There is now widespread recognition that the euro’s woes are rooted in three mutually reinforcing economic issues: fragility of sovereigns, fragility of banks, and a fragile economic outlook. These three economic issues are coupled with a very inefficient decision-making process at the euro-area level.
When a government gets into trouble, so does the country's banking system (eg Greece), and vice versa (eg Ireland). Troubled banks worsen the economic outlook, because financing of European firms is very much dependent on banks. Weak economic outlook worsens bank balance sheets and reduces the tax revenues of governments, feeding the three-fold crises of banks, sovereigns and growth (eg Spain). Since the crisis has reached Spain and nearing Italy, the risk of a catastrophic crisis has increased, since the “fall” of a large country can lead to meltdown. This in turn reduces investment incentives throughout the euro-area, feeding the three-fold economic crisis even further.
What should be done?
The euro area needs an effective governance framework, which cannot be achieved without a much stronger political integration. In the current largely intergovernmental setup there will always be some governments, parliaments or constitutional courts which will water down or block otherwise useful initiatives. But political integration would require changes in political preferences and changes in national constitutions – apparently a mission impossible at the moment.
For economic growth, first and foremost financial stability is needed in order to restore investors' trust, and credit flows to the private sector. Structural reforms and strengthening the single market would of course help in the medium run, and the minuscule “growth compact” may also have some marginal impacts, but they will not be the main determinants of the euro-area’s economic recovery. Yet even if financial stability is achieved, growth prospects at the euro-area periphery will remain weak due to fiscal adjustments, deleveraging of the private sector, limited credit supply and weak competitiveness positions. As in fiscal federations like the US, federal fiscal stabilisation and investment instruments would also be essential in the euro area, to compensate for the weak state-level demand and to help kick-start growth. This of course would entail temporary transfers between euro-area member states, which is a non-starter, even if such transfers would be temporary and in a few years from now euro-area core countries could also benefit from them, should their growth prospect deteriorate.
For banks and financial stability, after many calls by experts, policymakers suddenly realised that the so called “banking union” is an indispensable element of a monetary union. They called for the establishment of a common euro-area financial supervisory authority at the 28/29 June 2012 Summit. Also, the European Stability Mechanism (ESM) could recapitalise banks directly after the supervisory authority is established. These were major steps. But many issues related to the supervisory authority and to bank resolution remained unclear and there is no timetable. The promises of euro-area policymakers lost their significance.
Concerning sovereigns, Spain could be rescued, even with a full-scale programme, but Italy is simply too big to be saved. Also, the decision of the 28/29 June 2012 Summit to use the ESM more flexibly in intervening in the government securities markets is of almost no use, because the ESM’s resources are severely limited compared to the government bond markets. Should Italy go wrong, there would have to be either massive ECB financing or a kind of Eurobond (joint and several liability of member states), if policymakers wish to head off a devastating financial crisis. I continue to be convinced that the most palatable solution would be a limited Eurobond covering up to 60 percent of GDP, which should be phased in through complete pooling of new issuances, in which a member state can participate until its share in the stock of Eurobonds reaches 60 percent of its GDP. But any kind of Eurobonds would require a brand-new governance framework and a curtailing of national fiscal sovereignty, which does not seem to be possible without political integration.
Unfortunately, the attempts to handle the three-fold economic plus governance crises have not been driven by a strategic vision during the past two years, but by a determination to alleviate the acute market pressures in a firefighting mode, given the major political, legal and other constraints. But the “hoping for the best” strategy may not last long. Its chances of success have diminished with the deteriorating economic outlook of the whole euro-area and the increasing market pressure on Italy.
A version of this article has been also published in La Tribune