EZ rescue: Déjà vu all over again

Guido Tabellini

27 October 2011



It is now a habit. Every three or four months, European summits are devoted to ending the Eurozone crisis. Each time tough and controversial decisions are taken and new innovations to European governance are introduced. For a few weeks things seem to get better, but then everything goes back to being as it was, if not worse. Why?

What should be done to solve the problems for real?

The Eurozone core weakness has been known since the beginning – the separation of monetary and fiscal policy. This is the principle upon which the European monetary union was built, but the crisis made it clear – without a central bank acting as lender of last resort, highly indebted countries are too vulnerable to changes in market confidence. Unless this central problem is addressed, the crisis is unlikely to reach a turning point.

Why the EFSF has failed to fix the problem so far

The EFSF was created as a remedy to this structural flaw of the Eurozone. After realising that its size was insufficient, its capacity was enlarged. A new idea came out of the European summit, namely to extend its scope, concentrating the resources of the EFSF in order to partially guarantee newly issued debt of countries at risk. This would allow both Italy and Spain to issue debt which would be partially guaranteed until the end of 2013.

The next failure

There are reasons to believe that this remedy – like the innovations of the past – will fail to restore market confidence.

  • First, the resources of the EFSF will be exhausted in a few years – but confidence cannot have an expiration date.

Knowing that there could be a confidence crisis in a couple of years, why should one trust the solution today?

  • Second, without guarantees, the debt that has already been issued would be penalized, making European banks even more fragile.

This would worsen the vicious spiral we are seeing at work, namely distrust towards debt and banks, higher cost of capital, lower investments and growth, and further slippage towards debt unsustainability.

To cope with this problem, the summit agreed to rely on a special purpose vehicle that would buy sovereign debt in the secondary market. But it is not clear whether its resources would be sufficient for the task, nor where they would be coming from.

  • Third, the guarantees that have been proposed – which cover the losses only up to 20% – are modest.

Experience teaches that, when debt is really restructured, losses are much higher – on average around 50%.

Adding financial stability to the ECB’s mandate

A turning point in the setting of monetary policy is needed to restore confidence. Financial stability should become at least as important as price stability as a guiding principle for monetary policy decisions.

Accordingly, the ECB should cut interest rates and announce the intention to sustain the price of the bonds of the Eurozone governments, unless their public finances are truly unsustainable. A depreciation of the euro would help relaunch the economy – something that would be welcome now that themain risk is a new recession and certainly not inflation. This is the current monetary policy of the other major economies. The economic situation would require the same approach in the Eurozone.

This turn in monetary policy is not necessarily incompatible with the European treaties, given the exceptional nature of the crisis, but it is surely against the prevailing opinion in Germany. And this is not only a political problem. Should the ECB challenge German public opinion, adopting a monetary policy deemed by Germany to be in contrast with the founding principles of the monetary union, the euro would be exposed to serious risks. Currencies, like debt, are based on trust. However, with deep contrasts on monetary policy, we do not know how long trust in the euro would last.

This is the underlying reason why this European summit has proven so difficult. Many realise that the contagion could reach France and that this crisis will not come to an end without a radical reset of monetary policy goals. Yet, the country that more than any other has foregone monetary sovereignty would consider this turn a betrayal.


If this analysis is correct, this outcome of this summit is unlikely to be decisive. The crisis will last for long. We have to wait for German public opinion to realise that the euro was built on imperfect foundations and that these imperfections must be corrected. Meanwhile, the Italian president of the ECB will need all his technical and political expertise to keep the boat afloat.



Topics:  EU institutions

Tags:  EZ crisis

Professor of Economics at Bocconi University and CEPR Research Fellow