weak governance and incomplete economic integration. I raise four major issues with regard to these. First, the rules-based Stability and Growth Pact failed, resulting in high public debt in Greece and Italy at the start of the crisis. Second, there was a sole focus on fiscal issues – and a consequent neglect of private sector behaviour. This resulted in unsustainable credit and housing booms in countries such as Ireland and Spain and the emergence of structural imbalances, such as high current account deficits and eroded competitiveness. Third, there were no proper mechanisms to foster structural adjustment. Some countries, such as Germany, could adjust within the euro area on their own, but others, such as Italy and Portugal, could not. Fourth, there was no crisis-resolution mechanism for euro-area countries and therefore the euro crisis came as a surprise without any clues about what to do about it.
But the crisis also exposed other serious flaws – and let me raise five main points. First, the national bank resolution regimes and the large home bias in bank government bond holdings imply that there is a lethal correlation of banking and sovereign debt crises. When a government gets into trouble, so does the country's banking system (eg Greece), and vice versa (eg Ireland).
Second, there is a strong interdependence between countries – much stronger than we envisioned during the good years before the crisis. The fall of a ”small” country can create contagion and the fall of a ”large” country lead to meltdown. Italy, for example, cannot be allowed to go bankrupt, because it would bankrupt the Italian banking system, which in turn would melt down the rest of the euro-area banking system through high level interlinkages, and would also have disruptive effects outside the euro area.
Third, the strict no-monetary financing by the European Central Bank/Eurosystem means that euro-area governments borrow as if they were borrowing in a ”foreign” currency. This is because a central bank can in principle act as a lender of last resort for the sovereign, ie print money and buy government bonds (as the Federal Reserve, the Bank of England or the Bank of Japan did during the crisis). While the ECB has also started such a programme, it is extremely reluctant to do this and said (so far) that these operations will remain limited. Lack of a lender of last resort for sovereigns is not a big problem when debt is low. For example, in the US the Federal Reserve does not buy the debt of the states of California, New York, etc, but buys only federal bonds. Even though California has been in deep financial trouble for the past three years, its eventual default would have not caused major disruption to the US banking system. The reasons are that the debt of the State of California is small, about 7 percent of California’s GDP (local governments in California have an additional 13 percent debt); moreover, this debt is not held by banks, but mainly by individuals. But Italy would be a game changer in Europe.
Fourth, there is a downward spiral in adjusting countries, ie fiscal adjustment leading to a weaker economy, thereby lower public revenues and additional fiscal adjustment needs. It is extremely difficult to break this vicious circle in the absence of a stand-alone currency. In the US, the automatic stabilisers, such as unemployment insurance, is run by the federal government, which also invests more in distressed states – but in Europe we do not have instruments that could play similar roles.
Fifth, the current crisis is not just a sovereign debt and banking crisis, but a governance crisis as well. The response of European policymakers has been partial, inadequate and belated, and they have thereby lost trust in their ability to resolve the crisis.
With luck, the EU’s current policy strategy might work. Italy and Spain still can issue bonds on the primary market – although at an interest rate of 6-7 percent. These rates are high, but if they persist just for a limited time, they will not necessarily lead to an unsustainable fiscal position. The new governments of these countries could impress markets, leading to a gradual decline in interest rates. In the meantime the ECB can keep banks afloat, as it has done quite effectively so far, even if bank runs start. But this strategy also runs a serious risk. Markets may decide against buying newly issued bonds from Italy and other larger countries, a situation to which the EU’s current strategy has no answer. In such an unfortunate event one of four scenarios could emerge.
- Immediate default – due to the size and interconnectedness of Italy this would also devastate the financial system beyond the euro area. The very existence of the euro would be at stake.
- External help – from the International Monetary Fund or from an ad-hoc consortium led by China and the US. The recent G20 meetings do not suggest that foreign governments are happy to invest in a seemingly sinking euro.
- Massive ECB financing – this would be the best way to moral hazard, unless it is used as the very last resort before giving up national fiscal sovereignty.
- A kind of Eurobond, ie joint and several liability of all euro-area member states – this would require far-reaching changes to the governance of the euro area.
If we rule out the first option due to its devastating impacts, and the second option as unlikely, then Europeans can chose the third or fourth (or both). The third could be implemented immediately, since it is up to the ECB to decide – and I am convinced that if ever they need to choose between an Italian default and massive intervention, they will choose the latter. Therefore, I think that the euro will survive 2012. But the fourth option would be preferable. In fact, recently, the German Council of Economic Experts came out with a similar proposal that they called the debt redemption fund. Countries would pool their debt above 60 percent of GDP into a special fund, through new issuances, and would pay down this debt in 20/25 years, under a radically reinforced governance structure. This proposal has similarities to Bruegel’s proposal on Blue and Red bonds, whereby the jointly and severally guaranteed Blue bonds would be introduced through new issuances – the major difference is that the debt redemption fund would be temporary.
Therefore, there are options for surviving 2012. But survival will not be enough. The deeper flaws I have discussed before should be addressed. To break the lethal link between banks and sovereigns, a kind of banking federation should be introduced, within which regulation, supervision, resolution, and deposit guarantee are all centralised. A centralised economic stabilisation instrument, ie an investment facility to be deployed only at a time of economic hardship, could also help to break the vicious circle of fiscal austerity and economic downturn that several countries face today. A limited budget is needed for a banking federation and the economic stabilisation tool, but there need not be any increased permanent redistribution within the euro area, and even the core countries, such as Germany, would benefit from these instruments. And the governance framework should be overhauled and centralised decision-making should be strengthened in place of inter-governmentalism, to overcome the flaws that we experienced already before the crisis.
Most of these changes would require significant changes to the EU Treaty, which is a hard job. But we have to choose: if things turn out for the worst, should we let the euro sink in a catastrophic financial crisis, allow money printing to solve our problems, or implement more radical changes for a better functioning euro? My choice, as an EU citizen, is clear.
This column was written on 18 November 2011 for the 2012 yearbook of TREND - Slovak Economic and Business Weekly