30 April 2010
With articles by D. Gros, T. Mayer, U. Häde, J. Pisani-Ferry, A. Sapir, J. Matthes, D. Mabbett, W. Schelkle, W. Kösters, P. Grauwe, D. Lachman
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Challenges Facing European Monetary Union
OTHER ARTICLES
Forum: Challenges Facing European Monetary Union
While past discussions on EMU tended to emphasise its role in limiting the impact of the global financial crisis on the euro area countries, the focus has now shifted to the destabilising effects threatening the entire euro zone as a consequence of the dire fiscal situation in some weaker member countries, notably Greece. Will the EMU be able to pass the first serious challenge it faces or is it a fair-weather construction with basic design flaws? What options are available to policymakers?
Contents:
How to Deal with the Threat of Sovereign Default in Europe: Towards a Euro(pean) Monetary Fund - Daniel Gros and Thomas Mayer
Legal Evaluation of a European Monetary Fund - Ulrich Häde
Crisis Resolution in the Euro Area: An Alternative to the European Monetary Fund - Jean Pisani-Ferry and André Sapir
The IMF is Better Suited than an EMF to Deal with Potential Sovereign Defaults in the Eurozone - Jürgen Matthes
Beyond the Crisis – The Greek Conundrum and EMU Reform - Deborah Mabbett and Waltraud Schelkle
Challenges Facing European Monetary Union – Rules and Assignment or Discretion and Coordination? - Wim Kösters
The Greek Crisis and the Future of the Eurozone - Paul De Grauwe
Greece’s Threat to the Euro - Desmond Lachman
Intereconomics Vol.45, No.2, March-April 2010, p64-95
(Gros, Daniel)
http://www.intereconomics.eu/downloads/getfile.php?id=725
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Forum
DOI: 10.1007/s10272-010-0326-7
Forum
DOI: 10.1007/s10272-010-0326-7
Challenges Facing European Monetary Union
While past discussions on EMU tended to emphasise its role in limiting the impact of the
global financial crisis on the euro area countries, the focus has now shifted to the destabilising
effects threatening the entire euro zone as a consequence of the dire fiscal situation in some
weaker member countries, notably Greece. Will the EMU be able to pass the fi rst serious
challenge it faces or is it a fair-weather construction with basic design flaws? What options are
available to policymakers?
Daniel Gros and Thomas Mayer
How to Deal with the Threat of Sovereign Default in Europe:
Towards a Euro(pean) Monetary Fund*
The case of Greece has ushered in the second phase of
the financial crisis, namely that of a public debt crisis.
Members of the euro area were supposed to be shielded
from a financial market meltdown. But after excess
spending during the period of easy credit, several euro
area members are now grappling with the implosion of
credit-financed construction and consumption booms.
Greece is the weakest of the weak links, given its high
public debt (around 120% of GDP), compounded by a
government budget deficit of almost 13% of GDP, a huge
external deficit of 11% of GDP and the loss of credibility
from its repeated cheating on budget reports.
Greece – as well as others in the EU, notably Portugal and
Spain – must therefore undergo painful adjustments in
government finances and external competitiveness if their
public debt positions are to become sustainable again.
But given the intense pressure from fi nancial markets,
it is likely that in some cases a tough fi scal adjustment
programme (or rather the promise that one will be forthcoming)
might not be enough to avoid a “sudden stop” of
external funding of the public sector. When this happens,
the euro area will no longer be able to fudge the question
of whether (and in what form) it can provide public fi nancial
support to one of its members.
One way out of this dilemma seems to be to call in the
IMF. In principle, the conditions for taking this route have
been clarified at the European Council of 25 March 2010.
*
This paper is based on D. Gros, T. Mayer: How to deal with sovereign
default in Europe: Towards a Euro(pean) Monetary Fund, CEPS
Policy Brief No. 202, Centre for European Policy Studies, Brussels,
February 2010.
“As part of a package involving substantial International
Monetary Fund financing and a majority of European fi nancing,
Euro area member states, are ready to contribute
to coordinated bilateral loans. This mechanism, complementing
International Monetary Fund fi nancing, has
to be considered ultima ratio, meaning in particular that
market financing is insufficient. Any disbursement on the
bilateral loans would be decided by the euro area member
states by unanimity subject to strong conditionality
and based on an assessment by the European Commission
and the European Central Bank.”1
However, it is also clear that the IMF would not be able to
solve the Greek problem on its own since the amount of
financial assistance it could give to the country is limited
to about € 10-15 billion, a fraction of Greece’s estimated
financing need for 2010 alone. This is why the statement
from the Heads of State of the Euro Area foresees that the
majority of the financing would be European and any disbursement
would be decided by euro area member states
(by unanimity).
This package which has now been agreed to for the case
of Greece is clearly designed to deal with a potential
emergency situation in an ad hoc manner.
We would argue, however, that this is not a satisfactory
approach in general. The EU needs to design a scheme
capable of dealing with the threat of sovereign default.
If
1
Statement by the Heads of State and Government of the Euro Area,
available at http://www.consilium.europa.eu/uedocs/cms_data/
docs/pressdata/en/ec/113563.pdf
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the IMF were called in to help and the country concerned
(today Greece, but tomorrow another country) refused to
comply with the conditions of a support programme, the
problem would only be magnified. The debtor country,
like Greece today, would retain its main negotiating asset,
namely the threat of a disorderly default, creating systemic
financial instability in the EU and possibly at the global
level. This dilemma could be avoided by creating a “European
Monetary Fund” (EMF), which would be capable of
organising an orderly default as a measure of last resort.
Our proposal for an EMF can also be seen as a complement
to the ideas presently under discussion for allowing
orderly defaults of private financial institutions and rescue
funds for large banks that would be funded by the
industry itself. The analogy holds in more general terms:
in the recent financial crisis, policy has been geared solely
towards preventing the failure of large institutions. In the
future, however, the key policy aim must be to restore
market discipline by making failure possible. For EMU this
means that the system should be made robust enough to
minimise the disruption caused by the failure of one of its
member states.
Purists will object to our scheme on the ground that it
violates the “no-bailout” provision of the Maastricht Treaty.
2 However, we would argue that our proposal is actually
the only way to make the no-bailout rule credible and
thus give teeth to the threat not to bail a country out. The
drafters of the Maastricht Treaty had failed to appreciate
that, in a context of fragile financial markets, the perceived
(and real) danger of a financial meltdown makes a
“pure” no-bailout response unrealistic. As with the case
of large, systemically important banks, market discipline
can be made credible only if there are clear provisions
that minimise the disruptions to markets in case of failure.
Key Issues for the Design of a European Monetary
Fund
Any mutualisation of risks creates a moral hazard because
it blunts market signals. This would argue against
any mutual support mechanism and for reliance on fi nancial
markets to enforce fiscal discipline. However, experience
has shown repeatedly that market signals can
remain weak for a long time and are often dominated by
swings in risk appetite which can be quite violent. Hence,
in reality the case for reliance on market signals as an enforcement
mechanism for fiscal discipline is quite weak.
In fact, swings in risk appetite and other forces that have
little to do with the creditworthiness of a country can lead
to large swings in yield differentials and even credit ra
tioning that have little to do with economic fundamentals.
The moral hazard problem can never be completely
neutralised, but for our proposal it could be limited in
two ways: through the financing mechanism of the EMF
and via the conditionality attached to its support. These
points will be discussed first, followed by a brief analysis
of two equally important issues, namely enforcement and
orderly default.
Contributors to this Forum
Daniel Gros, Centre for European Policy Studies
(CEPS), Brussels, Belgium, and CEPR.
Thomas Mayer, Deutsche Bank.
Ulrich Häde, European University Viadrina Frankfurt
(Oder), Germany.
Jean Pisani-Ferry, Bruegel, Brussels, Belgium,
and Université Paris-Dauphine, France.
André Sapir, Université Libre de Bruxelles and
Bruegel, Brussels, Belgium.
Jürgen Matthes, Cologne Institute for Economic
Research (Institut der deutschen Wirtschaft Köln),
Germany.
Deborah Mabbett, Birkbeck, University of London,
UK, and Hanse Wissenschaftskolleg, Delmenhorst,
Germany.
Waltraud Schelkle, London School of Economics
and Political Science, London, UK, and Hanse Wissenschaftskolleg,
Delmenhorst, Germany.
Wim Kösters, Ruhr Universität Bochum and Rheinisch-
Westfälisches Institut für Wirtschaftsforschung,
Essen, Germany.
Paul de Grauwe, University of Leuven, Belgium.
Desmond Lachman, American Enterprise Institute
(AEI), Washington, DC, USA.
2 Article 125 of the TFEU (formerly Article 103 TEC).
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Financing Mechanism
A simple mechanism to limit the moral hazard problem
would be to ensure that the main contributions would
come from those countries that breach the Maastricht criteria.
The contribution rates would be calculated on the
following basis:
...........................................
Final Conclusion extract
Greece’s Threat to the Euro
All too often in the midst of an economic and fi nancial
crisis, policymakers either engage in denial or else take
flights into fantasy. Sadly, the present Greek crisis is
proving to be no exception. Rather than recognising the
Greek crisis for the solvency issue that it is, European
policymakers seem to be convincing themselves that foreign
speculation is at the core of the crisis. And at a time
when the European economic house is burning, European
policymakers are now indulging in the fantasy that
an inevitably tortuous Treaty modification allowing for the
establishment of a European Monetary Fund will have
any relevance for the resolution of the present Greek crisis.
A more realistic analysis of Greece’s present economic
situation would reveal that Greece now poses a very real
existential threat to the continuation of the euro in its
present form. This is not simply because of the extraordinarily
large internal and external imbalances that Greece
is now trying to address within the straightjacket of eurozone
membership. Rather, it is because similar imbalances
are shared to a disturbingly high degree by the very
much larger Spanish economy as well as by the economies
of Portugal and Ireland.
European policymakers’ understandable reluctance to
own up to the solvency problems facing by the countries
at the eurozone’s periphery will not make these
problems go away. Nor will repeated bailouts of these
countries do more than kick the can forward. What it will
do, however, is distract attention from the most basic of
questions that Europe will have to confront within the
next year or two. How is the euro to be restructured in
a manner that inflicts the least damage possible on the
European economy?
Greece’s Solvency Problem
At a time when European policymakers are contemplating
banning naked CDS positions and embarking on the
drawn-out process of setting up a European Monetary
Fund, the Greek economic crisis is playing out in real time.
At the root of the crisis is Greece’s longstanding failure to
remotely live up to its Maastricht Treaty obligations with
respect to its public finances. Indeed, from the moment
that Greece adopted the euro in 2001, the Greek authorities
have been engaged in shameless creative budget accounting
that evidently misled not only Greece’s eurozone
partners but Greek policymakers themselves.
Last October, after a new Greek government took office,
markets were rudely reminded of how fast and
loose Greece has been with its public spending and
budget reporting. It was then that Mr. Papandreou, the
newly elected Greek prime minister, shocked markets
by owning up to the fact that Greece’s budget deficit
in 2009 would be around 12 ¾ percentage points of
GDP or around double the former officially projected
number. It is little wonder that of all the eurozone member
countries, Greece has received the worst ratings
from the credit rating agencies. It is even less wonder
that the Greek government now has to pay the highest
interest rates in the eurozone on its sovereign borrowing.
Greece’s budget largesse has clearly put the country’s
public finances on an unsustainable path. This is suggested
by a budget deficit that is more than four times
the Maastricht criteria’s limit of 3 per cent of GDP. It is
also underlined by a public debt to GDP ratio that is
expected to exceed 120 per cent by the end of 2010.
Equally disturbing is the fact that budget profl igacy,
coupled with inappropriately low ECB interest rates for
Greece, has resulted in persistently higher wage and
price inflation in Greece than in the rest of the eurozone.
Since adopting the euro in 2001, Greece is estimated
to have lost around 30 percentage points in unit labour
competitiveness, which has contributed to a widening
in its external current account deficit well into the double
digits in relation to GDP.
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The sad reality is that Greece’s domestic and external
imbalances have reached such a dimension that their
correction within the straightjacket of eurozone membership
will necessarily involve many years of painful
deflation and deep economic recession. Lacking
its own currency, Greece cannot restore international
competitiveness through currency depreciation. Nor
can it use exchange rate devaluation to stimulate its
export sector as a means of offseting the negative
impact of massive budget consolidation on domestic
demand.
In the context of an ECB that aims for price stability in
the eurozone, the only realistic way that Greece can
regain international competitiveness without currency
devaluation is by engineering a 20-30 per cent fall in
domestic wages and prices over time. This would necessarily
involve many years of painfully slow economic
growth and very high unemployment. It would also
contribute to raising Greece’s public debt to a GDP
ratio beyond 150 per cent, or to a level that Greece
could hardly support without a major debt restructuring.
An even surer recipe for many years of a depressed
economy and extraordinarily high unemployment levels
would be an attempt by the Greek government to
reduce its budget deficit over the next three years by
the 10 percentage points of GDP needed to bring that
defi cit into line with the Maastricht criteria. Even if one
were to assume that the Keynesian multiplier was only
1.2 for Greece, a 10 percentage point of GDP cut in
public spending must be expected to directly cause
Greece’s GDP to contract by 12 per cent over that period.
Since tax collections in Greece are around 40 per cent
of its GDP, were GDP indeed to decline by 12 per cent,
Greece would lose around 5 percentage points of
GDP in tax collections. The net upshot would be that
Greece’s budget balance would only have improved
by 5 percentage points of GDP rather than the desired
10 percentage points of GDP. This would necessitate
yet a further round of savage public expenditure cuts
that would only further depress the Greek economy.
Taking this line of reasoning to its logical conclusion,
it would seem that if Greece is indeed to keep cutting
budget spending to meet the Maastricht criteria, while
at the same time getting no benefit from a depreciated
exchange rate, Greece could very well see its GDP declining
over the next few years by a cumulative 15 to
20 per cent. In that context, Greek policymakers might
want to take a close look at the experience of the hap
less Latvia, which is some eighteen months ahead of
Greece in the application of a hair-shirt fiscal austerity
programme under IMF supervision to preserve its
euro currency peg. Latvia’s GDP has already fallen by
18 per cent and the IMF is expecting a further 4 per
cent decline in 2010. Equally disturbing is the fact that
for all of its economic pain, Latvia’s budget deficit remains
around 8 per cent of GDP, more than double the
desired Maastricht target.
It is difficult to believe that Greece’s social and political
fabric would hold together were Greece’s recession
to be half as deep as that being experienced in
Latvia. It is also difficult to believe that a major Greek
recession would not result in a wave of household defaults
that would shake the Greek banking system to
its very roots and that would spark the very capital
fl ight that Greece is seeking to avoid.
Greece Is Not Alone
Within this sombre picture, there is one silver lining
for the Greek government. It is the knowledge that
the European Central Bank and the European Commission
are as fearful of the consequences of a Greek
default on the US$ 400 billion in its sovereign debt as
the Greek government itself is. Not only would a Greek
sovereign default deal a major blow to a still very fragile
European banking system, it would also focus the
market’s full fury on the other highly vulnerable eurozone
members. Spain, Ireland and Portugal all have
very troubling public finances and international competitiveness
problems that must be expected to raise
serious questions in the markets as to whether they
would be the next dominoes to fall.
At five times the size of the Greek economy and with
around US$ 1 trillion in sovereign debt, the Spanish
economic domino is Greece’s most potent argument
for a European bailout. In all too many ways, the Spanish
economy suffers from the same sort of economic
vulnerabilities as the Greek economy does. Worse
still, in some ways the Spanish economy is less well
placed than that of Greece to endure many years of
defl ationary budget policy.
Over the past decade, mainly as a result of a housing
market boom that dwarfed the one in the USA, the
Spanish economy has lost even more price and wage
competitiveness than the Greek economy. This loss in
international competitiveness has been an important
factor underlying the widening of Spain’s external current
account deficit to a peak of US$ 150 billion, or
more than 10 per cent of GDP, in 2007. It has also con-
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tributed to the exponential increase in Spain’s gross
external debt burden to a staggering 135 per cent of
GDP at present.
Now that the Spanish housing bubble has started to
burst, it has become all too evident how overly dependent
Spain’s public finances were on property
market related revenue collections. From a modest
surplus in 2007, Spain’s budget position has swung
dramatically to a deficit of 11 ½ per cent of GDP by
2009, a level not materially different in relative size
from that of Greece.
Like Greece, Spain will be required to adhere to many
years of budget austerity if it is to regain its more than
30 per cent loss in international competitiveness and
to restore budget sustainability within the straightjacket
of eurozone membership. Yet Spain will have to
start the budget consolidation process with an unemployment
rate already close to 20 per cent. And Spain
will have to engage in draconian budget cutting at the
very time that the continuing bursting of its housing
bubble will be a major drag on the Spanish economy.
Under these circumstances, it is difficult to see how
Spain’s banking system will be spared a major crisis
sometime down the road.
Kicking the Can Forward
A Greek sovereign debt default would almost certainly
trigger severe market pressure on Spain, Ireland and
Portugal, which the market would perceive as being
the next countries in line to default. By meaningfully
raising these countries’ borrowing costs, such market
pressure would make it virtually impossible for
these countries to service their sovereign debt obligations.
Armed with this knowledge, one can be sure
that the Greek government will exert its leverage to extract
a bailout from its main European partners since
this is vital to staving off the European periphery’s
day of reckoning. Despite all of the German government’s
huffing and puffing about moral hazard risk
and Greece’s lack of policy commitment, it knows that
when the chips are down, the very continuation of the
eurozone experiment in its present form is in question.
Sadly, when Greece does get bailed out, be it by its
European partners or by the IMF, there will be a basic
question that will go unasked: are Greece’s long-
term economic interests best served by delaying what
seems to be Greece’s inevitable need to restructure
its sovereign debt and to devalue its currency? Not
only will a bailout needlessly put the Greek economy
through the wringer and worsen the starting point
from which an eventual Greek economic recovery
might begin, it will also cruelly saddle Greece with a
mountain of official debt that Greece will not be allowed
to reschedule.
Europe in Denial
Instead of considering how best an eventual breakup
of the euro in its present form might be handled,
European policymakers are toying with the quixotic
idea of setting up a European Monetary Fund. They
do so in the full knowledge that the setting up of such
a fund will require Treaty modification. And they do so
knowing that, if the tortuous process of ratifying the
Lisbon Treaty is anything by which to go, gaining final
approval for a European Monetary Fund could take at
least fi ve years.
It is fanciful to think that markets will patiently hold
onto their Greek paper while the European policymakers
take their sweet time setting up an institutional
change as far-reaching as the EMF. It is also difficult to
see how such a fund would do anything to reverse the
enormous damage that has already been done to the
Club Med countries’ economic fundamentals. It would
seem to do little good to close the stable door now
after the horse has long since bolted.
The recent strong public outcry in Germany against
the notion of bailing Greece out should give one pause
before suggesting the establishment of a new European
Monetary Fund that should be funded by market
borrowing backed by member country guarantees.
The German public will rightly ask how lending by the
proposed European Monetary Fund to member countries
in distress would be different from the sort of
sovereign bailouts that are supposed to be proscribed
by existing eurozone agreements. They will also understand
that it would be the German taxpayer rather
than the markets that would be left holding the bag in
the event of any failure by Greece to repay.
It would seem that Europe’s interests would be better
served if its policymakers were to recognise the basic
flaws in the eurozone concept as patently revealed
by the outsized internal and external imbalances of its
Club Med members. The fact that the euro’s founders
deliberately omitted the mapping out of an exit strategy
from the euro does not mean that the arrangement
will not be torn asunder by the insuperable vulnerabilities
of its peripheral member countries. Better that the
eventual break-up of the euro in its present form occurs
in a well thought out manner than in a disorderly
fashion driven by market forces.
Intereconomics 2010 | 2
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