Summary: The debt crisis in Europe’s monetary union, sparked by Greece’s recourse to bail-out liquidity in May 2010, is well into its fourth year and does not look likely to end anytime soon. The eurozone has not yet escaped from the recession that followed the global financial crash of 2007-2008. Aggregate per capita GDP remains below 2007 levels. Meanwhile, despite considerable fiscal adjustment, levels of public debt are still too high and they continue to rise as a share of GDP, owing to slow or negative output growth. The reasons for this unhappy state of affairs relate to structural and, largely, systemic flaws in Europe’s economic constitution, which have been brought to the surface after the eruption of the global financial crisis. A review of the origins of the debt crisis helps bring into relief the deeper causes of the present malaise as well as the difficulties in overcoming it.
Europe: Crisis and Influence
by Yannos Papantoniou
Introduction The debt crisis in Europe’s monetary union, sparked by Greece’s recourse to bail-out liquidity in May 2010, is well into its fourth year and does not look likely to end anytime soon. The eurozone has not yet escaped from the recession that followed the global financial crash of 2007-2008. Output losses in Europe have been larger relative to the United States, China, and the other major economic powers. Aggregate per capita GDP remains below 2007 levels. In Greece, per capita income hovers around the level in had in 2000; in Italy, it remains around the level it had in 1997. Unemployment is about 12 percent on average, a record high. In Spain and Greece, more than one-quarter of the labor force is jobless, while the unemployment among young people in Greece exceeds 60 percent. Meanwhile, despite considerable fiscal adjustment, levels of public debt are still too high and they continue to rise as a share of GDP, owing to slow or negative output growth. Medium-term debt sustainability, a key condition for restoring financial stability, remains unresolved. Moreover, banks are still undercapitalized and unable to provide the finance needed for economic growth. Lately the loss of competitiveness has been
only partly reversed, with most of the improvement coming from internal devaluation rather than reforminduced productivity gains. Prospects for economic recovery thus remain clouded with uncertainties. The reasons for this unhappy state of affairs relate to structural and, largely, systemic flaws in Europe’s economic constitution, which have been brought to the surface after the eruption of the global financial crisis. A review of the origins of the debt crisis helps bring into relief the deeper causes of the present malaise as well as the difficulties in overcoming it. Origins of the Eurozone Crisis Over the last decade — which was also the first since the birth of the euro — large external imbalances were allowed to emerge within the currency union. The competitive position of peripheral member countries, particularly Greece, Italy, Spain, Portugal, and Ireland, deteriorated sharply as measured by unit labor costs vis-à-vis the core countries of Europe. Governments in the periphery ignored warnings and turned a blind eye to the accumulation of credit-fueled bubbles and public or private debt while they failed to take anti-cyclical fiscal measures or promote structural
reforms for improving competitiveness. Large peripheral external deficits were matched by surpluses in Germany and other core countries. The persistence of these imbalances has transferred excess savings to the periphery creating the conditions for extensive borrowing on the part of both the private and public sectors. In fiscally responsible countries like Spain, excess savings resources have been borrowed by the private sector and invested in what later became bubbles: housing assets. The burst of the bubbles created problems of insolvency to the banks, as people were unable to repay their loans, while the bubble-induced recession, coupled with the disruption produced by the financial crash and the associated collapse in exports, led to an explosion of budget deficits and full-blown fiscal crises. In fiscally profligate countries, like Greece, the chain of events was more straightforward. Excess savings resources had mainly been borrowed by the government, leading directly to a fiscal crisis. Debt growth undertook catastrophic proportions after the financial crash, when the recession led to drastic cuts in private spending and the automatic capture of redundant savings resources by the government. An interesting, and critically important, part of the story is that much of the debt that was induced by the savings glut in core economies ended up, whether indirectly or directly, on government books of the peripheral countries.1 Fiscal crises, when they hit structurally weak economies such as Europe’s southern countries, eventually evolve into debt crises threatening to lead to sovereign defaults — and a potential breakup of the currency union. The challenge facing European policymakers since the emergence of the debt crisis has been twofold: • First, how to strengthen the over-indebted economies by helping them to consolidate their public finances and promote productivity-enhancing structural reforms, so as to make them more resilient to external or internal shocks. • Second, how to reform the system of economic governance of the currency union so as to control imbalances and thus restore confidence in the euro while securing conditions for stability and steady growth.
1 For an analysis of the debt crisis, see Yannos Papantoniou, “The Lessons of the Eurozone Crisis that Should Shape the EU’s G20 Stance,” Friends of Europe, 2011.
Much of the debt that was induced by the savings glut in core economies ended up... on government books of the peripheral countries.
The effectiveness of the eurozone’s response to the challenges is being vividly debated with views diverging widely. Eurozone leaders such as the presidents of the European Council and the Commission, as well as heads of government of core countries such as Germany, talk of success and refer to the considerable progress in reducing fiscal deficits and adjusting labor costs — tantamount to an internal declaration. This contributed, alongside with the recessioninduced fall in imports, to an improvement in external balances. They attribute this progress to the effectiveness of austerity policies. They also take stock of some institutional changes, in particular the creation of the European Stability Mechanism (ESM), with €500 billion at its disposal for rescue purposes, and the steps taken in the direction of setting up a European banking union. The initiatives of the European Central Bank President Mario Draghi, who pledged to do “whatever it takes” to save the euro and proceeded to establish the ECB’s “outright monetary transactions” program in order to make purchases of bonds issued by eurozone member-states in secondary markets under certain conditions, also helped to restore calm in financial markets. Facing the Crisis: Austerity Critics stress the fact that the economic and social costs of austerity, in particular the destruction of productive capacity and the resultant mass unemployment, are enormous while the chances for a fast recovery and return to higher rates of economic growth are slim. Crucially, they point out that the social rifts produced by excessive austerity in the weaker economies of the south are spreading instability and creating political strains that may soon reach breaking point. The Italian government remains very fragile while the Greek center-right coalition faces intense opposition as it is pushed by the creditors to take further austerity
measures. The Spanish and Portuguese governments are confronted with similar challenges. The prospect of populist anti-austerity parties gaining power in peripheral countries alongside anti-euro anti-bailout parties in the core winning significant shares of votes in the next year’s European Parliament elections is being brought forward. If that happens, financial turbulence would return, setting the scene for new episodes in the trajectory of the eurozone crisis, while recession will persist and, eventually, aggravate the crisis itself. The question arises as to whether such outcomes could have been forestalled. The present strategy for overcoming the eurozone crisis, relying on austerity and structural reforms, focuses exclusively on supply factors and ignores demand. But if all countries simultaneously attempt to improve their fiscal or external balances by cutting spending and raising taxes, all will fail, because each country’s austerity implies less demand for other countries’ output in turn perpetuating both domestic and external imbalances. “Bailing in” creditors, as has been already applied in Cyprus, will exacerbate these trends. Rising debt to GDP ratios testify to the ineffectiveness of generalized austerity in securing debt sustainability over the medium term. Moreover, a deep and prolonged recession implies vanishing support for reforms, as governments fail to convince citizens that their current sacrifice will ensure a better future. Privatization, market liberalization, the opening of closed professions, and government downsizing involve conflicts with powerful vested interests, such as businesses in protected industries, public-sector unions, or influential lobbies. Resolving such conflicts requires social alliances, which are invariably undermined by discontent, civil disorder, and political instability. The emphasis on harsh austerity, which was to be pursued everywhere, was a critical error in the design of the lenders’ strategy for overcoming the crisis. Indeed, the International Monetary Fund has belatedly acknowledged that its evaluations of the impact of fiscal measures on the GDP were wide of the mark. Adjustment programs systematically take into account demand factors. Since devaluation is not possible in a currency union for propping up external demand, other instruments should be used to balance the effects of fiscal austerity. Countries with a stronger fiscal position should be encouraged to adopt more expansionary policies in order to compensate for demand losses elsewhere. Moreover, the European Investment Bank’s lending capacity should be increased substantially, and European Union Structural funds mobilized, to boost investment in the peripheral economies. Public investment projects, public-private sector partnerships, and small and medium-sized enterprises could benefit from such flows of grants and low-interest loans. The European Central Bank (ECB) should also play a more active role in sustaining demand in the peripheral economies. Further reductions in key interest rates would raise inflation in core countries with external surpluses and thus help close the competitiveness gap and increase the periphery’s net exports. The ECB should emulate other major central banks, such as the U.S. Federal Reserve, the Bank of England, and (more recently) the Bank of Japan in aggressively pursuing unconventional monetary policy measures such as quantitative easing so as to improve credit conditions. ECB’s cautiousness, encouraged by Germany’s Bundesbank, exacerbates the division of the currency union into northern and southern subzones with widely differing interest rate levels. Currently, enterprises in the periphery borrow at substantially higher rates than the enterprises in the core economies. In bank loans, the relation is close to two to one while in long-term financing it may reach ten to one. The transmission mechanisms of the monetary union seem to be broken inflicting considerable damage to the international competitiveness and the growth prospects of the weaker economies. Overall, austerity policies have achieved considerable progress in fiscal deficit reduction and internal devaluation but, as a result of the deep and prolonged recession they have provoked, they failed to secure debt sustainability over the medium term. Besides the enormous economic and social costs imposed on the weaker economies, they exerted a negative impact on the reform effort by depriving the motivation for accepting the sacrifices associated with
A deep and prolonged recession implies vanishing support for reforms.
significant structural changes and related productivity gains. The widening gap in real performance between the core and the periphery produced a corresponding spread in relative borrowing costs, further exacerbating the northsouth divide. Facing the Crisis: Institutional Reform The progress achieved over the last couple of years in the field on institutional reform is limited. The euro is a monetary, not a political union. It possesses a central bank, but not a treasury. The central bank can provide liquidity in times of crisis though only a treasury can address problems of solvency. The challenge for the eurozone today is to make a qualitative step forward on the road to economic and political integration so as to fill in the gaps in its institutional framework and equip itself with mechanisms that will effectively prevent and, if required, redress imbalances. Only then will Europe be able to ensure the sustainability of the common currency and create conditions for stability and growth, thereby enabling it to maintain its social model and punch its weight in the world. No amount of effort of individual countries to strengthen their fiscal position and their competitiveness can succeed in making them resilient to shocks unless it is conducted in the context of a broader reform that fortifies the eurozone as a system. This is a lesson learnt during the present turmoil. The United States, being the only model of a well-functioning monetary union, is the standard against which the eurozone’s current attempts at institutional reform should be evaluated. The dollar zone rests on a common budget, common taxation, and a common treasury, while debt is mutualized through the issuance of common bonds. There are centralized structures in banking with common supervision and resolution authorities and a common deposit guarantee scheme. Lastly, the dollar is guaranteed by the Federal Reserve, which is empowered to act as a lender of last resort. Europe’s history rules out emulating the U.S. model. But, to make the eurozone work and restore confidence in the sustainability of the euro, the present feeble attempts at fiscal and financial unification should advance significantly further. Centralized institutions should acquire powers to coordinate fiscal and economic policies backed by common taxation, Eurobonds, and a fully-fledged sovereign-debtresolution mechanism. Banking union should include a single, comprehensive supervising authority, a common fund to wind up insolvent banks, and a common deposit guarantee scheme. The European Stability Mechanism (ESM) should be empowered to undertake direct equity recapitalization of banks so as to fully separate bank risk from sovereign risk. The ECB should be allowed to intervene in the primary sovereign bond markets — subject to conditions concerning fiscal discipline — offering an ultimate backstop for the euro. There is considerable distance to be traveled from the recently established “European Semester,” a yearly cycle of economic policy coordination aimed at guiding national budget policies through issuing “recommendations,” as well as the present structure and size of the ESM. However, the recent German parliamentary elections have confirmed the strategy of small steps or “muddling through.” Mistrust between the lenders and the overindebted economies, a growing reluctance within the countries of the core to mutualize debt, and deep-seated political resistance to transferring sovereignty to supranational institutions got the upper hand. Sovereignty rests on democratic legitimacy at the European scale, which involves the election of European Commission President by universal suffrage and significant strengthening of the European Parliament. However, support for such moves remains weak. The eurozone appears to be trapped in a strategy that deepens recession while simultaneously undermining the confidence in the euro. The mix is toxic so far as the weaker economies are concerned because, instead of increased spending — particularly for investment — it induces hoarding and capital outflows. This is the reverse of what economies need to recover and grow. As funding problems recur, owing to continued recession, governments in the over-indebted
The challenge for the eurozone today is to make a qualitative step forward on the road to economic and political integration.
countries may resist further austerity measures that would be demanded by the leaders. Civil unrest and political destabilization could erupt into financial and social crises that would ultimately threaten the monetary union’s survival. Eurozone: Alternative Perspectives for Global Influence It is too early to make predictions for the eurozone’s future and how it will affect the transatlantic relationship. The interconnection of economics and politics contains dynamic elements that are difficult to evaluate in order to work out how they interact and project themselves in wider contexts. However, it is useful to draw some preliminary conclusions concerning the eventual significance of alternative economic trends of the euro area for the global economy and the way it will be organized over the next few decades. Broadly speaking, it is clear that the faster the eurozone manages to move along the road to unification, the stronger the European economy will be. A strong euro, shared by a large majority of EU members, will sustain an improved competitiveness while enabling Europe to play a stronger hand in international negotiations, matching its real economic potential. It will also be an expression of unity reflecting greater confidence and authority. A more forceful global European presence is likely to produce, on balance, positive results. It is widely recognized that Europe possesses benign soft power, projecting principles and values that are cornerstones of modern civilization. Democracy, human rights, open markets, and rules-based resolution of conflicts are likely to gain from European interventions in global issues, notwithstanding potential positive contributions to policies addressing climate change and sustainable development. Moreover, if stronger economic performance is combined with significant progress in political unification, speaking with one voice and spending more on defense may allow Europe to also contribute to global security cooperation and promote more effectively peace and stability. However, economic strength may not necessarily lead to a more ambitious foreign policy. In a recent study by the German Marshall Fund of the United States,2 alternative foreign policy scenarios were worked out depending on which trajectory Economic and Monetary Union would take. Four cases were distinguished: • Complete integration • Partial integration • Partial fragmentation • Complete fragmentation Although it is acknowledged that there is a positive correlation between progress in integration — or avoidance of fragmentation — and Europe’s global influence, the relation is not linear and even at the top of the scale (complete integration), it does not necessarily produce game-changing results. Following the hard work of federalization, Europe may continue to look inward and choose to act as a “larger Switzerland.” As it begins to look outward, it may engage in selective globalization like a “larger Japan.” Only the third option, muscular globalism, or the “larger Canada” scenario, would fully exhaust Europe’s considerable potential in setting global norms and agendas. All three options, however, are clearly superior to the implications of complete fragmentation, which would certainly represent a sea change, cementing Europe’s decline on the world stage and, possibly, signaling the beginning of the end of the international liberal order. Diminishing economic weight and lost cohesion would eventually exclude Europe from the class of global players and allow the new emerging economic superpowers to have a stronger voice in determining the global agenda. The United States will feel increasingly isolated in international negotiations while the Transatlantic Trade and Investment Partnership (TTIP) will cease to hold significant promise for upgrading the transatlantic relationship. The severe weakening in the trade authority of the European Commission will likely result in a failure of negotiations, while even in a partial fragmentation scenario, a deal would be limited and saddled with exemptions and ugly compromises. It will hardly set the norm for global trade liberalization.
The faster the eurozone manages to move along the road to unification, the stronger the European economy will be.
“Four Foreign Policy Scenarios,” The Riga Conference Papers, 2013
The boundaries between partial fragmentation and partial integration are not sharply drawn. Perhaps the only clear difference is that “fragmentation” includes the possibility of weaker eurozone members to default and leave the currency union while also allowing for Britain to exit the EU. Otherwise, both scenarios confirm present policies and trends that reflect a continued faith in intergovernmentalism and incrementalism. Germany will retain a dominant position in the European system, heading a strengthened core group, while frictions will develop within both the EU and the currency union weakening Europe’s voice in the world. Europe Versus the World Assuming a best-case scenario where the transatlantic partnership is reinforced through active U.S. leadership and a reinvigorated and unified Europe, the question arises as to how this will play out with respect to the future of the international liberal order. The present balance of economic power in the global economy shows a distinct superiority of the Atlantic partners in terms of size and strength — both economic and military. The combined weight of the United States and the EU in the world GDP although falling, still reaches 45 percent. The key emerging superpowers — China, Brazil, India, and Russia — add up to close to 20 percent. Japan is not included in either camp. Similar differences persist in defense budgets despite the limited European contribution. However the trends over the next couple of decades play out, the predominance of the West is unlikely to be seriously affected so far as the measured indices are concerned. The key for the survival of the open, rules-based international order instead lies in the attractiveness of the Western model, particularly as regards its economic vitality, social inclusiveness, and cultural appeal. The reputation of Western economics has been severely damaged by the global financial crash, while the eurozone is facing unprecedented financial and political strains and the United States’ political system is stumbling, reflecting deeper social divisions. The challenge for the West is to overcome these weaknesses and restore the vigor of its economic and political system so as to make it, again, a model for the world, as it has been for the first few decades of the post-war period. The integration of markets, in recent decades, coupled with enormous technological progress in communications and transport, has diffused growth to regions that for centuries had lagged behind the dramatic rise in living standards
The key for the survival of the open, rules-based international order lies in the attractiveness of the Western model.
witnessed in Europe, North America, and Japan since the Industrial Revolution. More efficient use of the global resources allowed productivity to grow, lifting significant sections of the world population out of poverty and into the modern world. However, national control over economic policy has been significantly diminished, and international economic governance confronts new problems. As markets integrate and systems converge, addressing imbalances in either the real economy or the financial sector becomes increasingly difficult, owing to the constraints on multilateral policy cooperation built into institutional arrangements designed for nationally bounded economies. A key task is to prevent the emergence of external imbalances, which were at the root not only of the eurozone debt crisis but also of the global financial crash. The excessive borrowing that fueled the housing bubbles was allowed to occur by the persistence of huge U.S. trade deficits mirrored by equivalent Chinese trade surpluses. Preventing or correcting such imbalances requires exchange-rate re-alignments and appropriate adjustments in fiscal policies. International policy coordination at the G20 level must be tightened by creating a permanent secretariat to make policy proposals and recommendations concerning macroeconomic and financial developments. The secretariat should actively cooperate with the IMF to benefit from its analysis, notably regarding exchange rates. A new global financial-services rule book, including tougher regulation, strengthened supervision, and internationally consistent mechanisms to address the problems posed by very large, global institutions that are considered to be too big to fail would also contribute decisively to raising the standards of international economic governance. In an open, globalized economy, the gap between winners and losers, the rich and the poor, widens as market liberal-
ization intensifies competition. The need for policy discipline and international cooperation increases while action should be taken to narrow the gap separating the developing from the advanced economies and eliminate poverty through easing market access for the exports of the developing countries and significantly strengthening the flows of aid and investment to them. Initiatives such as Transatlantic Trade and Investment Partnership (TTIP) and a resumption of global trade negotiations in the WTO framework, together with higher volumes of appropriately targeted development assistance, would provide new impetus for a balanced growth of the global economy. The challenge for world leadership is to ensure that the current era of rising prosperity not only endures, but becomes better shielded against shocks, with the gains spread more equitably. Only thus will the humanity’s poorest will eventually share in the modern civilization. If the present generation of political leaders rises to this challenge, they will make a critical contribution to enhancing the rules-based order established during the last few decades, opening the way for a more inclusive world. Conclusion This analysis has attempted to show that the transatlantic partnership constitutes the foundation of the international order that was established following the horrors of World War II. The United States and Europe have led the world to an era of rising prosperity and a deepening spread of democracy and human rights. However, in more recent times, the international liberal order has come under stress and increasing criticism for several reasons: • First, prosperity was not evenly or fairly diffused. Market liberalization, by the nature of its dynamics, rewards the strong and punishes the weak. The gap between the rich and the poor has become larger as insufficient effort has been made to correct market outcomes, create appropriate social safety nets, and channel aid and capital to the developing countries. • Second, the faster growth of global output exerted pressure on natural resources and raw materials leading to environmental costs and climate change, indirectly contributing to ecological catastrophes. The questions
The challenge for world leadership is to ensure that the current era of rising prosperity...becomes better shielded against shocks.
raised regarding sustainable development have not been yet addressed. • Third, the global financial crash acted as a catalyst revealing the inequities and the flaws of the established order and challenging, on a more fundamental basis, the free-market foundations of the global economic system. The excessive liberalization of the financial sector came to be seen not only as generator of injustice and uneven rewards, but also as a source of instability leading to crises associated with enormous social costs. Throughout humanity’s modern history, newcomers in an economic system go through a catch-up phase during which they grow faster than existing older members. During the early centuries of the first millennium, northern European tribes gained in power in a rebalancing act that led to the downfall of the Roman Empire. As the historian Peter Heather notes, “the dismantling of the Western Roman Empire has to be seen as part of a total recalibration of prevailing Europe-wide balances of strategic power, equivalent to the kind of processes working themselves out in our own time, as the regional and global political consequences of the massive expansion of Near Eastern, Asian and some Southern economies slowly make themselves clear.”3 In a similar process during the 19th century, the rise of industrial powers on both sides of the Atlantic challenged British supremacy and, eventually, undermined the empire “where the sun never set.” Transposing the question to present conditions raises a new set of issues. The catch-up process that underlies the
3 “The Restoration of Rome: Barbarian Popes and Imperial Pretenders,” p. xvii, Macmillan, 2013. He describes the acceleration of development of central Europe as follows: “By the mid-fourth century AD, agricultural production had intensified, population densities increased massively, and economic patterns acquired previously unknown complexity. The military capacity of the region as a whole had also grown remarkably — not least through the adoption of Roman weaponry — and its political structures had become much more robust.” ibid., p. xiv.
ongoing rebalancing faces various barriers. Developing economies often fall into the “middle income trap,” a situation when a country gets stuck before reaching the levels attained by advanced economies, on account of various rigidities in their economic, social, and political structures. Moreover, although the emerging economies and their societies may prefer to reshape the Western liberal order according to their norms and cultural standards, they have not converged on a common alternative paradigm. The present challenge has not yet grown to a degree that it becomes a real threat to the international order. Rather, it lives on its weaknesses and flaws. The damage inflicted on its attractiveness and appeal by the global financial crash and the European debt crisis is considerable. So far as the global crisis is concerned, the worst has been avoided while the United States, Japan, and other powers of the global economy are slowly returning to the path of growth. Europe, however, is still stumbling while the future of the currency union remains uncertain. If it manages to overcome the crisis and restore conditions of stability and growth, there is a chance that, together with the United States, they will form a stronger partnership and set a new agenda for confronting major challenges such as poverty and sustainable development. From this perspective, and to the extent that policies prove to be successful, the Western liberal order does not, over the medium term, run a significant risk of being displaced. In the opposite case of a serious weakening of Europe as an Atlantic partner, the appeal of the Western model will suffer. Lack of effective world leadership will aggravate the flaws and injustices of the existing system so that the ground will be fertile for new approaches to the organization of the global economy opening the way to an eventual erosion of the foundations of the liberal order. From a longer-term historical perspective, it is of course inevitable that the international system will adjust to the changing balances of strategic power. If globalization breaks down as in the aftermath of World War I or, alternatively, if Asian power grows steadily within the existing global economic structures, different patterns of “order” will prevail. Presently, however, conditions do not seem to be ripe for such adjustments because the shifts in strategic power are not yet sufficiently pronounced. Time will tell which direction the global economy will take. Will there be a renewal of the Western model? A collapse of the system? Or a fundamental power shift in favor of Asia? So long as the prospects are not clear, the existing international order is gaining time. To ensure, however, that the eventual adjustment to changing conditions will take into account its positive aspects, namely the openness of markets and the respect for rules, its initiators — the United States and Europe — will have to work hard to improve it, by correcting its flaws and increasing its appeal.
About the Author
Yannos Papantoniou is a Bosch Public Policy Fellow with the Transatlantic Academy and president of the Centre for Progressive Policy Research. He is also a former Minister of National Economy, Minister of National Economy and Finance, and Minister of National Defence in the Greek government. The views expressed here are of the authors’ own, and they no way represent the official position of the Transatlantic Academy, the Robert Bosch Stiftung, or the German Marshall Fund.
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