Blog Post

The summit of survival

The euro area is at crossroads. Although the stress on sovereigns has slightly abated and stock markets have rallied, banks are reluctant to lend to each other, yields on Italian and Spanish sovereign bonds are still high and the situation is extremely tense. The slight improvement in market sentiment came as a response to the […]

By: Date: December 5, 2011 Topic: Global economy and trade

The euro area is at crossroads. Although the stress on sovereigns has slightly abated and stock markets have rallied, banks are reluctant to lend to each other, yields on Italian and Spanish sovereign bonds are still high and the situation is extremely tense. The slight improvement in market sentiment came as a response to the coordinated actions by the world’s six major central banks and to the comments of European Central Bank President Mario Draghi, in which he hinted at further ECB measures after a proper deal on controlling public finances has been reached. There are heightened expectations that the European Summit on 9 December will deliver this deal.

What would the Summit bring? Most likely it will lay down the details of revised operations of the European Financial Stability Facility (EFSF), largely along the lines of the October agreement. More importantly, an agreement could be reached on stricter budgetary surveillance, such as ex-ante control of national budgets before they are submitted to national parliaments, as the European Commission proposed. Legally enforceable rules, through the EU Court of Justice, and more automatic sanctions are also on the table, and the agreements could be enshrined by a change to the EU Treaty.

Would such an agreement be enough? The answer depends on whether the ECB finds it to be enough and being ready to announce new measures. If so, it could pave the way for a gradual improvement in market sentiment, which is a precondition for the euro’s survival.

However, even though structural, and in particular product market, reforms are lagging behind, at present the problem for the adjusting countries, such as Italy or Greece, is not that their new technocratic governments are not sufficiently committed to fiscal adjustment and structural reform. This will likely be the case with the incoming Spanish government as well. The problem is also not that the current rules are not legally enforceable and that sanctions are not applied at the moment. The foreseen agreement could be helpful once we come out of the crisis and reached a sustainable situation.

But we need to come out of the crisis and there are several problems that are not yet addressed. One such problem is that in the Mediterranean countries of the euro area there is a downward spiral, whereby fiscal adjustment leads to a weaker economy, thereby lower public revenues and additional fiscal adjustment needs. It is extremely difficult to break this vicious circle especially for a euro-area member state. In the US, the automatic stabilisers, such as unemployment insurance, are run by the federal government, which also invests more in distressed states. Similar instruments would be needed in Europe, but there has been little discussion in this direction. It is unquestionable that the long-term growth potential can only be boosted through painful domestic structural reforms, but a revival of the short-term economic outlook would be indispensable for coming out of the trap.

Another important direction in which European fiscal integration should head would be a kind of banking federation, within which bank regulation, supervision, resolution, and deposit guarantee are all centralised. That would break the lethal link between banks and sovereigns and make the euro-area financial system more resilient. Germany would also benefit greatly from such an integration, both directly (since about three quarters of the total amount of bank rescue in the euro area has been spent in Germany and German banks may need support in the future as well) and indirectly (through reduced risks in German bank exposures to other euro-area countries).

A common Eurobond, in particular, a limited one to eg 60 percent of GDP would help in enforcing fiscal discipline and at the same time would also help to break the lethal correlation of banks and sovereigns. It would require far-reaching changes to the governance of the euro area, yet it would be preferable to massive ECB financing.

Unfortunately, these desirable elements of a fiscal union are unlikely to come, at least in the near term. We could only hope that the currently agreed measures, along with further ECB action, would save the euro, because disintegration would be the worst of all possible outcomes. It would bring a catastrophic crisis, in which certain countries could lose, according to calculations by UBS analysts, as much as half of their GDP – and it is not clear-cut if growth would be speeded up from this halved level of output, and if so, how many years it would take to compensate for the lost output. Also, a break-up may lead to severe consequences for the future of the EU.

There is no way, at least in the short and medium terms, to avoid different speeds in economic growth: Mediterranean euro-area members will most likely have much lower economic growth rates, if any, than their northern neighbours. But a similar scenario has happened before: Germany had much slower economic growth from the mid-1990s till the mid-2000s than most southern euro members, and used this time to make its economy more competitive. The coming years should also be used wisely by Mediterranean countries and the euro’s new governance framework could help them design their badly needed reforms. Yet the euro area should also pursue additional desirable elements of a fiscal union.


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