The problems of the euro turned critical when the Greek government nearly defaulted in May 2010 and the International Monetary Fund and European Union agreed to a bailout. In truth, the 17-nation euro area had deep troubles long before that. Its oversized and undercapitalized banks, its common monetary policy but diverse and fragmented fiscal policies, the persistent economic imbalances among nations that use the euro, and a cumbersome decision-making structure all made the euro-area economy vulnerable. The crisis, which still bears the mark of the Greek tragedy that first set it off, has now spread far beyond Greece.
The euro was created for normal times, but the EU lacked good mechanisms for crisis management. At every step of the Greek drama, policy-maker responses have remained behind the curve of economic deterioration. Slowly but surely, this erosion of confidence ensnared other countries, such as Ireland and Portugal, then spread to Spain and Italy, both perceived to be fiscally vulnerable. If European leaders cannot resolve Greece’s problems, they can hardly save the much larger economies of Spain and Italy.
As the Greek crisis unfolded and the focus shifted to sovereign debt, the pressure on policy--makers to tackle the endemic capital and liquidity problems in EU banks temporarily eased. However, EU–wide bank stress tests carried out in 2010 were discredited when Irish banks had to be bailed out just months after receiving a clean bill of health. The next set of stress tests in July 2011 were better but still did not inspire confidence, and EU leaders failed, yet again, to adequately address the problems of Greece in a summit at the end of July. Predictably, the money markets began betting against both the securities of banks and the sovereign debt of weaker EU member states.
The fates of the banks and the debt of member states are intimately linked. European banks are not required to hold capital against their investments in holdings of an EU country’s debt, so they keep a large amount of sovereign bonds on their books. As the rising borrowing costs of an increasing number of European nations have driven down the market value of their bonds, bank balance sheets have suffered accordingly.
Sovereign states and banks in Europe are now engaged in a dance of death where weak sovereigns pull banks down and weak banks push countries ever closer to default. Bold action is now needed on multiple fronts to break this downward spiral and restore growth and confidence in the euro-area economy. But the unfolding Greek disaster, an ill-suited institutional structure, and the poisoned political atmosphere among EU leaders all limit their room for maneuver as they grapple with multiple challenges.
Greece's problems are mostly fiscal—tax collection is terrible, and public spending is both high and inefficient. Public debt, at nearly 158 percent of gross domestic product and rising, is clearly unsustainable and unpayable. Yet the EU stubbornly refused to acknowledge this obvious truth and treated Greece as though it only had a temporary liquidity problem. This denial hurt the credibility of EU leaders and institutions. They now insist that Italy and Spain are solvent—but they said the same of Greece, which is not, making it much harder to restore market confidence in sovereign debt. The EU will need to go far beyond anything that is currently on the table—in restructuring the Greek debt, restoring growth, recapitalizing banks, building confidence in European sovereign debt, and reforming the EU system of governance.
By viewing the larger European problems through the lens of the special case of Greece, policy--makers have emphasized the fiscal aspects of the crisis. Lingering problems in the financial sector as well as failures of governance were left to fester. Instead, the EU prescribed austerity as a cure for all troubled member states including Spain and Ireland—which in fact had banking but not fiscal crises.
This fashionable austerity mantra has now been applied across Europe, even in countries like Germany that do not face a near-term public-debt problem, and in the U.K., where excessive austerity is driving the economy deeper into recession. All this has brought growth in Europe to a standstill, worsening the sovereign-debt crisis. Troubled countries desperately need growth but are forced to cut spending, hurting their near-term growth. Meanwhile, countries such as Germany that do have fiscal room to finance expansion are unwilling to spend. As growth falters, the debt overhang worsens.
The additional capital needs of EU banks, and the serious funding problems they face, have been belatedly recognized at a time when the market’s capacity to raise capital could hardly be worse. Most member nations are hesitant or unable to provide additional bank capital from public funds, except after a bank collapses, as in the case of Dexia. The European Central Bank (ECB) has reluctantly bought some sovereign debt but can only provide liquidity, not capital support to banks.
The EU’s approach has put Greece in a downward spiral from which, no matter what Greece does, it cannot extricate itself. The EU, IMF, and ECB have advanced the Greeks just enough money to keep current on their payments to creditors but have not supported sufficient restructuring to allow them to leave the debtor’s prison or grow. The bailout decision was accompanied by the politically convenient rhetoric of “lazy Greeks” in countries such as Germany and the Netherlands. This has now come back to haunt leaders as the public opinion that they themselves helped stoke now makes it more difficult to get even modest improvements in the European Financial Stability Facility (EFSF), which provides emergency financing to distressed economies.
European finance ministers and leaders have now met countless times to discuss Greece’s growing problems. These fraught discussions have not just used up precious time but worse, have sown personal mistrust and exhausted scarce political capital. This has poisoned the atmosphere and seriously limits the ability of the 17 euro-area countries to make decisions that are collectively sensible but individually difficult.
The institutional conflicts among the European Council (which represents member states), the European Commission, and the European Central Bank have further complicated the already-difficult politics. The ECB, for example, refuses to allow the mandatory restructuring of Greek debt needed to reach sustainable levels. As a result, EU leaders have tied themselves in knots trying to get a fair sharing of the financial burden between the EU public sector that is aiding Greece and the private bondholders holding Greek government bonds. Even more important, while the ECB has provided some support to troubled countries by buying their bonds in the market, total ECB purchases of euro-member bonds is puny—much smaller than the purchases of U.K. government bonds by the Bank of England. The refusal of the ECB to act as a proper lender of last resort to euro-area governments and to allow a proper restructuring of Greek debt seriously limits sensible solutions to the larger crisis of the euro area.
The October 23 European summit followed the pattern of doing too little, too late. Under the plan, private-sector holders of Greek debt will face restructuring losses of 40 percent to 60 percent, up from the 21 percent agreed to in July. But this is not enough to restore Greek debt to sustainability. Second, the EFSF will be allowed to offer partial guarantees for new borrowing by illiquid countries such as Spain and Italy to reduce their borrowing costs. This plan, at best, will offer only temporary relief and buy some time. The recapitalization of EU banks, in the amount of 100 billion euros or so, will disappoint markets and analysts. Finally, the governance reforms will not tackle the fundamental problems facing the euro area.
To solve the crisis, four big interrelated issues need to be tackled, urgently: halting the vicious sovereign debt/bank death spiral; rekindling growth without encouraging fiscal incontinence; ending political parochialism, pettiness, and procrastination; and finding a workable governance structure that addresses the structural deficiencies in the euro area. We cannot tackle fundamental issues without restoring confidence first, yet the panic will not go away unless Europe charts a credible path to improving governance.
More support for illiquid but solvent countries such as Italy, which are weighing down EU banks, will reduce the amount of capital needed for banks. Additional capital can then be mobilized through imposing a moratorium on bonuses and dividends, mandatory rights issues for shareholders and, for weak banks in weak states, support from the EFSF. In the longer term, strong legislation to allow resolution of failing banks will stop banks from bringing down entire nations. Allowing the issuance of eurobonds, jointly issued sovereign bonds of euro-area member states, could limit the damage weak countries could inflict on banks by reducing direct bank exposures to any sovereign bonds.
On the economic front, an open-ended ECB commitment to purchase troubled sovereign bonds would work best, though a more limited role may also work in combination with EFSF, at least temporarily. Using EFSF guarantees may make it politically easier for the ECB to ramp up its support.
In order to restore growth, weaker nations must be given more time to adjust fiscally, and healthier countries should reverse their austerity. An EU–wide agreement to coordinate ongoing country-level initiatives against tax evasion would generate substantial additional revenues; new taxes on carbon emissions and financial transactions would also help. Doubling European Investment Bank capital to finance pan–EU infrastructure will generate much-needed structural growth.
None of the short-term fixes or longer-term structural plans would be credible without a major improvement in the fractious politics of the euro area. Good economics has repeatedly fallen victim to bad politics. Making difficult but binding political commitments would signal a seriousness that has been missing thus far.
Greece’s problems, having cost Europe dearly, must be addressed decisively. A much deeper haircut of private debt, an EU–led investment program, and deeply concessional public support would make tomorrow look promising in Greece. Germany needs to swallow a bitter political pill and map out a medium-term route to adopting eurobonds. This will allow the euro area to exploit the fact that its fiscal situation looks healthier than that of the U.S., when Europe is considered as a single economy. Eurobonds would lower borrowing costs for all euro-area nations, though they are not a silver bullet. In exchange for this commitment, the ECB must stop playing a high-stakes game of chicken with leaders and increase its own support for sovereign bonds. This will provide countries the economic space to enact essential structural reforms.
The European Commission for its part must lay out clear plans for the closer fiscal coordination that complements a single monetary policy. At the same time, it needs to put special fast-acting crisis institutions in place since slow-moving EU institutions are designed only for normal times. Accelerating the creation of the European Stabilization Mechanism, a kind of European Monetary Fund, and giving it more powers and flexibility would help.
Most of all, a sustainable solution must be found to the structural problem of having diverse and divergent economies follow a single monetary policy without causing instability. Allowing the ECB to impose different, inflation-specific reserve requirements in different member states, using customized capital buffers for banks across countries with different growth rates, and making smarter use of old-fashioned tools such as maximum loan-to-value ratios would all help address the structural flaws of the euro area.
Without all countries and EU institutions pulling their weight, this could be the beginning of the end. Parochialism and pettiness cannot deliver stability in Europe; only the series of urgent short-term measures and sensible medium-term reforms suggested here can. Good policies and good politics must reinforce each other. United, the EU will stand; divided, we will fall and take the world economy down with us.