The European Economic and Monetary Union is intended to promote economic stability, growth and integration of its members. However, in order to reap the economic benefits of more deeply integrated goods and financial markets that promote competition through low transaction costs free from exchange rate risks, member countries had to give up their independent monetary policies. Thereby, they forgo an important economic adjustment mechanism that had repeatedly been relied upon in the decades prior to the introduction of the euro. In the event that a member suffers an economic downturn, it is no longer able to devalue its currency vis-à-vis the other members. This option for gaining external price competitiveness and for reducing the country's debt burden by means of unexpected inflation has been eliminated.
Countries are left with the option of internal devaluation, that is, adjusting wages and prices to restore price competitiveness and debt sustainability. The more rigid goods and factor markets are, the more time internal devaluation takes and the more difficult it becomes to reduce unemployment.
With the loss of monetary policy as a tool for national policymaking, fiscal policy gains in importance. Employing fiscal policy in an effective and sustainable manner requires the unity of liability and control in the respective political decision making. If joint liability for the fiscal policy of individual member countries was accepted without moving control to the European level, the result would be substantial moral hazard. Before the Eurozone debt crisis, this risk was often dismissed as an abstract discussion and therefore ignored by policymakers. However, it has by now become evident how important the moral hazard problem is in practice.
There are two basic options for a common currency area that hold the promise of long-term stability. One is a political union, in which member countries cede sovereignty over their fiscal policies to a supranational body for the entire Eurozone. In return, the union assumes shared liability for collective government debt. Joint liability alone would de-stabilise the monetary union – only an extensive transfer of sovereignty can effectively sustain this model of political union.
The other option is that fiscal sovereignty and liability remain at the national level. Individual member countries then remain responsible for the repayment of their debt. In this case, there must be a credible ban on transferring liability to other member countries, i.e. a no-bailout rule. Otherwise, financial markets will not exercise the disciplining function on national governments’ decision making that would result from higher risk premiums on government bonds reflecting markets perceptions of sovereign risk.
In the Maastricht Treaty, the members of the Eurozone committed themselves to fiscal discipline, and hence to the principle of fiscal sovereignty rather than political union. However, several countries subsequently violated the rules they had agreed upon in the Treaty, in particular the Stability and Growth Pact that had been intended to embed the no-bailout clause in fiscal policymaking. The sanctioning mechanisms that were agreed upon were barely employed – there were 34 breaches of the 3% threshold for the general government deficit between 1999 and 2007. None of these cases were escalated to the highest level of sanctions (see Figure 1). The breaches of the pact by Germany and France set particularly detrimental precedents.
Figure 1. Breaches of the 3% threshold from 1999 to 2007
1 Number of breaches of the yearly budget deficit of 3 % as a percentage of nominal GDP according to the Maastricht treaty.
Source: Eurostat.
During this period, neither the Stability and Growth Pact nor financial markets exercised sufficient discipline over fiscal policy. Despite substantial differences in macroeconomic and fiscal policies, member countries were able to access financial markets at almost identical yields between 2001 and 2007 (see Figure 2). The absence of significant differences in yields was not surprising. Rather it was encouraged by financial regulations and the policies of the ECB. Member countries' government bonds were treated equally in the collateral rules of the ECB's refinancing operations and in the regulation of banks where Eurozone sovereign bonds were assigned zero risk weights.
Figure 2. Long-term government bond yields.
1 Government bonds with a residual maturity of around 10 years.
Source: Eurostat.
This constellation provided no incentives for conservative fiscal policies. As a result of expansive policies prior to 2007, some member countries lacked sufficient fiscal space when the global financial and economic crisis hit the Eurozone. At the same time, there was no crisis mechanism available within the monetary union that would have been capable of overcoming a systemic crisis. Such a crisis mechanism evolved only gradually after the Eurozone debt crisis broke out, and only in parts. A forceful intervention by the ECB succeeded in calming financial markets in July 2012. By linking the outright monetary transactions to the conditionality of the European Stability Mechanism programme, the ECB entered a grey area between monetary and fiscal policy (Annual Economic Report 2013, paragraph 253).
The principle of unified liability and control was also violated in banking regulation and supervision. In the currency union, the member countries jointly bear the risks on the ECB’s balance sheet. If banking supervision and resolution are organised at national level, incentives are created to shift the liability for risks in the domestic banking system to the European level (Annual Economic Report 2013, paragraph 270). As a result, there was little incentive to limit the build-up of excessive debt by the banking system. In addition, there was a tendency to delay the restructuring of the domestic banking system in a crisis. This was reinforced by the fact that banks themselves were important creditors of member countries' governments, which laid the ground for a vicious circle of bank and sovereign debt crises. Hence, the absence of a common bank supervision and a credible common resolution mechanism represented another fundamental problem of the monetary union.
The build-up of public and private debt as prelude to the crisis
The introduction of the euro and the liberalisation of European financial markets were accompanied by a drastic reduction in country-specific risk premiums. This reduction implied a massive improvement in financing conditions for private and public borrowers in many Eurozone member countries from the mid-1990s onwards. As a consequence, the Eurozone experienced high capital flows between member countries and corresponding changes in the macroeconomic saving and investment ratios (Jaumotte and Sodsriwiboon 2010). Initially, these flows could be motivated by the anticipation of higher growth in countries with lower per-capita income. It seemed appropriate that such countries imported foreign capital in addition to domestic savings in order to increase investment. However, notably in Greece and Portugal, saving ratios declined considerably between 2001 and 2007 while the investment ratio remained unchanged or even weakened – see Figure 3.
Figure 3. Investment and saving.
1 Investment and saving in percent of nominal GDP.
Source: IMF.
The improved financing conditions reduced the interest burden on public budgets and could have served to reduce the stock of public debts over time. See Box 1. However, the relief was not used for debt reduction. See Figure 4.
Figure 4. Government debt and government balance.
1 In percent of nominal GDP. 2 Until 1998 IMF data, then data from Eurostat to ESA 2010; for the euro area and Greece until 2010 by the ESA 95. 3 Maximum debt 60 % and maximum budget balance –3 % under the Treaty of Maastricht.
Sources: Eurostat, IMF.
Additional public funds were often used for government final consumption expenditure rather than for capacity- and productivity-enhancing investment. This outcome can be illustrated by the development of public sector employment and wages. See Figure 5. In Greece, for instance, public sector employment rose by more than 25% between 2000 and 2007. Spending on public sector employees doubled from around €14 billion to €28 billion. The increase in government spending exceeded inflation also in other areas, for example, pensions (OECD 2011a).
Figure 5. Employment and compensation of employees.
1 EA-18-Euro area (18 countries), DE-Germany, GR-Greece, IE-Ireland, PT-Portugal, ES-Spain. 2 In percent of nominal GDP.
Source: Eurostat.
Spain and Ireland, contrary to Greece and Portugal, did not violate the SGP prior to 2007. They reported public budget surpluses for several years and were able to reduce their stocks of public debt. In these countries, macroeconomic vulnerabilities built up mainly in the private sector. The improved financing conditions following the introduction of the euro triggered significant credit growth, particularly in the household sector. Ample credit led to excessive booms in the real estate sectors of some countries (GCEE Annual Economic Report 2013 box 26). Lack of regulation, insufficient supervision and loose monetary policy all contributed to the credit boom.
Despite the different origins of the sharp rise in overall indebtedness, it had similar effects in these economies. They suffered a considerable loss in price competitiveness during the debt-financed booms, due to major wage increases and high inflation. Consequently, domestic export companies were put at a competitive disadvantage and lost trade shares. The loss of price competitiveness combined with the debt-financed increase in domestic demand and the associated imports resulted in high current account deficits – see Figure 6. For instance, Greece and Portugal reported average current account deficits of around 10% of GDP between 2000 and 2007.
Figure 6. Current account balances and real effective exchange rates.
1 In percent of nominal GDP. 2 On unit labour costs basis. 3 Forecast of the European Commission.
Source: European Commission.
Developments in countries with adjustment programmes from 2008 onwards – three success stories and one failure
Prior to 2007, growth in the four countries that later underwent adjustment programmes had relied on strong capital inflows. Investors either expected that growth could be sustained, or that the no-bailout rule would be suspended in the event of a crisis and therefore did not demand appropriate risk premiums. Following the outbreak of the global financial crisis, the world economy went into recession. Investors had to reassess the likely profitability of past investments, primarily in the real estate sector. Additionally, uncertainty with regard to potential losses and whether the involved banks and financial institutions could bear them cast doubts on the stability of the financial system. The resulting drop in demand spread to other national economies via global trade.
A systemic financial crisis unfolded throughout Europe and caused distrust among financial market participants. Accordingly, risk premiums rose sharply. New loans were subjected to increased scrutiny. Even Germany saw a tightening of lending standards. Increasingly, financial markets focused on the structural problems of the later programme countries.
Figure 7. Indicators for economic development.
1 Real values, seasonally and calendar-adjusted. 2 In relation to the labour force.
Source: Eurostat.
Once the crisis had broken out, market participants increasingly discussed the loss of competitiveness experienced by Greece, Ireland, Portugal, Spain and other countries such as Italy or France. Unfavourable fiscal positions led to sovereign debt crises in Greece and Portugal. Ireland and Spain – with initially low public debt – came under pressure because their public budgets had to assume the burden of non-performing loans in order to support their banking systems. Banking systems all over the Eurozone were supported by vast amounts of public funds. In Ireland, for instance, the costs of the 2009-2011 bank rescue operations alone caused an increase in the government debt ratio of some 40 percentage points (Laeven and Valencia 2012). Hence, the weakness of banks substantially contributed to build-up of public debt in these countries.
Doubts regarding the solvency of the crisis countries triggered a sharp rise in risk premiums for government bonds. A vicious circle of rising debt, dwindling trust and increasing risk premiums followed, which further impaired the stability of financial systems. Greece was the first member country forced to make use of assistance loans from the IMF and the European partners in May 2010. With the European Financial Stability Facility and European Financial Stability Mechanism, a system of European rescue funds was created. In part it was hoped that the mere existence of a rescue fund would generate sufficient trust and prevent a worsening of the crisis in other countries. However, this was not the case. Subsequently, Ireland and Portugal were also forced to apply for assistance loans combined with a macroeconomic adjustment programme in November 2010 and April 2011 respectively. Spain followed suit in July 2012 with an assistance loan to support its banking system.
The rescue package was based on the ‘loans for reforms’ rationale, i.e. rescue loans were granted in exchange for the implementation of extensive reforms. These included fiscal consolidation, structural measures to regain price competitiveness, deregulation of goods and factor markets, and improvements of the institutional framework. Implementing these measures represented a major social and economic challenge for the governments of all programme countries. They all saw a massive decline in employment. Labour mobility was only partly able to mitigate the rise in unemployment – see Figure 8, right panel.
In Ireland and Portugal, the agreed reforms were largely successfully implemented. The IMF's evaluation of the Irish adjustment programme shows that Ireland achieved the agreed programme objectives almost completely and on schedule (IMF 2015). Portugal was also successful in implementing the agreed measures in its macroeconomic adjustment programme (EU Commission 2014). However, the development of the Portuguese economy has not been as dynamic as that of Ireland.
The Greek economy fared much worse, although the first signs of positive growth had become visible in 2014. The lack of progress in Greece has prompted many voices – including the newly-elected Greek government – to question the rescue policy in its entirety. Yet the situation in Greece should not be taken as proof of failure of rescue policies as such. We discuss the developments in Greece elsewhere in more detail (GCEE Special Report 2015).
Ireland, Portugal and Spain have now exited their rescue programmes, thanks to successful consolidation and reforms, as well as the ECB's extensive monetary easing. The economies of these countries are recovering – there is a marked decline in unemployment in Spain and Portugal, and gross value added has been on the rise since last year. The development in Ireland has been particularly positive, partly owed to its comparatively flexible labour market and the recovery of key trade partners, in particular the US and UK.
Two fundamental weaknesses
The crisis in the Eurozone has revealed two fundamental weaknesses.
- Firstly, there was a lack of economic and fiscal policy discipline, accompanied by dysfunctional sanctioning mechanisms, leading to the build-up of huge public and private debt levels and a loss of competitiveness; and
- Secondly, there was no credible mechanism for crisis response that would be able to reign in moral hazard problems and establish market discipline – this concerned the handling of bank and sovereign debt problems.
These institutional deficits contributed to economic imbalances in the economically heterogeneous currency area, which made the economies of some member states vulnerable to a deepening of the crisis. In the aftermath of the global financial crisis, these imbalances led to government debt crises in Greece, Ireland, Portugal and Spain and ultimately threatened the cohesion of the entire Eurozone.
Given these developments, macroeconomic adjustment was unavoidable in crisis countries. The adjustment required wage and price changes, as well as fiscal consolidation and structural reforms to enhance competitiveness. These steps are associated with painful cutbacks affecting the populations of the respective countries.
To support the crisis countries in this process and stabilise their financial systems, adjustment programmes were agreed with the affected countries. These programmes followed the ‘loans for reforms’ rationale. The crisis countries were responsible for implementing the reforms themselves. The prerequisite for the success of this model was ownership, i.e. the willingness and ability to reform. The rescue policy of 2010-2014 helped avert a systemic crisis and maintain the cohesion of the monetary union. The time was also used to implement substantial reforms to make the monetary union more resilient against economic crises. Ireland, Portugal and Spain have been able to regain investors' trust. They are experiencing an economic recovery, although unemployment remains high.
Greece remains in deep difficulties. The confrontational course of its new government and the conflict with its European partners revealed political weaknesses of the Eurozone. Completing the currency union’s architecture and achieving credibility for its rules are key, given the heterogeneity and rigidity of its member countries' economies. In this column, we have abstained from laying out our proposal for completing the euro’s architecture. Our proposal, entitled Maastricht 2.0, will be presented in a subsequent volume. Many of the steps taken so far aimed at creating a crisis mechanism, strengthening fiscal rules and forming a Banking Union are consistent with the Maastricht 2.0 framework that we have envisioned. Yet there are a number of important gaps that still need to be filled. The key objective is to restore the unity of liability and control. This objective requires resurrecting the no-bailout rule and rendering it more credible than in the past.
References
European Commission (2014), “The economic adjustment programme for Portugal 2011-2014”, European Economy - Occasional Papers 202, Directorate General for Economic and Financial Affairs, Brussels.
German Council of Economic Experts (2013), “Against a backward-looking economic policy”, Annual Economic Report, Wiesbaden, November.
German Council of Economic Experts (2014), “More confidence in market processes”, Annual Economic Report, Wiesbaden, November.
German Council of Economic Experts (2015), “Konsequenzen aus der Griechenlandkrise für einen stabileren Euro-Raum“, Special Report, Wiesbaden, July.
IMF (2015), “Ireland: Ex post evaluation of exceptional access under the 2010 extended arrangement”, IMF Country Report No. 15/20, International Monetary Fund, Washington, DC.
Jaumotte, F and P Sodsriwiboon (2010), “Current account imbalances in the southern Eurozone”, IMF Working Paper 10/139, International Monetary Fund, Washington, DC.
Laeven, L and F Valencia (2012), “Systemic banking crises database: An update”, IMF Working Paper 12/163, International Monetary Fund, Washington, DC.
OECD (2011), “Pensions at a glance 2011: Retirement-income systems in OECD and G20 countries”, Organisation for Economic Co-operation and Development, Paris.
