The European Rescue Plan: Opportunities and Limitations

Domenico Lombardi
Domenico Lombardi Director, Policy Observatory - Luiss University, Rome, Former Brookings Expert

May 13, 2010

Editor’s Note: In response to the European rescue package recently announced by the European Union and the International Monetary Fund, Domenico Lombardi analyzes whether the plan can stabilize the euro, the future of the European monetary union and the implications for the U.S. and global economy.

While the European Union emergency plan led to an immediate gain in stocks, will the plan succeed in the long run? What additional action can the EU and its member states take to regain financial stability?

Shortly after the announcement of a European emergency fund to stabilize the euro-area economy, gains were seen in the financial markets. The European Stabilization Mechanism (ESM) may throw up to $1 trillion (or EUR 720 billion, including some EUR 220 billion to be provided by the IMF on a country-by-country basis) at the euro-area economies. But within hours, the euro exchange rate with the dollar soon dropped back to its pre-announcement levels.

Two factors may explain this lukewarm reaction. First, the bulk of the money promised by the euro-area countries is not there yet. In fact, euro countries will be providing guarantees that will enable the ESM to borrow from the financial markets and then lend to countries in need. How these funds will be disbursed, and under what decision-making mechanism, is not yet known. Can they be used to fund precautionary arrangements as a preemptive strike? Or will the requesting countries need to show they have no alternative, as was the case with Greece? Will the disbursements require the unanimous consent of all 16 euro-area countries? Markets are eager to know.

Secondly, there is widespread understanding that the ESM is more of a cure for the symptom rather than the cause. Countries in financial difficulty will be offered further debt to tackle an already unsustainable pile of debt. It is true that some euro-area countries are frontloading their fiscal adjustment but what market participants would like to see is a far-ranging, sustainable plan that would foster the growth potential of the euro area in the long run, rather than just an increase in the fiscal pressure, which will further cripple their growth prospects.

Is greater political and economic integration needed for the euro area to function under one monetary unit?

The basic principle that has underpinned, in practice, the policymaking within the eurozone is that it is sufficient to delegate the conduct of the monetary policy to an independent central bank, rather than harmonize the full spectrum of economic policies beyond the European Central Bank (ECB)-run monetary policy. The European monetary union cannot run on automatic pilot based in Frankfurt. It needs to be underpinned by a common policymaking framework and a constantly-renewed political commitment to this historical achievement.

The policymaking framework has increasingly weakened as countries have been running unsustainable fiscal and financial policies that the recent international crisis has definitely highlighted. Instead of pursuing medium-term growth plans consistent with economic stability, the euro area policymaking was being anchored to the thresholds indicated by the Maastricht Treaty. What was meant to be a set of criteria to benchmark the stability of the euro-area economy has inappropriately become the comprehensive anchor of the entire euro-area policymaking. Despite that, countries have deliberately and continuously broken those rules that they had created for themselves. No wonder that the IMF has been called in to underpin the credibility of the ESM.

What are the immediate and long-term implications on the United States and global economies?

The White House has had several calls with its counterparts in Europe in the recent weeks; and the U.S. Federal Reserve has started to lend large amounts of dollars again to various central banks, including the ECB, in an attempt to ease liquidity in the markets.

For the U.S. economy, the consequences may be more relevant than commonly assumed: Europe is its most important trading partner and the U.S. needs to export more to this area to increase job creation and consolidate the recovery. Moreover, as the euro may remain weak in the near future, this will increase the competitiveness of European exports to the international markets in which Europeans compete with American manufacturers.