What more do European governments need to do to save the Eurozone in the medium run?

Key building principles of the Eurozone were:

• Each country is responsible for its own government finances; and
• The ECB must not be instrumentalised for fiscal policy purposes.

These principles were based on lessons learned from previous monetary unions that failed when monetary policy became subservient to fiscal policy objectives (Bordo and Jonung 1999).1

The Stability and Growth Pact was established to maintain the first principle. Government finances were to be closely monitored and fines were to be imposed when countries strayed from the path of fiscal virtue. Prevention and early correction of “excessive deficits” (defined as government deficit ratios in excess of 3%) were supposed to eliminate even the slightest possibility that a fiscal crisis in one country could affect the entire Eurozone.

To ensure the second principle, the ECB was made independent from political interference, and prevented from funding government deficits. By introducing a firewall between national fiscal policy and the ECB, the founders of the euro thought that monetary policy was safe from being used by governments in fiscal distress as a lender of last resort.

The Eurozone crisis has pulled the rug out from under both principles. Ensuring the long-run survival of the euro will require a speedy return to these two key principles. Failure to do so could induce some countries to look for alternatives. One can ask: Is a German withdrawal from the Eurozone beyond the realm of the plausible?

The demise of the first principle

Due to actions taken by Germany and France in 2004, the Stability and Growth Pact came into the current crisis severely damaged. There had already been widespread breeches of the excessive deficit strictures and the procedures had been weakened. The pact’s death knell came with Greece’s revelations this year. Not only did the country run excessive deficits before and during its Eurozone membership, but it actually hid the true size of its violations.
After these revelations, nothing about the pact seemed solid and markets’ dim view of Greek solvency spread doubts about the stability of the Eurozone. Markets have sold the euro against other key currencies and are selling government bonds in the euro periphery against German Bunds (see Figure 1).

Figure 1. Ten-year government yield spreads over Germany

Source: IMF

In response to the Greek crisis, the European Commission presented proposals for a fundamental overhaul of the Stability and Growth Pact on 12 May 2010. Key elements in the proposal are:

• Improvement of the functioning of existing mechanisms under the pact;
• Greater focus on high public debt and long-term fiscal sustainability;
• Better incentives and sanctions to comply with the rules of the pact; and
• A framework for crisis management, including financial assistance to financially distressed countries under policy conditionality (European Commission 2010).

‘Blackmail’ possibilities must be eliminated

The Commission proposal are an important and a useful improvement. The Commission’s proposals, however, fail to address the crucial question in my view – what do we do when a country is unable or unwilling to follow the fiscal rules? What happens when a Eurozone member fails to bring its deficit and debt numbers in line or improve its external current account deficit?

If such countries pose a threat to Eurozone financial stability, they can blackmail their partners into open-ended transfers to cover both fiscal and external deficits. Or they can press the ECB to buy up and monetise their debts so as to avoid default.  This is not a solution for long-run stability. In my view, the Eurozone’s fiscal policy coordination apparatus must be completely overhauled to rule out such blackmail situations. What the Eurozone needs to rule out such situations is a facility that allows an orderly sovereign debt rescheduling/default as a last resort.

Earlier this year, Daniel Gros and I proposed the creation of a “European Monetary Fund” for this purpose (Gros and Mayer 2010). This fund would manage and finance assistance programmes of countries with excessive deficits (along the lines of the IMF-led Greek programme). It would also engineer a debt restructuring if unavoidable – sharing the resulting losses between private creditors and the Eurozone governments backing the fund.

I believe that speedy establishment of such a fund is essential. I also believe that it could be done without a Treaty modification by using the enhanced cooperation clause. This, of course, is essential since Treaty changes take years, while Europe needs a solution within weeks or months. The €80 billion stabilisation programme for Greece and the €500 billion stabilisation facility for the Eurozone could be merged into the fund.

The demise of the second principle

The political economy forces currently at play are far from novel. What we are seeing today is a situation much like that predicted by Bordo and Jonung (1999) more than a decade ago. Closer fiscal policy integration follows from monetary integration if the latter is to survive. But how can deeper fiscal integration be accomplished?

Full political union of Eurozone members is not on the agenda. Instead, we need structures that allow controlled fiscal support for countries in financial difficulties as well as orderly debt restructuring as a measure of last resort. The absence of the latter has forced the ECB to step in and to buy bonds of Eurozone governments with fiscal problems that have difficulties accessing the market. True, the ECB has emphasised that it will sterilise the liquidity effects of this intervention by offering term deposits to banks. Hence, their action should not be compared to the “quantitative easing” conducted, for example, by the Bank of England.

Indeed, assuming that sterilisation is successful, the ECB’s action will come to resemble the “credit easing” undertaken during the financial crisis by the US Fed. Yet, there is a major difference. The Fed eased credit costs of some US private sector borrowers at a possible cost for the US tax payer. The ECB lowers the borrowing costs of Eurozone governments in financial distress at the cost of raising costs for all borrowers in all other Eurozone countries. By subsidising some government borrowers at the expense of others, the ECB has moved dangerously close to becoming a supranational fiscal agent.

While France has always favoured a closer relationship between the central bank and the political authorities, this has been an anathema in Germany. Hence, the ECB’s decision to support governments in financial difficulties is seriously undermining public support for the euro in Germany. A rift is growing between the two countries.

Blurring the distinction between monetary and fiscal policy and engaging in international income redistribution creates other risks as well. It poses a danger for the internal cohesion of the “Eurosystem”-- euro-jargon for the complex set of relationships binding national central banks and the ECB. The ECB justified its actions as a way of calming dysfunctional markets. Other Eurozone national central banks may find good reasons why their government bond markets are also “dysfunctional”. If other central banks are more sceptical, conflicts within the ECB’s governing structure could multiply. We may already have seen the start of this. The Bundesbank President did not support the Governing Council decision to buy Greek bonds – and he voiced his disagreement publicly.

What if the ECB’s Greek debt goes bad?

This ECB manoeuvre has opened the door to unprecedented political risks. If the ECB’s bond holdings go bad, the ECB could require recapitalisation. The problem is that Germany, as the largest shareholder, would have to foot the biggest bill – and this would undoubtedly provoke another public backlash. Alternatively, if Eurozone members resisted recapitalisation, the bad debt would have to be monetised, thus eventually causing inflation. With these alternatives as the backdrop to the ECB’s purchases of government debt, it seems absolutely clear that these interventions will be temporary, limited in size, and a singular event.

References

Bordo, Michael D. and Lars Jonung (1999) The Future of EMU: What Does the History of Monetary Unions Tell Us? NBER Working Paper 7365, September.

European Commission (2010), Reinforcing economic policy coordination, Brussels.

Gros, Daniel and Thomas Mayer (2010), “Towards a Euro(pean) Monetary Fund”, Policy Brief 202, Centre for European Policy Studies (CEPS), Brussels, February.

---

1For instance, the Latin and Scandinavian monetary unions of the late 19th century eventually failed because member countries took recourse to monetary financing of government spending in World War I.