Is the Euro-Cure Worse Than the Disease?

Editor's Note: This article was originally published in the February 2012 edition of Longitude, a monthly Italian publication on world affairs.

The fiscal crisis that began in October 2009 in Greece—a smaller European economy, accounting for just 2% of the total area’s GDP—has now turned into a systemic crisis of the eurozone itself. Most recently, in an unprecedented—but not unexpected—move, Standard & Poor’s took rating actions on nine members of the eurozone, lowering the long-term ratings on Cyprus, Italy, Portugal, and Spain by two notches and those of Austria, France, Malta, Slovakia, and Slovenia, by one. In the communiqué motivating the decision on Italy, however, there is hardly any element mentioned that falls under the direct control of the national authorities; the emphasis is on the collective weak response to the crisis at the European level. And, in fact, immediately after the regional wave of downgrades, the US rating agency also lowered the rating of the European Financial Stability Facility (EFSF), the European rescue fund.

While countries themselves are mostly to blame for running economic policies that led to the current crisis, the incomplete architecture of the euro area hasn’t helped. It has created unprecedented scope for contagion by exposing each member of the monetary union—if to varying degree—to the vulnerabilities of the other members. Coupled with the lack of a lender of last resort and a limited regional financial safety net, market expectations can quickly become self-fulfilling in the eurozone. Italy is a case in point. While the sluggish growth of its economy and its high (and increasing) public debt are nothing new, the crisis of the peripheral eurozone economies has been the trigger for market investors to focus on the Italian economy’s long-run ability to service an increasing stock of public debt. Even with the recent, substantial progress in the reform agenda, long-term interest rates remain stable at record levels since Italy joined the single currency, along the lines of those in countries like Indonesia or Peru.

Of course, the institutional framework established at the outset for the single European currency didn’t include a safety pillar like an EFSF-type mechanism, reflecting the assumption—unfulfilled, as it turns out—that after the introduction of the euro, the overall stability of the eurozone would be underpinned by a sustained convergence toward a unique policy process, one that would go well beyond monetary policy and would be geared toward macroeconomic stability. This expectation hasn’t materialized, as economic policies have diverged.

Even now, long after the establishment of the EFSF in 2010, there are still no emergency instruments for intervening in support of large sovereigns, like Italy, should market pressure significantly escalate in the coming weeks or months. Given that the EFSF only has a net credit capacity of approximately €250 billion, it wouldn’t be sufficient to ring-fence Italy, were it to be cut off from markets. In 2012 alone, the Italian Treasury will need to provision approximately €450 billion including BOT (Buoni Ordinari del Tesoro) treasury bills. The IMF has a similarly limited financial firepower, of approximately €300 billion, in terms of its forward commitment capacity. In other words, a hypothetical, standard two-year financial arrangement jointly funded by the EFSF and the IMF would drain them both. But, at this stage of the crisis, would more financial firepower really matter? Possibly, but not on its own.

Drawing from the lessons of this crisis, it would seem that any credible response needs to rely on at least three pillars. Under the first pillar, the available financial safety nets—that is, both the EFSF and the IMF—ought to be significantly strengthened to stabilize larger sovereigns that might face escalating market pressures. Right now, though, there are no signs that European policymakers are considering stepping up, if not the EFSF, at least its successor, the European Stability Mechanism (ESM), to be established as of July.

This means that the IMF’s financial capacity would then have to be significantly strengthened, too, since its current size makes it unfit to stabilize sovereigns that aren’t small developing economies. Accordingly, the IMF’s Managing Director has requested from the membership a top-up of $600 billion (or approximately €460 billion), which could go as high as $1 trillion (or almost €800 billion), if global economic conditions further deteriorate. In response, European leaders have put some €200 billion on the table, but have yet to finalize their commitments—all the more critical as the European transaction is expected to catalyze, in the leaders’ own estimates, commitments to the IMF of equal magnitude from non-European countries. To make matters worse, some eurozone national central banks insist that the resources be lent to the IMF’s General Resources Account, thereby transferring the risk of any debt haircut or restructuring onto the meager balance sheet of the Washington-based organization and its membership at large (hardly away of making new friends when you need them). With limited safety nets, the economies of larger sovereigns are bound to experience painful adjustment and sharper contractionary policies if they’re hit by further, deeper market disruptions.
On the other hand, the availability of larger financing would do little to help economies if they face unsustainable fiscal positions. Which is why, under the second pillar, the eurozone would need to establish a framework for pooling the fiscal sovereignty of its members in order to consistently underpin the stability of the monetary union. This would not necessarily require a eurozone-wide finance ministry. Instead, a centralized entity like the EU Commission could be allowed to vet national fiscal policies or strategies on behalf of the eurozone as a whole and on the basis of commonly agreed upon and binding criteria. In return for much stricter fiscal discipline, member countries could issue eurobonds, that is, government bonds backed by a common, eurozone- wide guarantee, up to a certain threshold, such as, for instance, 60% of GDP, as has been suggested.

So where does Europe stand on all this? At the time of writing this article, the draft International Agreement on a Reinforced Economic Union (“Fiscal Compact”) defines more rigid fiscal parameters compared to the changes agreed on in the so-called “six pack,” which was designed to strengthen the framework established by the Stability and Growth Pact. In particular, Art. 3 of the draft Agreement on the golden rule delineates a regime different from that of the six pack by, on the one hand, setting more rigid parameters for the definition of a structurally balanced budget—defined now as - 0.5% of nominal GDP, not -1%, as a medium-term objective—and, on the other, by entrusting its implementation and assessment to the states themselves, thus leaning toward an even broader nationalization of budgetary policies, completely contradictory to the objective of fiscal union. It foresees, moreover, that eurozone members report on their planned issuances of government bonds, although this clearly falls short of any eurobond in the sense described above. In essence, members would commit to a credible and binding fiscal framework but in return would benefit from no form of pooling of fiscal sovereignty. The only form of fiscal policy coordination would take place through the simultaneous achievement of a balanced structural budget by all members of the eurozone, regardless of their underlying fiscal and macroeconomic positions. As a result, the overall fiscal sustainability of the single currency area would be achieved, in the medium term, by setting all the national economies on a simultaneous, contractionary fiscal path.
For Italy, this balanced-budget constraint doesn’t represent the biggest concern in the draft being circulated to European capitals. The “Save-Italy” decree that Prime Minister Monti signed at the beginning of December, immediately following his appointment, already allows for increasing primary surpluses over the years, in line with the pledges made to the EU. Rather, what is troublesome in the draft agreement is the provision contained in Art. 4, which stipulates that, when the ratio of government debt to GDP exceeds 60%, the relevant national government must take measures to reduce it at an average rate of one-twentieth per year. In other words, this obligation, if approved in the current form, would mean for Italy an additional burden of €40-50 billion a year, at least double the adjustment of the annual budget established by the “Save- Italy” decree, or approximately 3% of the current GDP. As a result, the strict implementation of that provision would likely mean for the Italian economy a stable deflationary trend that, over time, would erode national consensus on the single currency.

One way of containing this contractionary effect would be to lift the eurozone potential growth rate by putting wide-ranging structural reforms in place. Accordingly, under the third pillar, eurozone countries should establish a coordinating framework that would go beyond fiscal policies and encompass macroeconomic and structural policies. This is necessary to make sure that aggregate demand is sustained over time and that national economies don’t pursue policies that are inconsistent at the eurozone level. Along these lines, for instance, eurozone economies like Germany can’t expect to run a persistent surplus in their current accounts while other national economies have to reduce their aggregate demand and, therefore, their imports from Germany as well. Rather, those countries in surplus could balance the reduced demand from the rest of the euro area by expanding their own domestic demand, the advantage being to support the rest of the eurozone economies pursuing sizable fiscal adjustment, economies that would otherwise face substantial retrenchment for years to come.

On this item, the draft agreement foresees that signatory members will work jointly toward an economic policy in order to foster growth. That is to say, they will make sure that all major economic policy reforms undertaken by members are coordinated with those of other members. Even so, the asymmetry between the provisions on budgetary discipline and economic convergence are striking. For budget discipline, the draft puts forward several dispositions that have to be adopted by the various national legislations and for which specific remedies are laid out in the case of non-compliance, including the possibility of recourse to the European Court of Justice. It also contains provisions, like the one on debt reduction, that are openly in contradiction with the growth objective laid out in the subsequent title. In contrast, the section on economic convergence, which is merely a few lines long, contains generic if not vague statements, with no provisions or benchmarks to be operationalized in any meaningful or credible way.

All in all, the current negotiations provide little comfort that the crisis will soon be over. And, even if it does pass, it may be at the cost of a sustained period of depressed demand in the entire eurozone. One hopes that the input of ECB President Mario Draghi and Italy’s Prime Minister Mario Monti will shift European policymakers in the right direction.