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More Europe, Not Less |
Looking back at the causes of the debt crisis in
Europe, we conclude that incomplete economic, financial, and fiscal
integration is part of the answer.
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When it comes to sovereign debt, the euro area seems to be different. Even
with a level of debt in line with that of other advanced economies, it has
been engulfed in a sovereign debt crisis. True, the euro area is not a
single nation, and its treaty prohibits member states from sharing each
other's liabilities. But why should that mean that one member's troubles
mean trouble for all and investors fret about the future of the economic and
monetary union?
Looking back at the causes of the debt crisis in Europe, we conclude that
incomplete economic, financial, and fiscal integration is part of the
answer. To function effectively, the economic and monetary union will
require some form of fiscal risk sharing, tighter monitoring of national
policies, and an integrated pan-European approach to its financial system.
Progress is being made on all these fronts, but rapid implementation remains
of the utmost importance.
Conspiracy of factors
The Economic and Monetary Union (EMU) was founded on the premise that the
benefits of a common currency would outweigh the costs of relinquishing
national currencies. The plan envisaged in the Stability and Growth Pact (SGP)
was to have European institutions keep a close eye on countries' budgets via
annual evaluations and to create enough fiscal discipline to leave room to
deal with country-specific shocks. The coordination of national product and
labor market reforms (for instance, opening up the electricity market or
encouraging labor market participation) would align economies so that they
would react more similarly to common shocks.
However, with the introduction of the EMU, southern euro area countries and
Ireland (loosely referred to as the periphery) experienced a very specific
shock: they witnessed a dramatic decline in borrowing costs after many years
of much higher interest rates than their northern counterparts. This allowed
firms to finance their productive investment more cheaply and
expand-certainly a welcome development. But it also led to a widespread
belief that strong growth would be permanent. Households assumed they could
afford much higher living standards, leading to credit-led buying sprees and
real estate bubbles. And governments-along with their creditors-took for
granted the revenues generated by the growth spurt, failing to save the
debt-service savings brought about by the drop in interest rates.
Meanwhile, because the common currency eliminated cross-border transaction
costs, financial integration within the euro area flourished-another benefit
of the EMU. But inflows to countries in the periphery came mostly in the
form of debt to banks, making them increasingly reliant on funding raised in
the markets (which is called wholesale funding), rather than on bank
deposits, to finance domestic credit. Conversely, equity flows-such as from
cross-border mergers and acquisitions, where risks are shared and hence
better monitored by investors-were small.
National financial supervisors fell under the same optimistic spell. They
became complacent about rising credit risks and allowed banking systems to
grow disproportionately to the size of the economy. As a result, the risk
grew that the banking sector would become increasingly unaffordable for
governments to support in a financial crisis. In the absence of a
pan-European supervisory body, risks related to the growing
interconnectedness of national financial systems through large cross-border
loans to banks were overlooked.
Readily available intra-euro area financing made it easy to dismiss
diverging trends in competitiveness. While Germany and neighboring euro area
countries were retooling their production model by integrating eastern
Europe into their supply chains to compete with lower-cost manufacturing
powerhouses in Asia, countries in the periphery seemed oblivious to rising
costs, as overheating led to large wage increases. For a long time,
policymakers and foreign private investors alike ignored the fact that the
dramatic deterioration in the periphery countries' external position was
financing mostly unproductive spending (for example, real estate
investment), so that the accumulating debt could prove hard to pay back.
Hard landing
Until the euro area came into existence, sovereign debt problems were
primarily external debt problems. The nominal value of domestic debt could
usually be preserved, albeit often at the cost of a bout of inflation. With
the establishment of the euro area, this mechanism disappeared. Member
countries' domestic and external debt were indistinguishable and there was
no (domestic) central bank to inflate problems away.
The opposite is also true, however. In the euro area, countries retained
control over fiscal policy and there was no common euro area treasury,
including to back the European Central Bank's operations. The founders of
the euro area were very much aware of the need to preserve fiscal
discipline, and counted on a combination of administrative tools (the SGP)
and market discipline. But both mechanisms were eroded: the SGP was watered
down and markets fell asleep at the wheel. The plan worked well during good
times, but fell apart when the global crisis hit.
The fall of the U.S. investment bank Lehman Brothers in October 2008 set the
stage for a dramatic reversal of fortune in the euro area. Operations of
wholesale funding markets came to a sudden halt, making it harder for banks
in the periphery to continue financing credit-driven growth.
Once credit dried up, fundamental competitiveness problems and structural
impediments to growth came to the fore, particularly in Greece and Portugal.
Fiscal revenue dried up, revealing weak underlying public finances. Private
investors started scrutinizing deteriorating balance sheets, and ailing
banks increasingly needed fiscal support, especially in Ireland.
As
a result, the private debt problem morphed into a sovereign debt crisis.
With banks still heavily financing their national sovereign debt, concerns
about fiscal solvency inhibited confidence in the peripheral banking sector,
setting in motion a pernicious feedback loop that persists to this day.
Soaring credit costs priced both sovereigns and banks out of private funding
in Greece, Ireland, and Portugal. Most recently, the crisis engulfed Italy
and Spain, which saw the cost of their sovereign debt climb during the
summer of 2011.
Contagion did not stop at the borders of the periphery. Banks in the core
euro area that had funded the booms in the periphery also came under
scrutiny. Growing uncertainties about exposures and asset quality delayed
the recovery in confidence that was essential for recovery in the euro area
as a whole.
Still searching for solution
The countries that had accumulated large imbalances, either fiscal or
external, came under intense market pressures. As a result, they immediately
started implementing significant adjustment measures, ranging from cuts in
public spending to tax increases and measures to improve the functioning of
their economy. But the absence of proper euro area-wide crisis management
institutions delayed decisions at the regional level. In May 2010, when it
became clear that Greece would need external financial support, European
leaders had to resort to bilateral loans. They later set up the European
Financial Stability Facility (EFSF) to provide support to euro area member
states in financial difficulty, which was tapped by Ireland in December 2010
and Portugal in May 2011.
But because it is politically difficult to use taxpayer money from some
countries to pay for the past profligacy of others-and indeed, the
Maastricht treaty was written in the spirit of avoiding fiscal transfers
across euro area countries-decisions regarding the EFSF have not been easy
to come by. As the market turmoil persisted, the EFSF's lending capacity was
nearly doubled to €440 billion in spring 2011; when the turmoil threatened
Spain and Italy, its mandate was significantly increased in summer 2011 to
allow for precautionary lending and additional flexibility.
But the markets remain wary. Credit rating agencies' downgrades have
continued, and as of mid-August 2011 market confidence had not turned
around. Debt sustainability remains challenging, and painful and protracted
adjustment looms. Growth-an essential ingredient for fiscal
sustainability-has proved more elusive than expected in the countries where
the crisis hit the hardest. Markets are therefore worried that reform
fatigue will set in before the adjustment is complete, in turn driving up
funding costs, which itself jeopardizes debt sustainability.
Early lessons
Economic and financial integration has brought benefits to the euro area
that far exceed the costs. But the institutions underpinning the common
currency have clearly been inadequate during the crisis, highlighting the
need to delegate more country sovereignty to the center.
The first lesson from the crisis is that effective functioning of the
economic and monetary union requires some kind of fiscal risk-sharing
mechanism at the euro area level, to provide assistance to countries
facing sovereign funding pressures and to back up European Central Bank
emergency operations. The EFSF-and its successor from 2013 onward, the
European Stability Mechanism (ESM)-presents a first step toward such a
fiscal insurance plan, especially after its recent enhancements. Among the
many ways forward, one option is that the ESM could evolve into a European
debt management agency issuing common bonds conditional on prudent national
policies.
A
second lesson is that the euro area institutions' oversight of fiscal and
macroeconomic policies at the national level needs to be seriously
strengthened. Governance is indeed being enhanced at the supranational
level to reinforce budgetary discipline and better monitor the buildup in
imbalances. But more could still be done, for example by requiring
correction to past upward drifts in public expenditure or establishing more
semiautomatic sanctions for fiscal offenders.
Finally, the need for an integrated, pan-European approach to financial
supervision, regulation, and crisis resolution has become increasingly
evident as the crisis has unfolded. European institutions have recently
been set up; they will bring much-needed coordination in supervision and
systemic risk assessment. But it will be equally important to complete the
region's financial stability framework with the establishment of a European
resolution authority that would provide a common backstop for banks
irrespective of nationality. Only then will the fate of banking sectors be
fully delinked from that of their respective sovereign.
Finding an orderly solution to the sovereign debt difficulties in the
periphery remains of the ulmost importance. European leaders have started to
make difficult decisions to deal with the crisis, most notably at the July
2011 European Union summit, but progress needs to be implemented swiftly if
markets are to be convinced.
Source: IMF / Finance & Development |
