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It’s been clear since May 2010 that the euro area is woefully under-institutionalised and consequently incapable of acting with the required political and economic decisiveness and credibility to end a financial crisis. Forced by necessity, euro area leaders must implement a dual institutional overhaul, simultaneously equipping the euro area with the tools to both end the current crisis and prevent a similar debacle from occurring again. This dual task invariably adds to the challenge.
The currency union must be equipped with a sizable independent fiscal capacity, capable during crisis of both providing emergency financial assistance to member states in need and acting broadly and forcefully to restore market confidence. To overcome concerns about moral hazard and the inherent democratic deficit in using eurozone taxpayers’ money to deal with the negative economic outcomes of poor decisions taken by governments other than their own, any emergency assistance must be subject to strict political and economic conditionality.
In addition, preventive binding rules on individual member states’ fiscal performance must be crafted, enabling the euro area as a whole to compel even large countries, like Italy, to comply. European leaders have begun this task, and could accelerate the process at their next EU Council in December 2011. Ultimately, any credible solution will require revision of the EU Treaty, a process that will take several years.
The fiscal crisis is cantered in Greece, which will need to restructure its government debt, and two other countries, Ireland and Portugal, subject to extended financial-assistance arrangements with the International Monetary Fund. However, as concerns over fiscal sustainability in the eurozone stretches also to Italy, a country “too big to bail out,” the principal challenge is how to avoid contagion and ring-fence the inevitable Greek debt restructuring so as to avoid a generalized undermining of the “risk free status” of euro-area government debt. Inside the euro currency union, the central bank is legally barred from guaranteeing the sovereign debts of individual member states.
For political reasons, the debts of each sovereign member remain distinct. The vast majority of European citizens still self-identify as citizens of their respective countries, so pooling the national sovereign debts of the euro area into single-debt instruments – similar to what Alexander Hamilton achieved for the US war debts in 1790 – is an unrealistic option in Europe. Also of note, the outstanding debts of individual euro-area members were not incurred to achieve a “common cause.”
Yet the debt is denominated in the same currency and governed by some common institutions, and so the phenomenon of contagion has particular force.
To counter contagion, leaders must ensure that after Greece no other debt restructuring becomes necessary in the euro area. This goal will necessitate that substantial financial support is made available to Greece, Ireland and Portugal in the years ahead to ensure their fiscal sustainability and impose severe austerity in those nations to prevent moral hazard.
Even as Europe’s leaders try to contain the debt crisis, large parts of the southern euro area suffer from an acute crisis of competitiveness. Countries that lack an ability to devalue national currencies have no short-term way to overcome this obstacle. Instead, indebted nations in the euro area are compelled to restore competitiveness gradually through deep supply-side structural reforms of labour and product markets. Previous experiences from, for instance, Germany and Eastern Europe suggest that these types of reforms will have positive economic effects in the longer term while limiting growth in the short run. In addition, complication lies in the necessity for the euro area to also limit intra-euro area current account imbalances, which will demand measures in surplus countries, such as Germany, too.
Compounding the first three crises is the euro area’s oversized and undercapitalized banking system, which owns a large amount of national government debt. Consequently, across the euro area there is a large degree of interdependence between the financial solidity of large domestic banking systems and national government solvency.
Banks’ large ownership of government debt in the euro area presents a particular concern. The series of Basel agreements, since 1988, have regulated banks that participate in international transactions, but did not require bankers to set aside risk capital to offset future losses on bonds issued by their own governments or any national debt from other euro-area governments. Such sovereign bonds were, by definition, deemed “risk free.” Consequently, restructuring of the Greek government debt will impose credit losses upon the euro-area banks for which they have not set aside capital. The scale of such debt held by domestic Greek banks is significantly above their total capital levels and the restructuring will require that recapitalization with funds from the euro area and the IMF.
The same dynamic is inevitable across the eurozone. So the banking system will face ruinous capital losses if national sovereign debt is restructured.
As long as solvency concerns exist about euro-area governments, they cannot sanction a comprehensive recapitalization of the euro-area banking system. A high degree of volatility will persist, again providing a powerful feedback loop, increasing investor fears about the financial stability of governments in the first place.
Given that Europe is America’s largest trade and investment partner and that large cross-ownership exists in the transatlantic financial sector, turmoil there invariably negatively impacts the US economy. However, the principal spillover concern for the United States is the continuing damage to investor and consumer confidence from the risk of a catastrophic tail-end event in Europe, which could cause tremendous damage to the US financial system.
VIEW FROM WASHINGTON
Four Distinct Crises
The eurozone crisis, which has gradually taken centre-place in an increasingly volatile global economy since May 2010, is characterized by an extreme degree of complexity that frustrates attempts at a single expeditious solution
The crisis is characterized by an extreme degree of complexity that frustrates attempts at a single expeditious solution. There is no silver bullet either for European Union policymakers. A drawn-out, inconclusive containment efforts witnessed in Europe since early 2010 is thus likely to continue.
The crisis consists of four distinct crises that frequently overlap and mutually reinforce one another:- A design crisis, as the euro area from its creation in the 1990s has lacked crucial institutions to ensure financial stability during a crisis;
- A fiscal crisis centred in Greece, but stretching across the southern euro area and Ireland;
- A competitiveness crisis manifested in large and persistent current account deficits; and
- A banking crisis first visible in Ireland, but spreading throughout the area via accelerating concerns over counter parties and sovereign solvencies.
It’s been clear since May 2010 that the euro area is woefully under-institutionalised and consequently incapable of acting with the required political and economic decisiveness and credibility to end a financial crisis. Forced by necessity, euro area leaders must implement a dual institutional overhaul, simultaneously equipping the euro area with the tools to both end the current crisis and prevent a similar debacle from occurring again. This dual task invariably adds to the challenge.
The currency union must be equipped with a sizable independent fiscal capacity, capable during crisis of both providing emergency financial assistance to member states in need and acting broadly and forcefully to restore market confidence. To overcome concerns about moral hazard and the inherent democratic deficit in using eurozone taxpayers’ money to deal with the negative economic outcomes of poor decisions taken by governments other than their own, any emergency assistance must be subject to strict political and economic conditionality.
In addition, preventive binding rules on individual member states’ fiscal performance must be crafted, enabling the euro area as a whole to compel even large countries, like Italy, to comply. European leaders have begun this task, and could accelerate the process at their next EU Council in December 2011. Ultimately, any credible solution will require revision of the EU Treaty, a process that will take several years.
The fiscal crisis is cantered in Greece, which will need to restructure its government debt, and two other countries, Ireland and Portugal, subject to extended financial-assistance arrangements with the International Monetary Fund. However, as concerns over fiscal sustainability in the eurozone stretches also to Italy, a country “too big to bail out,” the principal challenge is how to avoid contagion and ring-fence the inevitable Greek debt restructuring so as to avoid a generalized undermining of the “risk free status” of euro-area government debt. Inside the euro currency union, the central bank is legally barred from guaranteeing the sovereign debts of individual member states.
For political reasons, the debts of each sovereign member remain distinct. The vast majority of European citizens still self-identify as citizens of their respective countries, so pooling the national sovereign debts of the euro area into single-debt instruments – similar to what Alexander Hamilton achieved for the US war debts in 1790 – is an unrealistic option in Europe. Also of note, the outstanding debts of individual euro-area members were not incurred to achieve a “common cause.”
Yet the debt is denominated in the same currency and governed by some common institutions, and so the phenomenon of contagion has particular force.
To counter contagion, leaders must ensure that after Greece no other debt restructuring becomes necessary in the euro area. This goal will necessitate that substantial financial support is made available to Greece, Ireland and Portugal in the years ahead to ensure their fiscal sustainability and impose severe austerity in those nations to prevent moral hazard.
Even as Europe’s leaders try to contain the debt crisis, large parts of the southern euro area suffer from an acute crisis of competitiveness. Countries that lack an ability to devalue national currencies have no short-term way to overcome this obstacle. Instead, indebted nations in the euro area are compelled to restore competitiveness gradually through deep supply-side structural reforms of labour and product markets. Previous experiences from, for instance, Germany and Eastern Europe suggest that these types of reforms will have positive economic effects in the longer term while limiting growth in the short run. In addition, complication lies in the necessity for the euro area to also limit intra-euro area current account imbalances, which will demand measures in surplus countries, such as Germany, too.
Compounding the first three crises is the euro area’s oversized and undercapitalized banking system, which owns a large amount of national government debt. Consequently, across the euro area there is a large degree of interdependence between the financial solidity of large domestic banking systems and national government solvency.
Banks’ large ownership of government debt in the euro area presents a particular concern. The series of Basel agreements, since 1988, have regulated banks that participate in international transactions, but did not require bankers to set aside risk capital to offset future losses on bonds issued by their own governments or any national debt from other euro-area governments. Such sovereign bonds were, by definition, deemed “risk free.” Consequently, restructuring of the Greek government debt will impose credit losses upon the euro-area banks for which they have not set aside capital. The scale of such debt held by domestic Greek banks is significantly above their total capital levels and the restructuring will require that recapitalization with funds from the euro area and the IMF.
The same dynamic is inevitable across the eurozone. So the banking system will face ruinous capital losses if national sovereign debt is restructured.
As long as solvency concerns exist about euro-area governments, they cannot sanction a comprehensive recapitalization of the euro-area banking system. A high degree of volatility will persist, again providing a powerful feedback loop, increasing investor fears about the financial stability of governments in the first place.
Given that Europe is America’s largest trade and investment partner and that large cross-ownership exists in the transatlantic financial sector, turmoil there invariably negatively impacts the US economy. However, the principal spillover concern for the United States is the continuing damage to investor and consumer confidence from the risk of a catastrophic tail-end event in Europe, which could cause tremendous damage to the US financial system.
The multifaceted character of the euro area crisis foreshadows a lengthy and volatile process. If successful, at the end of the reforms Europe will be a more tightly integrated union than it ever was in history. But there is no guarantee that the prolonged shock therapy ahead will unite the rich and poor nations of Europe and keep the euro flag flying.
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