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INET COUNCIL ON THE EURO ZONE CRISIS
INETeconomics.org
 
1
Institute For
New Economic Thinking
BreakingtheDeadlock:APathOutoftheCrisis
23July2012Summary
Itisstillpossible--economicallyandpolitically–tofindawayoutoftheeurozonecrisisifpolicymakersseparatelyaddresstwoproblems:dealingwiththelegacycostsoftheinitiallyflaweddesignoftheeurozone,andfixingthedesignitself.Theformerrequiressignificantburdensharingandaneconomicstrategythatfocusesonstabilisingthecountriesthataresuffering fromrecessionandcapitalflight.Incontrast,fixingthedesignrequiresafinancial(banking)unionwithstrongeuro-areainstitutionsandaminimalfiscalbackstop.
I.
 
Theeuroisdriftingtowardabreakdownofincalculablecosts
1.
 
WebelievethatasofJuly2012Europeissleepwalkingtowardadisasterofincalculableproportions.Overthelastfewweeks,thesituationinthedebtorcountrieshasdeteriorateddramatically.Thesenseofanever-endingcrisis,withonedominofallingafteranother,mustbereversed.Thelastdomino,Spain,isdaysawayfromaliquiditycrisis,accordingtoitsownfinanceminister.Thisdramaticsituationistheresultofaeurozonesystem,whichasitiscurrentlyconstructed,isthoroughlybroken.Thecauseisasystemicfailurethatexacerbatedaboomincapitalflowsandcreditandcomplicateditsaftermathaftertheboomturnedtobust.ItistheresponsibilityofallEuropeannationsthatwerepartiestoitsflaweddesign,construction,andimplementationtocontributetoasolution.Thisdoesnotmeanthatthecostsofthecrisisshouldbesocialisedacrosseurozonecitizens:systemicfailuredoesnotabsolvefromresponsibilityindividuals,banks,andsupervisorswhotookoroversawimprudentlendingandborrowingdecisions.Butitdoesmeanthattheextenttowhichmarketsarecurrentlymetingoutpunishmentagainstspecificcountriesmaybeapoorreflectionofnationalresponsibility,andthatasuccessfulcrisisresponsemustbecollectiveandembodysomeburdensharingacrosscountries.Absentthiscollectiveconstructiveresponse,theeurowilldisintegrate.2.
 
Europeanleadersrecognisetheneedforacollectiveresponse.Yet,theeurozonehasbeendriftingtowardbreakupforseveralmonthsnow,notwithstandingtheincalculableeconomiclossesandhumansufferingthatthiswouldentail.Thecauseofthishasbeenthefailureofsurplusanddeficitcountriestoagreeonanactionplanthatbothreassuresfinancialmarketsandaddressestheneedsandconcernsofthepublicinbothsetsofcountries.Deepeningrecessionsandhighunemploymentaretearingatthesocialfabricinthedeficitcountriesandcausingenormousandavoidablehumansuffering.Alleviatingthissufferingshouldbethefirstpriorityofeurozonepolicymakers.Moreover,thesensethatthereisnoendinsightisunderminingpublicsupportforfiscaladjustmentandstructuralreformandfuellingcapitalflight.Atthesametime,growingcrisis-relatedliabilitiesandaviewthatreforminthedeficitcountrieswillonlysucceedunderpressurehaveunderminedpublicsupportinthesurpluscountriesforastepped-upcrisisresponse.Risingadjustmentfatigueinthesouthhasbeenmatchedbyincreasingsupportfatigueinthenorth.
 
INET COUNCIL ON THE EURO ZONE CRISIS
INETeconomics.org
 
2
Institute For
New Economic Thinking
3.
 
Solvingthecurrentcrisisisnotazero-sumgame.Instead,itisawin-winchoiceforbothcreditoranddebtorcountries.
1
Theeconomicandpoliticallossesthataeurobreakupwillbringaboutarelikelytobeanorderofmagnitudelargerthanthepotentialtransfersrequiredtosolvethelegacyproblems.However,lackoftrustbetweencreditorsanddebtorsisstoppingthemfromarrivingatmutuallybeneficialsolutions.Forexample,ifthedeficitcountriescouldcrediblycommittofiscalrulesthatbringtheratioofnationaldebttoGDPdowntoreasonablelevelsinthelongrun,thenthesurpluscountrieswouldhavelittleobjectiontonewdebtissuesintheshortruntosupportcountercyclicalfiscalpoliciesinthedeficitcountries,sincetheseadditionaldebtswouldbetemporaryandcouldberepaid.Theproblemisthatitisdifficultforthedeficitcountriestomakeacrediblelong-termcommitmenttofiscalprudencesincethatwouldbindfuturevoters.Whatisneededarecreativewaystosolvethisproblembymakingsupportavailableinsufficientamounts,butalsoundersafeguardsandconditionsthatarebothperceivedasfairbydebtorcountryvotersandcrediblebycreditorcountryvotersandthefinancialmarkets.4.
 
Althoughtheycontainedstepsintherightdirection,themeasuresannouncedbyeurozonepolicymakersonJune29andagainonJuly9didnotmeetthisthreshold.AgreeingonatimetableforcreatingasingleeuroareabankingsupervisorybodyandsubsequentlyallowingdirectbankrecapitalisationfromtheESMwouldhelptoaddresscriticalshortcomingsoftheeurozonedesignandthecrisisresponsesofar.However,thesummitdidnotpresentaconvincingplantostopthedownwardeconomicspiralinthedeficitcountries.StabilisingbondyieldsbasedonlyonexistingESMresourcesandinvestmentprojectsfinancedmainlybyexistingE.U.structuralfundsandtheEIBdonotadduptoaconvincingpackage.Furthermore,thesummitofferednosharedvisionforthelongrunbeyondtheagreementoncommonEuropeanbankingsupervision.Butsuchavisionisneededtorestorethecredibilityofthecurrencyunionintheeyesofbothinvestorsandthegeneralpublic,andhencetorestoreconfidenceingovernmentbondmarketsandstopcapitalflightfromthedeficitcountries.
II.
 
Anewstrategywhichrecognizeslargecommongains
5.
 
Acomprehensiveactionplanmustmeetfourobjectives.
•
 
ItmustrestorefaithintheeuroareaandtheEuropeanUnionthroughacrediblepromiseofabettertomorrowthatholdstheprospectforgreaterwelfareandmorestability
•
 
Itmuststabiliseinterestcostsandreversethedeclineofoutputandemploymentinthedeficitcountries;
•
 
Itmustbeconducivetoareductionindebtlevelsoverthemediumterm–includingpublicdebtinItalyandprivatedebtinSpain,butalsoelsewhere–andsupportthecontinuedreductionofbalanceofpaymentimbalanceswithintheeurozone;
1
Thisnoteusestheterms“surpluscountries”,“creditorcountries”,or“north”interchangeablytorefertocountriessuchasAustria,Finland,Germany,Netherlands,andtheSlovakRepublic;and“deficitcountries”,“debtorcountries”,“crisiscountries”or“south”toreferprimarilytoItalyandSpain.Ireland,Portugal,Greece,andCypruscouldalsobeconsideredtobeinthisgroup,buttheirsituationissomewhatdifferentbecausetheyareinIMF-EUsupportedadjustmentprogrammes.Weavoidthe“centre”versus“periphery”terminologythathasbecomeengrainedinthelastyearbecauseacountrysuchasItalyistoocentraltoEurope–geographically,economically,andhistorically–tobeconsideredpartofthe“periphery”.
 
INET COUNCIL ON THE EURO ZONE CRISIS
INETeconomics.org
 
3
Institute For
New Economic Thinking
•
 
Itmustaddressthefundamentalstructuralflawsinthecurrencyunion,bothtomakethesinglecurrencycredibleagainasalong-termpropositionandtomakeitmuchlesslikelythatacrisisaswearewitnessingtodaywilleverrecurintheeurozone.6.
 
Thechallengeofcomingupwithsuchaplanrelatesinparttoactualorperceivedconflictsbetweentheseobjectives.Stabilisingoutputandemploymentintherecession-struckdeficitcountriesisimpossiblewithoutdelayingsomeoftheon-goingfiscaladjustmentandchannellingmoresupporttothedeficitcountries.Fromtheperspectiveofthesurpluscountriesthisraisestwoconcerns:howtoprovidesupportwithoutoverstretchingthefiscalresourcesinthesurpluscountriesthemselves,andhowmaintainincentivesforadjustmentintheeventthatstabilisationsucceeds.Arelatedconcerniswhetherthecurrencyunionisworkablewithoutpermanenttransfersinthefuture.ExceptinthecontextofaEuropeansuper-stateinwhichfinancingandcontrolofspendingaretightlylinked,amajorityofthepopulationinthesurpluscountriesbelievesthatapermanent“transferunion”istoohighapricetopayforthepreservationofthesinglecurrency,evenifthealternativeisacatastrophiccrisis.Theresistancetoscaled-upsupportasameansofgettingoutofthecurrentcrisisisinpartduetothefactthatitisviewedasthefirststeptowardsucha“transferunion”.7.
 
Hence,theCouncilbelievesthatthecriticalrequirementfortacklingthecrisisistoseparatethesolutionofthe“legacyproblem”–stoppingtheon-goingrecessions,reducingdebtlevels,andloweringcurrentaccountsurplusesanddeficitswithinthecurrencyunion–fromtheproblemoffixingthestructuralflawsoftheeurozoneforthelongterm.Theformerrequiressignificantburdensharing.Butitdoesnotfollowthatthelatterrequirespermanenttransfersorjointlyandseverallyissueddebt.8.
 
Asfarasthelegacycostsareconcerned,Europeanpolicymakersinthesurpluscountriesmustmakeanefforttoconvincetheirvotersthatsignificantburden-sharingisnotonlynecessarytostopthecrisis,butalsojust,andthatitcanbereconciledwith–andindeedisnecessaryfor–goodincentives.
•
 
Itis
necessary 
becausedeficitcountrieswillotherwiseremainstuckinaspiralwherefiscaladjustmentdepressesoutputintheshortrun,makingitharderfortheprivatesectortorepayitsdebts,puttingpressureonassetpricesandassetqualityofbanks,constrainingcredit,andfurtherdepressingoutputandrevenue,whichunderminesfiscaladjustment.Thisleadstoabreakupoftheeurozone,whichimposeslargelyavoidablebutveryhigheconomicandothercostsonbothsurplusanddeficitcountries.
•
 
Itis
 just 
becausetheproblemsthatthedeficitcountriesarestrugglingwithwerenotcausedbythesecountriesinisolation,butweretheresultofaflawedeurozonedesignthatencouragedbothrecklessborrowing(inthedeficitcountries)andrecklesslending(inthesurpluscountries).Hence,allcountriesthatsigneduptothisdesign,andtookpartinthelendingandborrowingboom,bearresponsibilityforthecrisis.
•
 
Itisconsistentwithgoodincentivesaslongas(1)theburdenofpayingforfinancialsystemlossesisinthefirstinstancetakennotonlybytheequity
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