Prime Minister Monti has shown increasing international leadership through his exchanges with his European counterparts as part of his proactive engagement on the European crisis. Following his recent visits to various European capitals, on Thursday, Monti will go to the White House for a meeting with President Obama and the euro crisis will be the first item they are going to discuss.
Monti’s new proactive international approach to engaging other countries on the euro crisis is in line with the new Italian government’s policy. Shortly after taking office, it became evident to his Cabinet that stabilizing the Italian economy and the larger euro area can only come from concerted efforts that include, but are in no way limited to, the reforms efforts in Rome.
Such concerted efforts first and foremost involve the establishment of a convincing policy framework in Europe that would create expectations that ballooning fiscal deficits and debt will be credibly reigned in the medium term. The new Inter-Governmental Treaty that 25 European Union countries are expected to sign at the next European Summit in March would aim to do exactly that.
However, the treaty in its current draft form poses for highly-indebted economies a potentially-deflationary drag by imposing to Italy, for instance, a reduction of “excessive” debt of some 3 percent of GDP each year, on top on the adjustment needed to attain a balanced budget.
To put that into context, the Italian Treasury would need to gather additional resources for €40 to 50 billion on an annual basis to comply with the debt-reduction clause—an amount that is at least double the correction to the annual budget balance that the prime minister enacted days following his appointment through the “Save-Italy” decree last December.
The challenge is to strike the right balance in terms of a steady but feasible reduction in the debt-to-GDP ratio of the indebted economies without jeopardizing their growth prospects. A protracted period of flat growth, if not outright contraction, would undo any potential improvement in the debt sustainability that one would hope to achieve.
Aware of the need of containing the potential harm from this provision, Monti has been meeting persistently with the European Commission, the chair of the European Council, and his counterparts in Paris, Berlin and London. He does not underestimate the potential strength that a benevolent support from the White House could add to his position.
Europe is the most important market for the U.S. exports and thus the prospect of a prolonged period of economic stagnation in Europe will almost surely exact a toll on American jobs and corporate profits.
There is a further element that could prompt the White House to exert its leverage on Berlin. While the euro area crisis appears to have stabilized, the possibility that an adverse shock would trigger a further escalation cannot be ruled out. This is why Washington sees the strengthening of financial safety nets for Europe as an important element in containing the spillover effects to the rest of the global economy.
This would entail a much bigger European financial safety net and a step up in the International Monetary Fund’s own credit capacity, which currently stands at approximately $400 billion—too little for the institution to be a potentially-stabilizing actor in the crisis. In fact, the IMF managing director recently requested an additional half a trillion dollar top up.
The emerging economies as well as Japan, Saudi Arabia and other IMF member countries who may be available to provide additional resources to the IMF have requested that the Europeans make the first move by pledging themselves some $250 billion and by stepping up the financial capacity of their own regional financial safety net.
In response, European leaders agreed to bring forward the establishment of the European Stability Mechanism (ESM), a permanent rescue fund for Europe. In addition, the ESM is likely to provide financial resources in parallel with the European Financial Stability Facility, the current rescue fund. Once the ESM is up and running, it will be able to mobilize an additional €500 billion on top of the current net credit capacity of €250 billion from the EFSF. The challenge is, however, that euro area countries have to find €80 billion to fund the paid-in capital injection to the soon-to-be-established ESM in order for the permanent rescue fund to mobilize half a trillion of loanable resources.
The strengthening of the financial safety nets is a policy issue of particular importance to the U.S. and the international community. Coupled with the strengthening of the euro area policymaking framework, in fact, these two issues could go a long way in stabilizing the crisis in Europe.
But there is another issue that the United States should be worried about: the need to solidly anchor Germany to its regional, European dimension. Many would see a broader cooperative stance in Berlin as key in order to successfully shape an effective policy response to the crisis.
Reflecting the “Berlin consensus” on the crisis, however, the previously-mentioned treaty focuses overwhelmingly on budgetary discipline but offers almost no insights on fostering growth-enhancing measures or on building (even a very embryonic form of) a fiscal union. The only coordination that will be taking place in the fiscal domain is that euro area countries will have to simultaneously retrench their fiscal positions at the national level.
All in all, this will result in a prolonged period of very weak economic performance of the euro area. Thus, Germany is likely to increase its penetration efforts in the emerging economies to compensate for the flagging demand in its “natural” euro area exports markets where German businesses currently sell roughly 40 percent of their exports.
It is not a coincidence that German Chancellor Angela Merkel has just been to China and the Chinese Premier Wen Jiabao will reciprocate the visit in a few weeks when the Hannover’s industrial fair opens this April. Inevitably, this will escalate competitive pressures that American businesses will be facing in the most dynamic markets.