Current events surrounding the Greek debt crisis have raised calls for further thought about the stability of the Eurozone as a system (e.g. Burda 2010 and Corsetti and James 2010). There must be something fundamentally wrong with the Eurozone if the possible default of a country engaged in irresponsible fiscal policy and accounting for only 3% of the Eurozone’s GDP can raise questions about “saving the euro” and the survival of the entire monetary system.
This column introduces a new CEPR Policy Insight that attributes the Greek-linked difficulty largely to the claim by the ECB and government officials in Eurozone member countries that the Eurozone is founded on fiscal discipline and the Stability and Growth Pact. This claim can only mean that Greek default is a big problem for the euro.
Unfortunately, financial markets give credence to the official view that any government default in the Eurozone would weaken the monetary union, and what these markets believe makes a lot of difference. We see the evidence everywhere, not only in the spreads on credit default swaps that emerged on Portuguese and Spanish government bonds earlier this year, and the rise in the risk premium on the Portuguese government debts that has persisted since January, but probably (though some of us doubted it at first) in the depreciation of the euro since January. Financial markets can act quickly enough to make their fears come true.
To guarantee a long-run future for the Eurozone, a change of doctrine is therefore key. The new doctrine should be that nothing as manageable as a Greek government default can upset Eurozone. This contribution offers reasons why the alternative doctrine is plausible, and in addition it proposes a reform to reinforce the doctrine. The reform would provide the ECB with a supervisory role over banks in the Eurozone and power to act as a lender of last resort. Nothing in the Maastricht Treaty forbids either change.
Eurozone versus dollar zone reactions
There is a striking contrast between the European response to the Greek debt crisis and the US response to the Californian debt crisis.
In June 2009, the state of California handed employees IOU’s, so-called vouchers, for payment. The incident has not been recognized as a default only because banks have honoured the vouchers thus far; but costlier and incontestable default still lies ahead as a significant probability.
This is reflected in the spreads on the credit default swaps on state bonds and the credit ratings of the bonds. The Californian economy is four times larger relative to the US than the Greek one is relative to the Eurozone. Yet nothing remotely resembling the concern and turmoil in Europe about Greece has occurred in the US regarding California.
Neither California’s recent or prospective future breaches of contract have caused a ripple in the US financial sector, not even the part of it heavily implanted in California. Upon examination, it is difficult to explain this difference without invoking the self-inflicted damage of the doctrine that any default would be anathema for Eurozone.
For example, it is not the case that the monetary policy of the ECB is any more affected by the Greek debt problem than the monetary policy of the Federal Reserve is by the Californian one. Alternatively, one might think that Greeks cannot count on help from the rest of the euro members whereas Californians can rely on help from the rest of the nation. But ironically, the opposite is closer to the truth. The Greek government has already received significant aid through the commitment of euro member governments to lend below market rates and now stands a good prospect of last-resort assistance from the rest of the Eurozone while any form of aid to California by the US federal government remains in the dark. Perhaps the most plausible explanation for the difference in Europe and the US, apart from the doctrinal issue in the article, is the idea that Greek default has broader implications than a Californian one for finance in the two respective currency areas. The proposed reform would bear on this particular aspect. But the doctrine of the inability of Eurozone to tolerate any default is important.
Arming the ECB
The recommended alternative doctrine is as follows. The Eurozone has no reason to view government defaults with any greater alarm than any other central bank management in the world would view government defaults within its territory. In the event of a Greek government default, the system would assure the stability of the Greek financial sector, and concern itself with any bank runs or bank failures in the country, but not with the Greek government’s difficulties. In step with this doctrine, government bailouts will never be contemplated. The Stability and Growth Pact will continue to serve as a code of good fiscal conduct for all members of the EU. But if any individual member government engages in irresponsible fiscal conduct, contrary to the Pact, its taxpayers and the creditors will bear the consequences. The Eurozone will only act to assure the stability of the financial sector in the Eurozone and the lack of any repercussions of undisciplined government spending behaviour on the risk premiums that the rest of the governments in the Eurozone need to pay. There has been some confusion on this matter in the past; there will be none in the future.
The reform proposed in this essay would begin by introducing EU charters for banks in the Eurozone. Next, all EU-chartered banks would come under EU supervision. The ECB would not necessarily be the sole supervisory authority but could share this authority with current national ones (who possess valuable experience and firsthand knowledge of individual banks). Finally, the ECB would be able to provide lender-of-last-resort services to EU-chartered banks. Following wide enough adoption of the charters, the ECB would then be as well armed as any other major central bank today to deal with problems of financial stability.
Burda, Michael (2010), “Greece: It’s not all tragedy”, VoxEU.org, 13 March.
Corsetti, Giancarlo and Harold James (2010), “A stitch in time save twenty-seven”, VoxEU.org, 12 April.
Melitz, Jacques (2010), “Eurozone reform: A proposal”, CEPR and VoxEU.org, 1 May.