The escalation of the fiscal situation in Greece has highlighted the problems of the Eurozone to deal with such crises. The reaction of EU countries up to date has appeared erratic and urgently needs clear, sustainable and credible direction (Baldwin and Wyplosz 2010, Cavallo and Cottani 2010).
Interest rate spreads on Greek government bonds have risen considerably (Attinasi et al. 2010), and rating agencies have downgraded Greece. However, judging from economic fundamentals, there appears to be no imminent danger of a sovereign default. Notwithstanding the rapid rise in the fiscal deficit and total government debt, interest rates and interest payments in relation to total fiscal revenues are still relatively low compared to the early 1990s. Still, there is the danger that financial markets get more nervous and that a self-fulfilling spiral is set in motion with continually increasing spreads, rising debt burdens, higher risk perceptions and again higher interest rates.
Beside these pressing concerns, we uncover the more fundamental policy problems in a new research paper (Busch et al. 2010).
Dysfunctional institutional framework for dealing with fiscal crises
To put it bluntly, the institutional architecture of the Eurozone for crisis prevention and crisis intervention appears dysfunctional. The first pillar to avoid moral hazard in fiscal affairs in the Eurozone countries, the Stability and Growth Pact, has been weakened in 2005 (Deutsche Bundesbank 2005) and was unable to prevent the fiscal profligacy of Greece. The second pillar, the “no-bailout clause” of Article 125 of the Treaty on the Functioning of the European Union (formerly Article 103 EC-Treaty), has lacked credibility from the outset. Both suffer from the problem of time inconsistency. No matter how often you have told your friend to learn swimming and to rely on his own in case of danger, if he is drowning, you will run to help him.
A Greek sovereign default is, politically, unimaginable. Moreover, this would entail severe collateral damages. Contagion could spread to Portugal, Spain, Italy, and Ireland, countries that, like Greece, suffer from a combination of fiscal strains as well as losses of international competitiveness (Matthes 2009). And no less important, the balance sheets of European banks and insurers would suffer considerable losses on government bonds of the respective countries– which could significantly aggravate the distress in financial markets again. Thus, any affirmation not to help Greece in case of need is simply not credible.
The no-bailout clause was called into question all the more by the vague announcements of possible assistance schemes for countries in danger of default. These were initially made in February 2009 by the then German finance minister and some prominent EU representatives in the wake of rapidly rising interest rate spreads on government bonds of some the Eurozone countries. They have been re-iterated in recent weeks by EU governments without spelling out the details of a resolution plan. Before this renewal, however, European officials had appeared to retreat from these promises and had put into question the availability of the protective shield – often by referring to the alleged relevance of the no-bailout clause (Financial Times 2010). These see-saw changes together with the vagueness of the possible assistance scheme clearly demonstrate that the Eurozone lacks an institutional mechanism to deal with an imminent fiscal crisis in a member state.
Many reform proposals suffer from the same time inconsistency problems
This stand-off urgently requires ground-breaking reforms. In fact, many proposals have already been tabled (e. g. Johnson 2009, Mayer 2009, and The Economist 2009), among them strengthening the Stability and Growth Pact, interfering with the sovereignty of a country in crisis, a bailout with ex post conditions or based on ex ante conditions, and the foundation of a European Monetary Fund. All of these suggestions, however, which rely on the Eurozone to solve its problems internally, will eventually suffer from the same time-inconsistency problems as the no-bailout clause and the sanction threat of the Stability and Growth Pact.
Political vulnerability of European integration is the root of the problem
The basic reason for the time inconsistency problem lies in the political and cultural vulnerability of European integration. The historical geopolitical motivation for EU integration to secure peace among formerly war-torn countries has gradually receded over time. It has made way for a more egocentric approach of many Europeans who tend to focus on their own economic advantages from EU-integration. Furthermore, due to the ever increasing scope of EU regulations, the image of Brussels has suffered over time.
Under these preconditions, the envisaged strict enforcement of fiscal austerity in Greece by the European Commission brings with it the danger of pulling the rug under the feet of the bureaucrats in Brussels. In other words, strong political resistance could arise against the European Commission - and may be also against Germany where traditionally the hawks of European economic stability and the guardians of fiscal austerity are said to reside. The strikes in Greece and other countries against deep but necessary reforms do not bode well in this respect. Moreover, strictly disciplining Greece (and possibly other Mediterranean countries) would potentially deepen the political and economic cleavage between northern and southern the Eurozone-countries and could eventually even incite cultural animosities. Together these potential effects pose a considerable threat to the spirit of European integration.
A dilemma arises in the face of foreseeable political resistance in Greece. Either the EU risks EU coherence or – facing such an imminent threat - EU-institutions retreat from strictly enforcing fiscal adjustment in Greece, so that the issue of moral hazard would re-emerge with full force.
The IMF as a scapegoat and credible disciplining force
As a result, an external solution appears more appropriate. The IMF is in an appropriate position to take on this task – in the short term with regard to Greece, but also more formally as a general institutional reform that would require the Eurozone countries to rely on the Fund in case of imminent default. This suggestion, which initially was put forward by the Cologne Institute for Economic Research already in March 2009 (Huether 2009), can be supported by several arguments:
- The IMF is well specialised in crisis resolution and fiscal stabilisation.
- The Fund is used to and institutionally strong enough to play the role of an external scapegoat. There would be no lack of credibility because the IMF is required by its statutes to impose and enforce reform conditions (conditionality).
- The threat of an eventual intervention by the IMF with a strict adjustment regime will reduce the moral hazard problem in fiscal affairs. Thus, this institutional innovation could become a substitute for and preserve the spirit of the no-bailout clause. Moreover, it is likely that the fear of the IMF can effectively strengthen the Stability and Growth Pact which is still badly needed to provide a framework for fiscal surveillance.
- Politically, drawing upon the IMF can even promote European integration, because the EU and the Eurozone countries could play a constructive role in providing co-financing.
Several arguments, which have been raised against calling in the IMF, can be qualified:
- It is sometimes said that the IMF can only help a country with a currency of its own. However, the Fund has already provided financial assistance for countries in other currency unions (Hagen 2009).
- Some observers see the problem that the IMF’s usual conditions concerning monetary policy would interfere with the ECB’s independence. Yet, in the case of Greece, monetary policy prescriptions appear to be dispensable. There is no need to stabilise an independent currency by raising interest rates. Furthermore, the required reforms concern other policy areas such as fiscal policy but also wage policy and deregulation issues. Limiting wage increases would also contain potential inflationary pressures which are, however, unlikely to become strong in the short to medium term due to the manifold adjustment needs in Greece.
- EU treaties, it is said, would not allow the IMF to bailout a Eurozone country because the Fund uses financial means from central banks of Eurozone countries. However, this use is only indirect and - different from direct financing government expenses by a Eurozone central bank – the IMF’s financial assistance is conditioned on reforms. In addition, the part of the IMF’s finances originating from the Eurozone central banks is only limited.
- Calling in the IMF is considered as a severe political weakness of the Eurozone which insists on solving its problems by itself, as has most recently been suggested at G7 summit in Canada. To a certain degree this is surely true. However, having been strongly criticised particularly from the US, the self-confidence of the Eurozone may be too low despite the fact that the first ten years of the euro were rather successful. Moreover, hardly any critical voices were heard when the IMF intervened to help Hungary, Latvia, and Romania.
Weighing the political arguments, the slight damage to the image of the Eurozone appears much less grave than the dangers for European integration which would arise if the Eurozone tried to sort out the problems on its own. Therefore, it appears reasonable to formally involve the IMF in the resolution of potential fiscal crises in the Eurozone countries.
Attinasi, Maria Garcia, Christina Checherita, and Christiane Nickel (2010), “What explains the surge in euro-area sovereign spreads during the financial crisis of 2007-09?”, VoxEU.org, 11 January.
Baldwin, Richard and Charles Wyplosz (2010), “How to destroy the Eurozone: Fieldstein’s euro-holiday idea”, VoxEU.org, 22 February.
Busch, Berthold, Manfred Jaeger-Ambrozewicz, and Juergen Matthes (2010), “Wirtschaftskrise und Staatsinsolvenz, Drohen auch den Industrieländern Staatsbankrotte?”, IW-Analysen, Cologne, forthcoming.
Cavallo, Domingo and Juaquín Cottani (2010), “For Greece, a “fiscal devaluation” is a better solution than a “temporary holiday” from the Eurozone”, VoxEU.org, 22 February.
Deutsche Bundesbank, 2005, “The changes to the Stability and Growth Pact”, in Monthly Report, April, Vol.57, No.4, Frankfurt a.M.pp15-21
The Economist (2009), “Default lines”, 5 December.
Financial Times (2010), “Stark words on Greece”, 6 January.
Hagen, Sean (2009), “10 Years of the Euro: A Perspective from the IMF”, speech held at the ECB, 29 January.
Hüther, Michael (2009) “Die Europäische Währungsunion in der Zerreißprobe: Wirtschaftspolitische Empfehlungen“, Press Conference, 9 March.
Johnson, Simon (2009), “The Choice: Save Europe Now Or Later”, VoxEU.org 28. February.
Matthes, Juergen (2009), “Ten years the Eurozone – Reality test for the OCA-endogeneity hypothesis, economic divergences and future challenges”, Intereconomics, 44(2):114-128
Mayer, Thomas (2009), “The case for a European Monetary Fund”, Intereconomics, Vol. 44(3):138-141