What in January 2010 started as a Greek debt crisis, which seemed manageable, is today a severe crisis of the European Monetary Union (EMU) that threatens the rest of the world. The reason for this enormous worsening of the situation is the extremely poor crisis management: an obvious lack of clarity and strategy; a string of clear breaches of the European Treaty including the liability restrictions of § 125 EU Treaty; aid package after aid package despite weak commitments by the Greek government; severe attacks on the independence of the ECB. Governments mainly looked at domestic issues (elections, banking sector etc.) and behave as hostages of the financial industry. The debt/Euro crisis has shown that the European Monetary Union is in a period of Olsonian decline: interest groups have a firm grip on governments.
This was the state of affairs before the European Summit on the 26th of October. The Summit reached some serious results, which seem to have calmed down the stock markets remarkably on the following day. First, Greek debt with private investors will be subject to a haircut of 50 per cent (the ECB is left out). This is an increase of almost 30 percentage points. Second, the second rescue package for Greece is accepted (details still have to be worked out). Third, the EFSF will be equipped with two forms of leverage: It will work as insurance (20 per cent) for fresh government bonds emissions by the GIIPS countries and it will set up a Special Purpose Vehicle (SPV) where international private and public investors can invest their capital. This capital will also be used for government bonds issued by GIIPS− details will follow soon. Fourth, Europe’s banks will be forced to pile up equity. Fifth, Spain is asked to strengthen its efforts to solve their fiscal and labor market problems. Sixth, Italy has agreed to start a reform program, including increasing the retirement age to 67 and to privatize SOEs. Again, details will follow in a few weeks. Finally, member countries’ fiscal policy will be subject to closer scrutiny.
Unfortunately, the European Summit did not even address the core problems of the Eurozone. These are a) the level of public debt in almost all member countries and ways to stop its increase, b) disincentives through bail-outs by other governments and monetization of public debt by the ECB, c) the degree to which the ECB already has monetized government debts and build up risks through the TARGET2-system and finally d) repressed structural reforms and steps to overcome vested interests blocking reforms.
Thus, the program is by no means likely to end the crisis as the politicians want us make to believe. A look at the seven measures decided upon shows a mixed blessing: some necessary steps, but severe shortcomings. The haircut of Greek debt is a reasonable step, as is the recapitalization of banks. The same holds for pressure upon Spain and Italy to address their structural problems. However, both countries did not credibly commit to these reforms. Given the history of the crisis, one must fear that the Italian promise will be hollowed out during the political process. This danger is even stronger in the light of the extended “firepower” of the EFSF. However, this extension may well be questioned. It seems rather optimistic – if not naïve – to believe that insurances and banks will start a run on GIIPS-bonds backed to 20 per cent by the EFSF. Whether the SPV will attract capital cannot be said. Even if the Chinese government will invest a substantial amount of money, this will not come for free. One can expect political demands in the future – such as market economy status, future abdications of EU government’ reminders to human rights, or even cheap access to patents. The future prolongation of bonds purchased today may give an excellent opportunity to exert this sort of pressure. Apart from that, taxpayer’s risk increases through the leverage; the size of the guarantee is the same, while the probability of being needed rises. This endangers the French and German ratings in the medium run.
So what should be done instead? The EMU must get back to stability. In order to make the currency union work smoothly, all members must agree on a) fiscal stability including debt brake or other enforcement mechanisms, which probably go beyond the latest measures to strengthen the SGP, b) a strict no-bail-out clause, including a reduction of the EFSF funds (the best would be to terminate it in 2013 as originally agreed), c) concentration on the ECB’s core tasks and d) flexibility on markets (i.e. good supply side conditions). Only if the Eurozone adheres to these rules can one expect the final end of the crisis. In other words: as long as governments rely on (increasing) rescue packages instead of fostering fiscal stability, we will have a (worsening crisis). The increased “fire power” might fire back and burn the European house down fast.
To give the analysis an optimistic twist, it all depends on how serious the reform efforts in Euroland will be in the future. The European Summit of October 26th may have bought some more time. Now it is necessary to deliver in all four points mentioned in this column. If the European Monetary Union fails another time, prospects might become very dark. Neither markets nor parliaments can be expected to be patient endlessly. The governments better do their jobs properly.
Prof. Dr. Andreas Freytag is a Professor of Economics at the Friedrich-Schiller-Universität Jena and is a frequent contributor to AICGS publications and events.
This essay appeared in the October 28, 2011 AICGS Advisor.