The euro crisis: A second wave

The bail–out strategy that rescued Europe’s peripheral economies is proving insufficient.
This threatens the whole project of European integration.

The Economist, Jun 16th 2011

Athens and London.– Europe’s year–long attempt to grapple with the sovereign–debt crisis is becoming more nailbiting by the day. For weeks European leaders have been feuding over what to do about Greece, which clearly needs more help with its precarious public finances. But a second rescue, adding even more funding to the original bail–out in May 2010, cannot work unless the Greeks push through more painful reforms. These are now in doubt, sending tremors through financial markets and causing stockmarkets to fall around the world.

From the nation that coined the word drama, there was plenty of it on June 15th. As a general strike took hold across the country, there were violent protests in central Athens, where tens of thousands of people had rallied. After failing to form a government of national unity, George Papandreou, the prime minister, announced that he would reshuffle his cabinet and later call a vote of confidence in parliament. The indignation of the protesters is widely shared. A recent poll published by Kathimerini, a newspaper, found that 87% of the public thought the country was heading in the wrong direction.

The same could be said for Europe’s approach to the sovereign–debt crisis, as it has spread relentlessly round the southern and western periphery of the euro area. The single–currency zone as a whole is doing well, outgrowing both America and Britain in the first three months of this year. The euro–wide budget deficit also compares favourably with that of other big advanced countries. But the debt crisis is proving intractable, partly because leading policymakers disagree about the way forward and at times seem lost themselves. Time is short. There is a summit of European leaders next week, and Greece must soon pass an austerity budget.

The way it all began

With hindsight, it was no surprise that the debt crisis started in Greece, which failed to join the euro area when it was set up in 1999 because it did not meet the economic or fiscal criteria for membership. Revisions to its budgetary figures showed that it shouldn’t have been allowed in when it did join, in 2001. When its debt crisis flared up last year European leaders hoped to contain it at the Greek border, providing a bail–out worth €110 billion ($158 billion) over three years, of which €80 billion came from other euro–area members and €30 billion from the IMF.

Any hope of containment was shattered when Ireland’s banking difficulties forced a second rescue last November. After that a third bail–out became inevitable, for Portugal, as the cost of its government borrowing shot up and Portuguese banks were shut off from normal funding, coming to rely on the European Central Bank (ECB), based in Frankfurt. What caused consternation was a new shock—from Greece, again—that the first package was insufficient and that the country needed more money for longer.

This sent European policymakers into a frenzy. Their attempts to find a solution have sometimes seemed to spring from the pages of an overwrought thriller. A secret session in early May of some of the main negotiators in Luxembourg leaked out amid official denials that it was even happening. Shortly afterwards the IMF, which has been playing a crucial role, lost its managing director when Dominique Strauss–Kahn had to resign after charges were brought against him for attempted rape in New York. Blazing rows have erupted between Jean–Claude Trichet, the usually unflappable French president of the ECB, and Wolfgang Schäuble, Germany’s redoubtable finance minister, over German demands to inflict some of the pain on private holders of Greek bonds and the central bank’s resistance to anything that could be construed as a default.

Europe’s heads of state will decide on the second Greek rescue package when they meet in Brussels on June 23rd and 24th. Help will be forthcoming only if the Greek parliament endorses the extra doses of austerity the country must swallow, together with a big programme to privatise state assets worth €50 billion (20% of GDP). Assuming that Greece does buckle down despite the commotion of this week, as it has promised, it can expect to get an additional €85 billion in bail–out funding that will now stretch to 2014.

How much of this will have to come from taxpayers? The answer hinges on how far private creditors who have lent to the Greek government can be made to “participate”, a euphemism for picking up some of the bill. The Germans have been pressing hard for debt maturities to be extended; the ECB has been adamantly opposed to such a policy, although it may accept a promise by bondholders to buy new bonds when the existing ones mature. Worries about a possible restructuring led Standard & Poor’s to downgrade Greek government debt this week from B to CCC, making it the credit–rating agency’s lowest–rated sovereign debt in the world.

Already the prolonged irresolution of European leaders about a second Greek bail–out has increased uncertainty for investors and businesses. If they make a false move, the repercussions will affect not just Europeans but Americans too, and indeed the global economy. President Barack Obama recently said that America’s growth depends on a successful resolution of the Greek crisis; an uncontrolled default (the first in an advanced country since 1948) would be disastrous. The risk of contagion to other countries through banking losses, which prompted the original rescue, remains acute, not least since the markets would immediately fret about Ireland and Portugal falling in turn. Worries would be rekindled, too, about Spain, which has so far managed to avoid needing a bail–out.

But a still bigger issue is at stake. Even if the European Council manages to cobble together a compromise that buys time for Greece, the fear is that Europe’s bold experiment—creating a monetary union among diverse economies without the underpinning of a fiscal union—may have been too audacious. If it founders, this would be an extraordinary setback for the larger cause of European integration.

Charlemagne’s coin

Europe’s creation of a single currency remains both futuristic and weighted with history. At a conference about the ECB on June 10th, Volker Wieland, an economist at Goethe University in Frankfurt, said that the euro was the first venture on such a scale in Europe since Charlemagne created a single currency in his empire in 794. In more recent history central banks have capped political unions—as when the Reichsbank was founded in 1876 in the aftermath of Bismarck’s unification of Germany through “blood and iron”.

The ECB, by contrast, is a supranational institution, although it emerged from an old–fashioned Franco–German deal. The French wanted to fetter German power—in particular the dominance of the German central bank in European monetary policy—after its second unification, in 1990, following the fall of the Berlin Wall. The Germans believed the ECB could be their Bundesbank writ large. Along with these political objectives, the single currency was expected to produce economic gains by eliminating the nuisance and cost of having to change money within Europe, removing exchange–rate uncertainty within the euro area and enhancing price stability. The mantra of its proponents was “one market, one money”. The single currency would reinforce the single market, emerging from reforms in the late 1980s and the early 1990s to open national economies to Europe–wide competition.

A stand–alone monetary union without the usual fiscal and political foundations was conceived at the momentous Maastricht summit in December 1991. The treaty set “convergence” criteria, such as low enough inflation and long–term interest rates, to check whether countries were economically fit enough to join the single currency. These also included fiscal criteria, notably ceilings for budget deficits of 3% of GDP and for public debt of 60%. The treaty stipulated that there would be no bail–out of a country that got into fiscal trouble.

But the rules were less strict than they appeared. Belgium and Italy were allowed to join the euro at the outset, even though their debt exceeded not 60% but 100% of GDP—because that debt was falling. Economic convergence at one point in time also proved misleading. What determines whether a country can survive, let alone thrive, in a monetary union is flexibility in both labour and product markets, since it can no longer realign its costs by devaluing.

As for the fiscal tests, what was to stop countries from misbehaving once they had joined? The answer, tacked on in the late 1990s to the Maastricht criteria, was a “stability and growth pact” to reinforce responsible public finances within the euro area. But this too was watered down in 2005, largely at the insistence of France and Germany, after they themselves faced possible sanctions for breaching the budget–deficit limit.

None of this seemed to matter during the first few years of the monetary union. While Germany went through a weak patch, the peripheral economies (Portugal excepted) flourished, thanks to the low interest rates that euro membership brought them. The elimination of exchange–rate risk unleashed cross–border lending, which built up large exposures among the banks in the lending countries while debt piled up in the borrowing countries.

The lending was on lax terms. Credit markets paid no heed to the risks that were building up from sustained big current–account deficits, which would have caused alarm in emerging economies (see chart 1). They smiled on Ireland’s property boom, overlooked Portugal’s slack growth and forgave Greece its poor public finances. Spain also benefited from dirt–cheap money even though it shared many of the same weaknesses, notably a housing–market bubble and a huge current–account deficit.

Weakness exposed

The flood of easy money disguised the hard truth that the competitiveness of the peripheral economies, gauged by measures like unit labour costs, had steadily worsened after joining the euro. This deterioration came from a poor starting–point, for Greece in particular. As one senior negotiator in the bail–out talks laments, Greece is part of the single–currency area even though it has managed in effect to stay out of the single market. With the lowest exports–to–GDP ratio in the euro area, membership became a way to import cheap goods on the never–never rather than a means to foster higher productivity. Ireland, with exports now roughly equal to GDP, is quite different, but Portugal also has a lowish exports–to–GDP ratio for a small economy within a single–currency zone and, like Greece, has insulated much of its economy from the single market.

Once the credit machine went into reverse as the financial crisis broke in the summer of 2007, the underlying weaknesses of the peripheral economies were exposed. The debt that had piled up in the good years became oppressive once lenders scented trouble. Spreads on government bonds over safe German Bunds, which had earlier narrowed to wafer–thin margins, ballooned out (see chart 2). Ireland had what looked like impeccable public finances, with government debt as low as 25% of GDP in 2007, but these were flattered by swollen property–market taxes and then swamped by the costs of propping up banks that had gone on a bender, the bill for which is now reckoned at 42% of national output. As a result, the debt burden will reach 112% this year, according to the European Commission’s May forecast. Portugal’s, too, will vault above 100% of GDP, while Greece’s will rise to almost 160% (see chart 3).

Fundamentally, then, the crisis that has engulfed three countries is rooted in a severe loss of competitiveness combined with levels of public debt that look unsustainable in the case of Greece and worryingly close to that for Ireland and Portugal. The rescue packages are accordingly trying to shake up the sclerotic economies of Greece and Portugal through sweeping changes to liberalise markets controlled by producer interests. The priority for Ireland’s more flexible economy, which has been regaining some of its lost competitive ground, is to finish healing its banks. All three economies are having to push through harsh austerity measures to create primary budget surpluses (ie, before interest payments) that will stabilise debt. As long as the three live up to their side of the bargain, the European creditor nations, led by Germany, have been prepared to provide bridging finance.

Voter resistance

The bail–out strategy made some sense in May 2010, since banking systems were still weak after the convulsions of 2008, exposures to Greek debt were not well mapped out and private creditors had had little time to adjust their positions. But it has lost credibility over the past year as Ireland and Portugal have also succumbed, and as markets have concluded that a bail–out will fail to put Greek debt, in particular, on a sustainable path.

Inherently, there are two conflicting economic tensions in the rescue packages. The first is that the austerity programmes needed to cut deficits are killing the growth needed to make debt bearable. If Greece had got into trouble outside the euro, the drachma would have fallen, creating an external offsetting boost to the economy by making exports cheaper and curbing imports. The other inherent tension is that the steps needed to improve competitiveness within the euro require prices and wages to be held down, making it even harder to cope with debt.

There are also conflicting political forces within both the borrowing and lending countries. The Greeks are not alone in feeling resentful about having to pay so high a price for past misdemeanours. Many Irish now see themselves as victims, paying a penalty for having done a favour to other European countries by propping up their banks and thus preventing losses by foreign bondholders that had lent to them. If the mood turns sourer, it may be harder for the new Irish government led by Enda Kenny to push through the further austerity that is needed.

Lender countries are also becoming restive. The recent general election in Finland propelled a loan–refusenik party, the True Finns, to third place in the polls. In Germany a majority of the public thinks that the original rescue of Greece was a mistake. On June 10th the ZDF Politbarometer showed 60% rejecting further assistance and only 33% backing it. A poll in April showed an overwhelming majority fearful that more countries than Greece, Ireland and Portugal will require help.

This stroppiness means that one solution to the debt crisis is a non–starter. Sharing budgetary resources, either through direct transfers or through the issue of “E–bonds” underwritten by the euro area’s taxpayers, is anathema in Germany, where the notion of a “transfer union” in which the better–off subsidise the worse–off is political poison, not least because of the vast transfers from western to eastern Germany since reunification. Northern taxpayers would also recoil from the idea of a future “ministry of finance of the union” which Mr Trichet recently floated.

An alternative course would be to try to make a “no bail–out” model work. Jordi Galí, an economist at Pompeu Fabra University in Barcelona, would ban collective rescues and stop trying to patrol euro–area states through debt and deficit limits. Instead he would leave the job of policing their public finances to investors. This would require recapitalisation of European banks so that they could withstand sovereign defaults, but that is not the only snag. The pass has already been sold. Investors know that when a banking crisis looms, European governments will flinch and extend taxpayer support.

Both these courses of action at least offer clear paths forward. By contrast, the long–term reforms set out by European leaders in March fall short of the comprehensive solution they purported to provide. Under a “pact for the euro” there will be economic and fiscal workouts that will allow countries to cope better with the rigours of monetary union—including, for example, greater wage flexibility. They will have to put into law their determination to get a grip on public finances. The temporary support measures will be turned into a permanent “stability mechanism” with an effective lending capacity of €500 billion that will be available to countries only if their debt is deemed sustainable. Private bondholders are served notice that they will be at risk from mid–2013 when the new regime comes into force.

In effect the reforms formalise the bail–out strategy, but try to ensure it will not have to be used again and leave open the possibility of restructuring. One objection is that the pressure remains on deficit countries within the euro area to put their houses in order, whereas none is brought to bear on surplus countries such as Germany. But the bigger worry is that the reforms will be overtaken by events.

The European summit on June 24th seems unlikely to get on top of things. Even if private bondholders can be made to share in some of the pain by rolling over their debts, this will still leave Greek public indebtedness unsustainably high. As long as that is so, markets will continue to bet on an eventual default. The pre–summit wrangling has only served to underline the extreme difficulty of reaching any solution that can be sold successfully to voters. The Greek protests have forcibly made the point that debt sustainability is ultimately a matter of political resolve.

At best, European leaders may buy more time. But the markets have a different timetable from the politicians, and their scepticism may continue to undermine the weaker economies by hurting their banks. Though the ministers will doubtless go on talking, it is increasingly hard to see a safe way out of this crisis.