VoxEU: The future of the Eurozone

Reprinted with permission:By Kai A Konrad, Managing Director, Max Planck Institute for Tax Law and Public Finance and a CEPR Research Fellow, and Holger Zschäpitz, Senior Business Editor, Der Welt. Source.

A year after the rescue of Greece, the Eurozone is still on life support. This column argues that Europe’s policymakers have got their strategy desperately wrong.

In the run up to the crisis meetings of May 2010, EU leaders witnessed a rapid loss of market confidence in government bonds. This loss of confidence not only affected bonds issued by the Greek government but also by several other Eurozone members. The default insurance premium on government bonds picked up rapidly for several countries, indicating that the market had revised its expectations about these governments’ ability and/or willingness to honour their outstanding debt.Country leaders reacted. Over the second weekend of May, they constructed what is known as the €750 billion rescue device. It consisted of the European Financial Stability Facility and additional guarantees provided through the IMF. In hindsight, some policymakers admit that the initial idea was that a European promise of support of this size would be sufficient to re-establish confidence among market participants. The hope may have been that market participants return to their prior expectations about government bonds, namely that holding these bonds was perfectly safe and that the bonds of different Eurozone members were almost perfect substitutes.

A failed policy

Now, one year later, it is clear that the plan has gone spectacularly wrong. In addition to the €110 billion rescue package for Greece, the governments of Portugal and Ireland had to be rescued. These countries have received considerable financial aid from the rescue facility while other countries such as Spain or Italy are candidates that may follow. Markets most definitely did not return to their old expectations. Indeed the insurance premiums for many of the relevant countries – including the ones rescued – are higher in May 2011 than they were in May 2010.

Officially, Greece was supposed to return to the private capital market after a period of no more than three years. But rather than an improvement in credit worthiness during the last 12 months, we have seen a process of deterioration. Rather than preparing for a return to the private capital markets, Greece has entered into debt renegotiations about prolonging the help and easing the debt burden further. There is seemingly almost a consensus that Greece cannot reach a financially healthy situation without either a partial devaluation of its debt in the process of a default followed by a debt restructuring, or massive foreign transfers.

Hard to admit a mistake

It is difficult to admit a mistake, in particular a mistake of this size. Not surprisingly the policy reaction to the failure is not a change of direction, but rather: “What we did was right, but it was not enough”. Projecting this behaviour into the future, a likely direction for European policy is a speedy integration of fiscal policy inside the Eurozone. Indeed, first steps in this direction have already taken place.

The modifications of the Stability and Growth Pact include a view on macroeconomic imbalances in member countries and the intensified reporting and benchmarking in the context of the “European Semester” and “Euro Plus” agreements. These instruments clearly strengthen the position of the European Commission in the EU, expand on existing tasks, and allocate new tasks to the bureaucracy of the European Commission.

We are doubtful whether these steps will cure the European government debt crisis. It is very likely that, given these steps, the problems will persist and may even grow further. At some point in the near future policymakers in the Eurozone will have to take further steps.

The road not taken

As we already emphasised (Konrad and Zschäpitz 2010) when the rescue mechanism was about to be introduced in May 2010, there are several, very different policy options.

One option is a complete reversal of the steps towards socialised fiscal responsibility that have been taken in the last months and a return to national fiscal responsibility. This step implies that some member countries that suffer from a severe fiscal imbalance are likely to face the prospect of debt restructuring, whereas others may need to take very painful steps to return to sound public finances.

As pointed out by Reinhart and Sbrancia (2011), “financial repression” may be one policy option.1 Politicians have so far wasted very valuable time which they had bought for themselves by the rescue device in May 2010. Policymakers in Europe could still use the time window that exists. They need to make the banking system in Europe – and the financial markets more generally – sufficiently resilient and robust to sustain such a period of crisis. We emphasised this as a necessity from the beginning of the crisis (Konrad and Zschäpitz 2010), and the Council of Scientific Advisors to the Federal Ministry of Finance in Germany (2010) followed a very similar line of reasoning.

This policy would, among other things, require a strong separation of the banking system and the business of financing government debt. The fact that private banks own considerable shares in European government bonds and risk a major share of their equity in this market makes a restructuring more difficult than otherwise. We understand why, under current conditions, banks have an interest in investing their assets in government bonds. Under current regulation, they need less equity to finance such investments than if they hand out loans to medium-size enterprises.

This clearly is like a subsidy by which the governments distort banking decisions, making banks more inclined to finance government debt than engage in their core business. And from the perspective of political economy, this type of subsidy is not difficult to understand. But from the perspective of economy-wide efficiency, we do not see a convincing reason why banks should use (or should even be stimulated to use) their own funds to invest it in government bonds. They should leave this business to insurance companies, pension funds and small private investors and should turn to their core business as it is outlined in the textbooks about banking business.2

The political process since May 2010, however, has not marched in this direction. In fact, it has drifted the opposite way.

Policy options going forward

Many key players inside the Eurozone seemingly want to rule out state bankruptcy inside the Eurozone. Early on, the German Chancellor considered intergovernmental transfers or financial aid as the “ultima ratio”, where economists would consider a process of default and debt restructuring as the more adequate “ultima ratio”. We expect that the political process will drift further into this other direction, essentially further socialising financial responsibility, and generating a common pool as regards European government debt.

European leaders may first try to implement fiscal sustainability via strengthening supervision and by a modified enforcement mechanism with sanctions for excessive government deficits, together with strict conditionality in case a country has to rely on fiscal aid from the newly installed European Stability Mechanism. We are convinced that this will not work. And once these attempts have failed, this could, directly or indirectly, lead to a dramatic expansion of the system of financial transfers between the member countries inside the Eurozone or the EU as a whole – a system in which a