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Paul De Grauwe: The Governance Of a Fragile Eurozone

Paul De Grauwe: The Governance Of a Fragile Eurozone

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Published by mrwonkish
When entering a monetary union, member-countries change the nature of their sovereign debt in a fundamental way, i.e. they cease to have control over the currency in which their debt is issued. As a result, financial markets can force these countries’ sovereigns into default. In this sense member countries of a monetary union are downgraded to the status of emerging economies. This makes the monetary union fragile and vulnerable to changing market sentiments. It also makes it possible that self-fulfilling multiple equilibria arise.

The paper analyzes the implications of this fragility for the governance of the eurozone. It concludes that the new governance-structure - the European Stability Mechanism (ESM), which is intended to be successor starting 2013 of the European Financial Stability Mechanism (EFSF), created in May 2010 - does not sufficiently recognize this fragility. Some of the features of the new financial assistance are likely to increase this fragility. In addition, it is also likely to rip member-countries of their ability to use the automatic stabilizers during a recession. This is surely a step backward in the long history of social progress in Europe. I suggest a different approach to deal with these problem
When entering a monetary union, member-countries change the nature of their sovereign debt in a fundamental way, i.e. they cease to have control over the currency in which their debt is issued. As a result, financial markets can force these countries’ sovereigns into default. In this sense member countries of a monetary union are downgraded to the status of emerging economies. This makes the monetary union fragile and vulnerable to changing market sentiments. It also makes it possible that self-fulfilling multiple equilibria arise.

The paper analyzes the implications of this fragility for the governance of the eurozone. It concludes that the new governance-structure - the European Stability Mechanism (ESM), which is intended to be successor starting 2013 of the European Financial Stability Mechanism (EFSF), created in May 2010 - does not sufficiently recognize this fragility. Some of the features of the new financial assistance are likely to increase this fragility. In addition, it is also likely to rip member-countries of their ability to use the automatic stabilizers during a recession. This is surely a step backward in the long history of social progress in Europe. I suggest a different approach to deal with these problem

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Published by: mrwonkish on Sep 10, 2011
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THEGOVERNANCEOFAFRAGILEEUROZONE
PaulDeGrauwe*UniversityofLeuvenandCEPS
 Abstract:
Whenenteringamonetaryunion,member-countrieschangethenatureoftheirsovereigndebtinafundamentalway,i.e.theyceasetohavecontroloverthecurrencyinwhichtheirdebtisissued.Asaresult,financialmarketscanforcethesecountries’sovereignsintodefault.Inthissensemembercountriesofamonetaryunionaredowngradedtothestatusofemergingeconomies.Thismakesthemonetaryunionfragileandvulnerabletochangingmarketsentiments.Italsomakesitpossiblethatself-fulfillingmultipleequilibriaarise.IanalyzetheimplicationsofthisfragilityforthegovernanceoftheEurozone.Iconcludethatthenewgovernancestructure(ESM)doesnotsufficientlyrecognizethisfragility.Someofthefeaturesofthenewfinancialassistancearelikelytoincreasethisfragility.Inaddition,itisalsolikelytoripmember-countriesoftheirabilitytousetheautomaticstabilizersduringarecession.ThisissurelyastepbackwardinthelonghistoryofsocialprogressinEurope.Isuggestadifferentapproachtodealwiththeseproblems.
 April2011
*IamgratefultoDanielGros,MartinWolfandCharlesWyploszforcommentsandsuggestions
 
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1.Introduction
InordertodesigntheappropriategovernanceinstitutionsfortheEurozoneitisimportanttomaketherightdiagnosisofthenatureofthedebtcrisisintheEurozone.Failuretodoso,canleadtodesigningagovernancestructurethatisinappropriatefordealingwiththeproblemsoftheEurozone.InthispaperIarguethatthegovernancestructurethathasemergedafteraseriesofdecisionsofsuccessiveEuropeanCouncilmeetings,althoughanimportantstepforwards,failstoaddresssomefundamentalproblemsinamonetaryunion.
2.AParadox
IstartwiththeparadoxthatisimmediatelyvisiblefromacomparisonofFigures1and2.Figure1showsthedebttoGDPratiosoftheUKandSpain.ItcanbeseenthatsincethestartofthefinancialcrisisthegovernmentdebtratiooftheUKhasincreasedmorethanthatofSpain.Asaresult,in2011asapercentofGDPtheUKgovernmentdebtstood17%higherthantheSpanishGovernmentdebt(89%versus72%).YetfromFigure2itappearsthatthefinancialmarketshavesingledoutSpainandnottheUKasthecountrythatcouldgetentangledinagovernmentdebtcrisis.Thiscanbeseenfromthefactthatsincethestartof2010theyieldonSpanishgovernmentbondshasincreasedstronglyrelativetotheUK,suggestingthatthemarketspriceinasignificantlyhigherdefaultriskonSpanishthanonUKgovernmentbonds.Inearly2011thisdifferenceamountedto200basispoints.WhyisitthatfinancialmarketsattachamuchhigherdefaultriskonSpanishthanonUKgovernmentbondsgovernmentbonds,whileitappearsthattheUKfacesalessfavourablesovereigndebtanddeficitdynamics?Onepossibleansweristhatitmayhavesomethingtodowiththebankingsector.Thisisunconvincing,though.ThestateoftheUKbankingsectoriscertainlynotmuchbetterthantheoneofSpain.IwillarguethatthisdifferenceintheevaluationofthesovereigndefaultrisksisrelatedtothefactthatSpainbelongstoamonetaryunion,whiletheUKisnotpartofamonetaryunion,andthereforehascontroloverthecurrencyinwhichitissuesitsdebt.
 
3
Figure1
Source:EuropeanCommission,Ameco
Figure2:
Source:Datastream
0102030405060708090100200020012002200320042005200620072008200920102011
Grossgovernmentdebt(%ofGDP)
UKSpain
22.533.544.555.56
     p     e     r     c     e     n      t
10-yeargovernmentbondratesSpainandUK
SpainUK

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