Is the euro crisis any closer to a resolution? Europe’s leaders have promised to devise by the end of this month a comprehensive package not only to end the crisis, but also to preserve the euro’s stability. Unfortunately, they are unlikely to succeed, because most of the elements of the package revealed so far address the symptoms of the crisis, not its underlying causes.
German Chancellor Angela Merkel likes to emphasise, rightly, that one should not speak of a “euro crisis,” but of a “debt crisis.” If she had added that this is a crisis of both sovereign and bank debt, she would have been even more right.
But an immediate corollary of this diagnosis is that dealing with this crisis requires finding a solution to the debt problem — that is, the problem of over-indebted sovereigns and insolvent banks. Unfortunately, nothing is being done on either of these crucial fronts.
The new complex mechanisms for economic-policy coordination that dominate the European Union’s agenda might be useful in pushing eurozone member countries to adopt more sensible policies to increase their economies’ competitiveness and strengthen their fiscal positions. But one should remember that, until recently, Ireland and to some extent Spain were held up as shining examples of competitive economies that created a record number of jobs.
So, it is doubtful that closer economic-policy coordination will prevent new bubbles from emerging. When powerful booms emerge in other sectors, the temptation to argue that “this time is different” will again be irresistible.
In any case, financial markets do not care much about the future framework for policy coordination in the eurozone. They need to know how the existing debt overhang will be dealt with today.
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But why should a debt problem in economies that are usually called “peripheral” be so important for financial markets? Greece, Ireland, and Portugal, which is now teetering on the brink of insolvency, account for less than 6 per cent of the eurozone economy. Their problems would not constitute a major issue if Europe’s financial system were robust. A peripheral debt crisis has mutated into a systemic crisis because the eurozone’s financial system is too interconnected and too weak.
Given the interconnectedness of financial markets in a common-currency area, weakness in any one corner spills over into the entire system, which cannot be stabilised until all major components of weakness have been addressed. But Europe lacks a common body with the fiscal resources needed to stabilise the system as a whole. Such resources exist at the national level, but purely national considerations and interests generally guide their use. In other words: Europe faces a fundamental collective-action problem.
Experience has shown that only an acute crisis can force Europe’s leaders to act together in a concerted effort. But, in the autumn of 2008, at the height of the global financial crisis, eurozone heads of state did not consider the creation of a common bank-rescue fund. Instead, they settled for a package of national measures to stabilise national banking systems one by one.
The sum of the headline commitment was impressive, amounting to 20 per cent of GDP. But the show of unity was short-lived. Execution of the package was uneven, with some countries ending up not doing anything. The key areas of weakness in Europe’s financial markets, including undercapitalised banks in core countries, were not addressed, and the system was not able to withstand the second wave of the crisis, triggered by the peripheral countries’ loss of credibility in financial markets.
The EU dealt with the Greek and Irish crises by granting both countries new lines of credit. But very little was done to strengthen the financial system’s ability to withstand a default of any significant magnitude. The only attempt in this direction was the publication, in July 2010, of the outcome of stress tests on more than 90 of the EU’s largest banks. But this episode showed once more what to expect when no EU-wide body exists to oversee systemic stability. Every national supervisor has an incentive to find that “our banks are safe,” even if many institutions are only thinly capitalised and thus weaken the system as a whole.
The degree to which this was true became apparent in November 2010, when it emerged that essentially the entire Irish banking system, which had received a clean bill of health in June, was bankrupt. The market decided that this might also apply to the Irish government, which then had to be bailed out by the European Financial Stability Facility (EFSF).
The “euro crisis” can end only when debt problems on Europe’s periphery can no longer threaten overall stability of the eurozone’s financial system. This will require a range of measures, such as higher capital requirements on sovereign debt, real stress testing of banks, and enlarging the EFSF’s mandate so that it can also recapitalise banks, not just bail out countries.
Ensuring systemic financial stability is the order of the day. That, rather than elaborate mechanisms for economic-policy coordination or grand designs for competitiveness, should be at the top of the European Council’s agenda.
Daniel Gros is Director of the Centre for European Policy Studies.
Copyright: Project Syndicate, 2011.
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