Europe: Crisis and Influence

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This policy brief reviews the origins of the European debt crisis.
  Summary: The debt crisis in Europe’s monetary union, sparked by Greece’s recourse to bail-out liquidity in May 2010, is well into its fourth year and does not look likely to end anytime soon. The eurozone has not yet escaped from the recession that followed the global nancial crash of 2007-2008. Aggregate per capita GDP remains below 2007 levels. Meanwhile, despite considerable scal adjustment, levels of public debt are still too high and they continue to rise as a share of GDP, owing to slow or negative output growth. The reasons for this unhappy state of affairs relate to structural and, largely, systemic aws in Europe’s economic constitution, which have been brought to the surface after the eruption of the global nancial crisis. A review of the srcins of the debt crisis helps bring into relief the deeper causes of the present malaise as well as the difculties in over -coming it. Europe: Crisis and Infuence by Yannos Papantoniou November 2013 Analysis Introduction Te debt crisis in Europe’s monetary union, sparked by Greece’s recourse to bail-out liquidity in May 2010, is well into its ourth year and does not look likely to end anytime soon. Te eurozone has not yet escaped rom the recession that ollowed the global financial crash o 2007-2008. Output losses   in Europe have been larger rela-tive to the United States, China, and the other major economic powers. Aggregate per capita GDP remains below 2007 levels. In Greece, per capita income hovers around the level in had in 2000; in Italy, it remains around the level it had in 1997. Unemploy-ment is about 12 percent on average, a record high. In Spain and Greece, more than one-quarter o the labor orce is jobless, while the unemploy-ment among young people in Greece exceeds 60 percent. Meanwhile, despite considerable fiscal adjustment, levels o public debt are still too high and they continue to rise as a share o GDP, owing to slow or negative output growth. Medium-term debt sustain-ability, a key condition or restoring financial stability, remains unresolved. Moreover, banks are still undercapital-ized and unable to provide the finance needed or economic growth. Lately the loss o competitiveness has been only partly reversed, with most o the improvement coming rom internal devaluation rather than reorm-induced productivity gains. Prospects or economic recovery thus remain clouded with uncertainties. Te reasons or this unhappy state o affairs relate to structural and, largely, systemic flaws in Europe’s economic constitution, which have been brought to the surace afer the eruption o the global financial crisis. A review o the srcins o the debt crisis helps bring into relie the deeper causes o the present malaise as well as the difficul-ties in overcoming it. Origins of the Eurozone Crisis Over the last decade — which was also the first since the birth o the euro — large external imbalances were allowed to emerge within the currency union. Te competitive position o peripheral member coun-tries, particularly Greece, Italy, Spain, Portugal, and Ireland, deteriorated sharply as measured by unit labor costs  vis-à-vis the core countries o Europe. Governments in the periphery ignored warnings and turned a blind eye to the accumulation o credit-ueled bubbles and public or private debt while they ailed to take anti-cyclical fiscal measures or promote structural  2 Analysis reorms or improving competitiveness. Large peripheral external deficits were matched by surpluses in Germany and other core countries. Te persistence o these imbalances has transerred excess savings to the periphery creating the conditions or extensive borrowing on the part o both the private and public sectors. In fiscally responsible countries like Spain, excess savings resources have been borrowed by the private sector and invested in what later became bubbles: housing assets. Te burst o the bubbles created problems o insolvency to the banks, as people were unable to repay their loans, while the bubble-induced recession, coupled with the disruption produced by the financial crash and the associated collapse in exports, led to an explosion o budget deficits and ull-blown fiscal crises. In fiscally profligate countries, like Greece, the chain o events was more straightorward. Excess savings resources had mainly been borrowed by the government, leading directly to a fiscal crisis. Debt growth undertook catastrophic propor-tions afer the financial crash, when the recession led to drastic cuts in private spending and the automatic capture o redundant savings resources by the government. An interesting, and critically important, part o the story is that much o the debt that was induced by the savings glut   in core economies ended up, whether indirectly or directly, on government books o the peripheral countries. 1 Fiscal crises, when they hit structurally weak economies such as Europe’s southern countries, eventually evolve into debt crises threatening to lead to sovereign deaults — and a potential breakup o the currency union. Te challenge acing European policymakers since the emergence o the debt crisis has been twoold:ã First, how to strengthen the over-indebted economies by helping them to consolidate their public finances and promote productivity-enhancing structural reorms, so as to make them more resilient to external or internal shocks. ã Second, how to reorm the system o economic gover-nance o the currency union so as to control imbalances and thus restore confidence in the euro while securing conditions or stability and steady growth. 1  For an analysis of the debt crisis, see Yannos Papantoniou, “The Lessons of the Eurozone Crisis that Should Shape the EU’s G20 Stance,” Friends of Europe, 2011. Te effectiveness o the eurozone’s response to the chal-lenges is being vividly debated with views diverging widely. Eurozone leaders such as the presidents o the European Council and the Commission, as well as heads o govern-ment o core countries such as Germany, talk o success and reer to the considerable progress in reducing fiscal deficits and adjusting labor costs — tantamount to an internal declaration. Tis contributed, alongside with the recession-induced all in imports, to an improvement in external balances. Tey attribute this progress to the effectiveness o austerity policies. Tey also take stock o some institu-tional changes, in particular the creation o the European Stability Mechanism (ESM), with €500 billion at its disposal or rescue purposes, and the steps taken in the direction o setting up a European banking union. Te initiatives o the European Central Bank President Mario Draghi, who pledged to do “whatever it takes” to save the euro and proceeded to establish the ECB’s “outright monetary transactions” program in order to make purchases o bonds issued by eurozone member-states in secondary markets under certain conditions, also helped to restore calm in financial markets. Facing the Crisis: Austerity Critics stress the act that the economic and social costs o austerity, in particular the destruction o productive capacity and the resultant mass unemployment, are enor-mous while the chances or a ast recovery and return to higher rates o economic growth are slim. Crucially, they point out that the social rifs produced by excessive austerity in the weaker economies o the south are spreading insta-bility and creating political strains that may soon reach breaking point. Te Italian government remains very ragile while the Greek center-right coalition aces intense opposi-tion as it is pushed by the creditors to take urther austerity Much of the debt that was induced by the savings glut in core economies ended up... on government books of the peripheral countries.  3 Analysis measures. Te Spanish and Portuguese governments are conronted with similar challenges. Te prospect o populist anti-austerity parties gaining power in peripheral countries alongside anti-euro anti-bailout parties in the core winning significant shares o votes in the next year’s European Parlia-ment elections is being brought orward. I that happens, financial turbulence would return, setting the scene or new episodes in the trajectory o the eurozone crisis, while reces-sion will persist and, eventually, aggravate the crisis itsel. Te question arises as to whether such outcomes could have been orestalled. Te present strategy or overcoming the eurozone crisis, relying on austerity and structural reorms, ocuses exclusively on supply actors and ignores demand. But i all countries simultaneously attempt to improve their fiscal or external balances by cutting spending and raising taxes, all will ail, because each country’s austerity implies less demand or other countries’ output in turn perpetu-ating both domestic and external imbalances. “Bailing in” creditors, as has been already applied in Cyprus, will exacerbate these trends. Rising debt to GDP ratios testiy to the ineffectiveness o generalized austerity in securing debt sustainability over the medium term.Moreover, a deep and prolonged recession implies  vanishing support or reorms, as governments ail to convince citizens that their current sacrifice will ensure a better uture. Privatization, market liberalization, the opening o closed proessions, and government downsizing involve conflicts with powerul vested interests, such as businesses   in protected industries, public-sector unions, or influential lobbies. Resolving such conflicts requires social alliances, which are invariably undermined by discontent, civil disorder, and political instability.Te emphasis on harsh austerity, which was to be pursued everywhere, was a critical error in the design o the lenders’ strategy or overcoming the crisis. Indeed, the International Monetary Fund has belatedly acknowledged that its evalua-tions o the impact o fiscal measures on the GDP were wide o the mark.Adjustment programs systematically take into account demand actors. Since devaluation is not possible in a currency union or propping up external demand, other instruments should be used to balance the effects o fiscal austerity. Countries with a stronger fiscal position should be encouraged to adopt more expansionary policies in order to compensate or demand losses elsewhere. Moreover, the European Investment Bank’s lending capacity should be increased substantially, and European Union Structural unds mobilized, to boost investment in the peripheral economies. Public investment projects, public-private sector partner-ships, and small and medium-sized enterprises could benefit rom such flows o grants and low-interest loans. Te European Central Bank (ECB) should also play a more active role in sustaining demand in the peripheral economies. Further reductions in key interest rates would raise inflation in core countries with external surpluses and thus help close the competitiveness gap and increase the periphery’s net exports. Te ECB should emulate other major central banks, such as the U.S. Federal Reserve, the Bank o England, and (more recently) the Bank o Japan in aggressively pursuing unconventional monetary policy measures such as quantitative easing so as to improve credit conditions. ECB’s cautiousness, encouraged by Germany’s Bundesbank, exacerbates the division o the currency union into northern and southern subzones with widely differing interest rate levels. Currently, enterprises in the periphery borrow at substantially higher rates than the enterprises in the core economies. In bank loans, the relation is close to two to one while in long-term financing it may reach ten to one. Te transmission mechanisms o the monetary union seem to be broken inflicting considerable damage to the international competitiveness and the growth prospects o the weaker economies. Overall, austerity policies have achieved considerable progress in fiscal deficit reduction and internal devalua-tion but, as a result o the deep and prolonged recession they have provoked, they ailed to secure debt sustainability over the medium term. Besides the enormous economic and social costs imposed on the weaker economies, they exerted a negative impact on the reorm effort by depriving the motivation or accepting the sacrifices associated with A deep and prolonged recession implies vanishing support for reforms.  4 Analysis significant structural changes and related productivity gains. Te widening gap in real perormance between the core and the periphery produced a corresponding spread in relative borrowing costs, urther exacerbating the north-south divide. Facing the Crisis: Institutional Reform Te progress achieved over the last couple o years in the field on institutional reorm is limited. Te euro is a mone-tary, not a political union. It possesses a central bank, but not a treasury. Te central bank can provide liquidity in times o crisis though only a treasury can address problems o solvency. Te challenge or the eurozone today is to make a qualita-tive step orward on the road to economic and political integration so as to fill in the gaps in its institutional rame-work and equip itsel with mechanisms that will effectively prevent and, i required, redress imbalances. Only then will Europe be able to ensure the sustainability o the common currency and create conditions or stability and growth, thereby enabling it to maintain its social model and punch its weight in the world. No amount o effort o individual countries to strengthen their fiscal position and their competitiveness can succeed in making them resilient to shocks unless it is conducted in the context o a broader reorm that ortifies the eurozone as a system. Tis is a lesson learnt during the present turmoil. Te United States, being the only model o a well-unc-tioning monetary union, is the standard against which the eurozone’s current attempts at institutional reorm should be evaluated. Te dollar zone rests on a common budget, common taxation, and a common treasury, while debt is mutualized through the issuance o common bonds. Tere are centralized structures in banking with common super- vision and resolution authorities and a common deposit guarantee scheme. Lastly, the dollar is guaranteed by the Federal Reserve, which is empowered to act as a lender o last resort. Europe’s history rules out emulating the U.S. model. But, to make the eurozone work and restore confidence in the sustainability o the euro, the present eeble attempts at fiscal and financial unification should advance significantly urther. Centralized institutions should acquire powers to coordinate fiscal and economic policies backed by common taxation, Eurobonds, and a ully-fledged sovereign-debt-resolution mechanism. Banking union should include a single, comprehensive supervising authority, a common und to wind up insolvent banks, and a common deposit guarantee scheme. Te European Stability Mechanism (ESM) should be empowered to undertake direct equity recapitalization o banks so as to ully separate bank risk rom sovereign risk. Te ECB should be allowed to inter- vene in the primary sovereign bond markets — subject to conditions concerning fiscal discipline — offering an ultimate backstop or the euro. Tere is considerable distance to be traveled rom the recently established “European Semester,” a yearly cycle o economic policy coordination aimed at guiding national budget policies through issuing “recommendations,” as well as the present structure and size o the ESM. However, the recent German parliamentary elections have confirmed the strategy o small steps or “muddling through.” Mistrust between the lenders and the over-indebted economies, a growing reluctance within the countries o the core to mutualize debt, and deep-seated political resistance to transerring sovereignty to suprana-tional institutions got the upper hand. Sovereignty rests on democratic legitimacy at the European scale, which involves the election o European Commission President by universal suffrage and significant strengthening o the European Parliament. However, support or such moves remains weak. Te euro-zone appears to be trapped in a strategy that deepens reces-sion while simultaneously undermining the confidence in the euro. Te mix is toxic so ar as the weaker economies are concerned because, instead o increased spending — particularly or investment — it induces hoarding and capital outflows. Tis is the reverse o what economies need to recover and grow. As unding problems recur, owing to continued recession, governments in the over-indebted The challenge for the eurozone today is to make a qualitative step forward on the road to economic and political integration.
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