The End of the Beginning for the Euro Crisis

February 7, 2011 9:30 AM

The European Union Council, meeting in the first week of February, did not produce the "comprehensive long-term solution" to the eurozone's debt crisis that some had hoped. Yet, EU leaders did agree on a deadline to produce their version of such a solution at the next Council in late March 20111, and they offered the general policy direction of the content of this long-term package. The EU and eurozone in particular are finally approaching the end of the beginning of the euro crisis, which is gradually being reflected in the calming eurozone financial markets.

As continued strong real economic indicators lift prospects for recovery in the EU, and important structural reforms continue to be implemented in the pivotal peripheral country, Spain2, it is no longer a question of the euro's survival.  (No democratic member – economically weak or strong – will ever leave the euro.) Nor is there any longer a question of whether EU leaders have the will and capacity to take the necessary painful economic reform decisions (Prime Minister Jose Luis Rodriguez Zapatero of Spain illustrates this best). There is finally no longer really a question of whether the eurozone periphery will achieve debt sustainability. Instead the question is precisely how, and crucially what the core eurozone countries want in return for providing the necessary assistance to the periphery.

The 2010-2011 eurozone debt crisis – the first real economic crisis of the euro era, which Milton Friedman famously but erroneously predicted the euro would not survive – should in many ways be thought of as the final chapter of the decade or so of the euro introduction process, during which several of the "original sins" of the currency setup are now being corrected.

The two original political sins of the euro introduction were the 1997 nixing of the 60 percent debt ceiling provision in the Maastricht Treaty, and the 2003-04 gutting of the original Stability and Growth Pact (SGP) framework by France and Germany. These errors guaranteed that out of political necessity the eurozone began as a club of highly fiscally "diverse national units," with the idea of politically enforced discipline leading to "economic convergence" abandoned. Meanwhile, due to a related "original financial market sin" of the euro era, in which the markets judged the countries as all alike in their fiscal sustainability, there was a phony bond market convergence of 1999-2008, enabling unreformed peripheral eurozone members to enjoy low German interest rates. As a result, their ultimately unsustainable fiscal policies and private sector indebtedness were allowed to deteriorate past the point of no return, as witnessed in the experience of Greece, Ireland and possibly Portugal.

The 2010-2011 crisis and the response to it have corrected several of these original sins. The full-scale adoption by the EU of the "International Monetary Fund (IMF) doctrine" in dealing with unsustainable fiscal policies and sovereign debt crises means that peripheral economically weak eurozone members, which entered the euro "unreformed," are now belatedly being forced to undertake the types of structural economic reforms that they ought to have implemented before joining3. The adoption of Collective Action Clauses(CACs) on all eurozone debt post-2013 and the resulting cementing of bond market spreads from the implied increased credit risk for investors of weaker sovereign will furthermore prevent a return of "phony bond yield convergence" among eurozone sovereigns.

As stressed in last week's EU Council conclusions4 and also by German Chancellor Angela Merkel, a strengthening of the financial assistance capacity of the temporary European Financial Stabilization Fund (EFSF) will be implemented by March 2011, as well as a clarification of the operational features of the permanent European Stabilization Mechanism (ESM). These developments suggest that the debt sustainability concerns over Greece and Ireland will be addressed through maturity extensions and interest rate reductions on the two countries' official sector liabilities, as well as potential voluntary debt exchanges at close to current market rates for interested private sector investors5. The latter solution is likely to appeal mostly to politically sensitive eurozone banks eager to curry favor with their sovereign backers during the imminent next round of bank stress tests.

As for the possibility of haircuts on private sector debt holders, EU leaders have evidently concluded such a course of action would produce too much instability in eurozone sovereign bond markets, as many traditional conservative investors might quit them all together. Hence, while the official sector debt will be restructured, the likelihood of haircuts being imposed on private sector holders of Greek or Irish sovereign debt (or senior Irish bank bondholders) now looks very close to zero, provided that both countries continue to adhere strictly to the existing EU/IMF programs6.

Meanwhile, the idea of E-bonds is surely dead for the foreseeable future. At the same time, EU leaders again reiterated their intent to implement more forceful banking stress-tests through the new European Banking Authority (EBA) and stand ready to provide capital support where required. However, despite this repeated leaders' political commitment to "tough stress tests," just how tough remains the main source of uncertainty surrounding the policy response to the eurozone debt crisis. History suggests that great skepticism is warranted concerning the willingness of Germany to face up to the problems in its banking sector. Accordingly, we still need to know more about the methodology and implementation of these stress tests.

A striking final step by the EU Council was its discussion of a new Franco-German "Competitiveness Pact" proposal. The precise content of this pact is not yet final, and it is certain to be the subject of fierce public debate between EU governments until decisions are taken in March. But its announcement alone suggests a longer-term trend toward continued EU and eurozone economic integration.

It is clear, for example, that much of the additional EU economic integration agreed among European countries as a result of this crisis will be "intergovernmental" in nature. This implies an agreement among willing member states (mostly in the eurozone, but open to other EU members, too), rather than a deference to initiatives overseen by the European Commission. Such an arrangement will surely disappoint many in Brussels, because it means that a more unified and integrated Europe no longer requires a more federal Europe with a strong executive and implied larger fiscal transfers. The lack of a legal anchoring, a permanent enforcer in the European Commission and ultimate recourse to the European Court of Justice (ECJ) of such "inter-governmentalist" economic integration in the EU is a worry. It means that new initiatives are open to changing political sentiments, with a high risk of failure in implementation. Peer pressure has historically been a much weaker enforcement mechanism in Europe than the European Commission. Yet at this time,  political realities dictate that this sort of voluntary "open two-speed Europe" arrangement is the only one available.

For all the talk of integration, on the other hand, and although the ultimate content of the "Competitiveness Pact" remains uncertain, it is clear that nothing in it will really constrain Germany or other "surplus countries" in their quest for export-oriented growth for themselves and discipline for other countries and trading partners.  Several types of measures have been floated as trial balloons, including an end to automatic wage indexation to inflation (opposed by Belgium and probably others), a common eurozone retirement age at 67 (surely opposed by many in France), national constitutional balanced budget/debt clauses a la the German "Schuldenbremse," and a harmonization of eurozone corporate tax bases. All these ideas suggest that the envisioned intra-eurozone "competitiveness adjustments" will come almost exclusively from the peripheral countries, as the price imposed by the eurozone core in exchange for providing the necessary financial assistance to the periphery.

The general direction of the "Competitiveness Pact" and the new post-crisis roles of the "Franco-German EU engine" are therefore reasonably clear. The next stage in EU/eurozone economic integration may occur via French methods (i.e. intergovernmentalism focused on the eurozone, as opposed to the European Commission and all EU-27), but will consist largely of German policy substance.

Last week's EU Council illustrates how the debt crisis has propelled the euro – one of the world's major global currencies – into the arms of leadership by a hegemonic surplus country, i.e. Germany. Inflation hawks may celebrate, but those with concerns about renewed global imbalances surely will not.



1. There will be an additional eurozone summit to decide on the details of new eurozone initiatives before the March 2011 full EU Council. Given the German electoral calendar with several state elections at the end of March and the possible adverse electoral effects among some of Chancellor Merkel's core supporters of the required compromises of a "comprehensive solution", it is in the German government's clear interest not to have a final agreement before the EU Council in late March just a few days ahead of these elections. This will minimize any negative effects among coalition supporters that the required compromises might have.

2. In recent weeks, Spain has finally begun reforming and recapitalizing its savings banks (cajas), raised its retirement age to 67 and struck a "Grand Social Pact" which crucially includes loosing up the country's excessively centralized collective bargaining wage setting mechanisms. As illustrated by the recent years of German experience, allowing firm-level flexibility on wages and related issues is an important competitive parameter.

3. It is evident that the Eastern European member states have learned from this experience are determined to enter the euro only at the point where they have "done their homework".


5. This suggests that voluntary debt exchanges would be offered at the say 20-25% discount that current market rates imply. A predictable significant narrowing of Greek and Irish bond spreads as the conclusion of the deal draws closer is thus not likely to be reflected in any voluntary offer extended to private debt holders. The changing of the Conclusion's expression from seeking more EFSF "flexibility" into more EFSF "effectiveness" suggests that debt-buybacks through the EFSF are now less likely. However, this will not materially affect the opportunities for achieving peripheral debt sustainability.

6. While a lot of rhetoric will be heard during the current Irish election campaign, this is a fact that is not likely to be lost on any new Irish government.