The EU Summit of 21 July 2011 has brought considerable adjustment impulses for the stabilization of the euro-zone. At first sight, the main problem is sovereign debt financing of Greece, Ireland, and Portugal—the three countries that benefit from euro-zone rescue packages—but, in fact, the bigger issue is a series of broader challenges for EU integration and institutional reforms in the euro-area.
The Root Problem: Sovereign Debt Financing in Greece, Ireland, and Portugal.
To a considerable extent, the problems in the crisis countries of Greece, Ireland, and Portugal are home grown, although they appear largely as a similar sovereign debt problem. Moreover, these countries’ crises are partly a result of the U.S. sub-prime crisis and of the transatlantic banking crisis. Taken together, these two factors led to expectations as early as autumn 2008 that risk premiums would drastically increase after the Lehman Brothers shock, which occurred after years of excessive credit expansion and artificially reduced risk premiums.1
The decisions made at the Brussels summit of 21 July are not adequate for stabilization of the euro-zone, as sound new policy principles were not established and traditional key principles of a market economy were not restored. For example, the European Commission or the European Parliament should have sued Ireland in the European Court, as the Irish government has violated key principles of prudential supervision of banks. The spirit of EU integration will die if member countries can violate EU directives—in this case, the banking directive—without fearing any consequences. Greece is a similar case, in which a conservative government produced fake deficit statistics in 2009; only once the new government took office was it revealed that, instead of a 5 percent deficit to GDP ratio for 2009, the country’s true figure was almost 15 percent. The maximum 3 percent deficit-GDP limit of the Stability and Growth Pact was ignored in a shocking way. The president of the European Commission did not even publicly admonish Greece for this scandal. Financial markets concluded that confidence in EU institutions should be weak, with the possible exceptions of the European Central Bank (ECB) and the European Court of Justice. It is also noteworthy that neither the EU nor the OECD countries have achieved consistent reforms—as a group—on prudential supervision and rules that would improve the quality of financial innovations2 so that unsolved problems of the banking crisis, plus government debt problems, overlap.
Financial Reforms of the Euro-area and Germany’s Role in the Crisis
Regarding the Greek sovereign debt problem, many economists in Germany—including the Council of Economic Experts, which shows a poor understanding of key capital market problems—have called for a “haircut” in early 2011. The EU Summit of 21 July, under pressure from the German government, which, along with France and several other EU countries, is among the few countries with a triple AAA rating in late 2011, sought to achieve the reduction through a certain line of reasoning. The summit suggested that private investors accept a 21 percent reduction on the Greek debt (€350 billion sovereign debt), which translates into a €50 billion reduction in Athens’ debt. This figure looks more manageable as it no longer stands at 150 percent of national GDP but, rather, at a more palatable 130 percent.
Germany’s government strongly favored the haircut solution, since getting political support in the German Bundestag seemed to require that policymakers force the private sector to share part of the burden of stabilizing Greece. The remaining question is whether the solution adopted in Brussels offers a consistent approach to solving the debt crises in the euro-zone. A critical problem clearly exists: despite both the voluntary debt restructuring, which imposes high costs on many who invested in high-yield Greek bonds, and the public emphasis of European Council president Herman van Rompuy that the haircut for Greece was an exception, every investor in bonds of highly indebted countries—such as Italy and Spain—will now fear a future 20 percent haircut, too. Twenty percent in the case of Italy’s staggering €1800 billion sovereign debt mean a loss of €360 billion; 20 percent of Spain’s debt amounts to about €120 billion. Together, investors in Italy and Spain stand to lose up to €480 billion.
This doubtful strategy of heavily involving the private sector in Greek debt restructuring implies that private investors are unlikely to refinance Italian or Spanish debt at pre-July 21 interest rates. Furthermore, refinancing from non-Italian sources might completely dry out in 2012/2013. Indeed, interest rates for Italy and Spain shot up by 2 percentage points after this date and it is only due to the ECB, which started to buy Italian and Spanish bonds, that the new spread vis-à-vis German Bund bonds is down to about 3 percent—still relatively high.
Allianz has proposed an interesting instrument for stabilizing the euro-zone, namely, that countries could receive insurance against default from the European Financial Stability Facility (EFSF)—an option that Italy’s government might want to consider once this instrument has been established (buying insurance from the EFSF’s rescue fund would be a relatively cheap option to stabilize the Italian bond market). Spain has announced a bipartisan agreement to add a “debt brake formula” to the Spanish constitution, to be implemented prior to advanced elections. Italy is a more difficult case, but Germany’s government will not allow Italy to re-finance debt through commonly guaranteed euro bonds, as this would give perverse incentives and would violate the Maastricht treaty. The only case in which euro bonds would make sense is a broader reform in the euro-area that would create a Euro Political Union, in which a new supranational economic policy layer would assume responsibility for anti-cyclical fiscal policy; the government expenditure GDP ratio thus should be raised to about 4 percent, which would quadruple the existing very low ratio. Germany and all of its EU partner countries—not only the euro member countries—have every interest to maintain economic and monetary integration.
1As pointed out by this author in the book P.J.J. Welfens, Transatlantische Bankenkrise (Stuttgart: Lucius, 2008).
2P.J.J. Welfens, Innovations in Macroeconomics, 3rd revised and enlarged edition (Heidelberg and New York: Springer, 2011.
Prof. Paul J.J. Welfens is a professor at the European Institute for International Economic Relations and a Non-Resident Fellow at AICGS.
This essay appeared in the September 8, 2011 AICGS Advisor.