Can the eurozone's emergence from crisis turn into a real economic recovery and a new vision for Europe's future? Or is Europe heading for a "lost decade" in terms of growth and a rise in old style nationalism? Kemal Dervis and Jacques Mistral have assembled an international group of economic analysts who provide perspectives on the most audacious supranational governance experiment in history. Will the crisis mark the end of the dream of "ever closer union" or lead to a renewed impetus to integrate, perhaps taking novel forms?
Among the key issues explored are the
· Onset, evolution, and ramifications of the euro crisis from the perspective of three countries especially hard hitGreece, Italy, and Spain.
· Concerns, priorities, and issues in France and Germany, the couple that has so far always driven European integration.
· Effects and lessons in two key policy areas: banking union and social policies.
The volume concludes with a possible renewed vision for the EU in the 2020s, including much greater political integration but where some countries may keep their national currencies and share less of their sovereignty. It is a vision of two Europes within one, ready for the twenty-first century.
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About the Author
Kemal Dervis is vice president and director of Global Economy and Development at Brookings. A former head of the UN Development Program and Turkish minister of economic affairs, he is the author of A Better Globalization: Legitimacy, Governance, and Reform and co-editor of The G-20 at Five, forthcoming, 2014.
Jacques Mistral is a nonresident senior fellow at Brookings, a senior fellow at the French Institute of International Relations (IFRI), and former economic adviser to the French prime minister. He is the author of several books, most recently Guerre et Paix entre les Monnaies.
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Europe's Crisis, Europe's Future
By Kemal Dervis, Jacques Mistral
Brookings Institution PressCopyright © 2014 THE BROOKINGS INSTITUTION
All rights reserved.
Europe's Crisis, Europe's Future: An Overview
KEMAL DERVIS AND JACQUES MISTRAL
The economic crisis that started in Greece in late 2009 quickly spread to Ireland and Portugal and then to Spain and Italy. After becoming a major eurozone crisis, it eventually came to threaten the global system in the autumn of 2011. And like the subprime crisis in 2008, no one had predicted it.
There had been, of course, many warnings in the 1990s, before the euro was launched, about forming a monetary union without a sufficient political union. But the first ten years of the euro seemed quite successful. The warnings and criticisms died down quickly. Interest rates inside the eurozone converged surprisingly rapidly, as if membership in this monetary union was a sufficient condition for an immediate equalization of sovereign creditworthiness; credit conditions became so favorable that growth in the periphery countries where there were more "catch-up" opportunities—those that would shortly become the crisis countries—was particularly strong; Spain, for example, was not far from being called a new economic miracle. As late as December 2008, The Economist published a spectacular assessment of what had been achieved, calling the "euro at ten" a "resounding success" and confirming to its readers the belief that the single currency had proved "demonstrably durable." The evolution of the euro-dollar exchange rate was a visible confirmation of these comments. Initially fixed at 1.19 dollars in 1999, the value of the euro declined during its two first years when "irrational exuberance" in the United States was fueled by the promise of the new information technology (IT) economy. But after the dot-com bubble burst, the value of the euro rose more or less steadily and exceeded 1.55 dollars in the spring of 2008.
We do not recount the details of the causes and the evolution of the eurozone crisis in this overview. The individual chapters in this volume describe the onset and evolution of the crisis in Greece, Italy, and Spain, as well as its effects in France and Germany; supporting comparative macroeconomic data are also available in the appendix. A chapter on the financial sector and one on social policies focus on two areas of particular importance for the eurozone.
A few words regarding the systemic aspects of the crisis at the eurozone level are nonetheless appropriate in this introduction. The global economic prosperity during the first ten years of the euro helped conceal a deeply rooted vulnerability that was fully exposed once the economic crisis set in. The global crisis that began in 2008 was not the cause of the eurozone's economic woes, but it was a tipping point for economies that had been operating on unsound foundations for a while. The monetary union and the way it had been managed had allowed a large build-up of public and/or private debt in many countries and a serious divergence of real unit labor costs, and therefore a loss of competitiveness. Regarding its public debt component, the crisis would have been much more manageable if the Maastricht Treaty, with its limits on public debt and deficits, had been fully enforced. Germany and France had been the first to violate the treaty, damaging the sense of discipline that was so essential to a proper functioning of the monetary union, and thereby set a bad precedent for others. It is also true, however, that the crisis in Ireland and Spain—countries that did not violate the Maastricht criteria—was not of a fiscal nature. It was due in both cases to a real estate bubble allowed by excessive increases in private debt—leading to a terrible banking crisis.
The dangers of excessive growth in private or public debt, despite being clearly reflected in large current account deficits, were not addressed in a timely way, as they would have been under the weight of the "external constraint" before the introduction of the single currency. Initially, the response to increasing levels of public debt was benign neglect. With regard to private debt, neither market players nor the eurozone's leadership imagined that private investors and financial institutions could make such huge mistakes. This blind belief in the infallibility of markets was similar to what had led to the subprime mortgage debacle that triggered the financial crisis in the United States. The currency union and the Maastricht Treaty alone did not have strong enough enforcement mechanisms to ensure adequate banking and fiscal restraint.
Have Early Critics of the Eurozone Now Finally Been Proven Right?
It starts with a very simple question: How did the (mis)management of a crisis in a marginal economy, Greece (whose GDP is 2 percent of that of the eurozone), become a continental and then a global systemic risk? Seen from the IMF headquarters in Washington, D.C., or the EU Commission's offices in Brussels, the Greek problem initially appeared to be just one more episode in a long history of debt-rooted financial crises. The international institutions had a long memory of countries that descended into similar financial disorder: Mexico, Argentina, Thailand, Russia, and Turkey, to name a few. And there was a well-known toolkit to deal with such situations. As unpleasant as it can be, an IMF-style rescue package is based on an adjustment program that, generally speaking, includes austerity measures, devaluation of the currency, and structural reforms to make the economy more competitive. These are accompanied by medium-term financing that gives the country time to restore its damaged international credit. The whole process is implemented under IMF surveillance. What made the Greek case so special is that Greece belongs to a monetary union. Greece cannot devalue its currency, and there was no Treasury in Brussels, no EU institution (like the IMF) in charge of dealing with a financial crisis in one component of the union. Exchange rates in the monetary union are irrevocably fixed; unrestricted capital mobility opens the way to massive capital exports at the earliest alert. The Maastricht Treaty includes an explicit no-bailout provision and bans any monetary financing of public deficits.
All this explains most of the hesitation in the first half of 2010—before the first European compromise was adopted. That first package of measures appeared to be a success because the creation of the European Financial Stability Fund (EFSF) opened the way to a rescue operation. But it was also the first error, because it was too little, too late, and visibly too reluctantly agreed upon. Doubts about the willingness of the eurozone countries to stick together were sown, and two years passed before the European Central Bank (ECB) president Mario Draghi delivered the final and convincing promise to do "whatever it takes to preserve the euro" (in July 2012). Meanwhile the situation had quickly deteriorated. In the years immediately preceding the crisis, the size of the problem in Greece had clearly been underestimated—partly due to Greece misreporting statistics before a new prime minister unveiled this deceit. The attempt to implement some adjustment and fiscal consolidation quickly exposed the weak public administration and the dysfunctional political system. In Brussels and the eurozone capitals, the response to the crisis had proved incoherent; future risks were faced with repeated indecisiveness; there was no serious attempt to elaborate a strategy that included support for growth alongside fiscal consolidation—and there were deep disagreements on burden sharing. By the end of the summer of 2010, the creation of a more powerful rescue mechanism became unavoidable.
In the eyes of many German voters, the Greeks were not only seen as having mismanaged their country: they were "sinners" who had betrayed the contract between the members of the European Monetary Union (EMU). Following two decades of effort to bring eastern Germany more or less in line with its western counterparts, German taxpayers, for understandable reasons, were not ready to pay for what they saw as the profligacy of the South. Moreover, citizens in Germany and elsewhere found it unacceptable that the reckless behavior of private banks should result in their having to bail out the shareholders and managers of these banks. After all, a credit transaction always has two sides to it: for someone to have borrowed excessively, there had to have been someone willing to lend excessively. This is why Germany found the first compromise hard to accept. Only a few months later, German chancellor Angela Merkel, with an eye on both the upcoming regional elections preceding the forthcoming national ones, and because of the genuine outrage prevailing in her country, felt that a more politically acceptable package was needed. A message had to be sent to both public and private actors that would reduce "moral hazard" not only for politicians but also for the private banks. The idea that gained traction in this context was to explicitly declare that the private sector would have to share the losses that would occur in bailouts, a mechanism known as "private sector involvement" or PSI. In the past, such PSI applied to previously incurred debt up to a clear cut-off date. It had been built into several IMF programs for emerging markets, always with fierce opposition from the private financial sector. The early discussion on Greece was unfortunately vague as to the cut-off date and, by presenting it as a general policy to be adopted by the eurozone, raised doubts about whether private debt restructuring would be confined to Greece.
Fearing destabilizing consequences for the financial markets, the ECB and most governments were not warm to this German proposal. The IMF, on the other hand, was supportive, and indeed IMF staff was pushing for very strong PSI. The fact that it was grudgingly adopted by the European Council in October 2010 relied heavily on the support of French president Nicolas Sarkozy after the so-called Deauville Compromise reached with Chancellor Merkel (what Paris got in this compromise was a suspension of pending pursuits by the EU Commission within the framework of a procedure against excessive public deficits).
The Deauville Compromise inflamed the markets and was followed by twelve months of chaos. The initiative had already received the label "haircut," and the financial markets immediately got the message: financing southern countries would be risky for all; be ready for investments in those countries to be valued at a possibly deep discount. The EU Commission, the Eurogroup (the eurozone finance ministers), and the IMF did not send the clear message that during the ongoing crisis at least (as opposed to future crises) insistence on PSI would be limited to Greece. On the contrary, the introduction of PSI as a general principle without clearly ring-fencing Greece, encouraged market panic. The contagion immediately spread to all southern countries; the country default spreads (CDS) became the daily measure of everything European; banks (where household savings are parked in Europe, and which in turn invest a large part of these resources into government bonds) were stuck in a vicious circle with a threat of depreciated portfolios. In an attempt to quickly fix their balance sheets, banks restricted their credits to the economy. Coming on top of fiscal austerity measures initiated by the governments, the credit squeeze pushed many economies into recession. Despite the fiscal consolidation measures, a declining GDP worsened the debt-to-GDP ratios. Credit ratings were finally downgraded for some countries, such as France and Austria, which, like Germany, until then seemed not to be mired in the worst of the crisis. In the autumn of 2011, the G-20 summit in Cannes—where national leaders were supposed to discuss the major problems of the world—was instead completely overshadowed by the intricacies and uncertainties of the eurozone crisis.
Did the Eurozone Emerge from This Vicious Circle?
Facing the abyss, the European Council, for the first time since the beginning of the debt crisis, took decisive and forward-looking action in December 2011, and the ECB forcefully backed its decisions. The ECB started by providing banks with huge refinancing funds with medium-term maturity. That move quickly eased financing conditions for the southern countries in the first quarter of 2012. The governments adopted a new "fiscal compact" that would significantly increase the power of Brussels to enforce fiscal discipline. A permanent financial institution, the European Stability Mechanism (ESM), was added to the temporary EFSF and endowed with greater power. A second Greek deal was successfully concluded; it was the largest haircut on privately held debt in history, in terms of the amount involved. But Chancellor Merkel clearly stated that Greece was "unique" and that "one euro was worth 100 cents." Plans for institutionalizing future PSI were temporarily shelved.
All of these initiatives and declarations were proof that the heads of states and governments had finally taken the measure of the crisis, had assessed the costs and benefits of different options, and had concluded that they would stick to the single currency and also keep Greece in the eurozone. The Council asked for a report to the "four presidents" (the presidents of the European Council, the European Commission, the Eurogroup, and the ECB) to design a plan that would create a better functioning monetary union. In June 2012, the Council adopted proposals that are known as the "four unions": a fiscal union, a banking union, an economic union, and a political union. Political "will" seemed to have been decisively formulated. And these political decisions were quickly followed up when ECB President Mario Draghi declared in July "The ECB is ready to do whatever it takes to preserve the euro." He added, "And believe me, it will be enough!" This was the announcement of the Outright Market Transactions (OMT) program committing the ECB to buying sufficient amounts of distressed sovereign debt in the secondary market to limit sovereign debt spreads to sustainable levels. This signaled possible massive intervention by the ECB in the sovereign debt market, in addition to the medium-term liquidity already provided to the banks. The markets had hoped for such a decision for months. The financial press had been asking over and over: "When will the ECB decide to use a big bazooka?" This declaration became the turning point in the evolution of the debt crisis. It is of course not in the power of the ECB alone to take responsibility for rescuing the single currency "at any cost": such a choice clearly lies in the hands of democratically elected officials. It took two years for the heads of states and governments to come to an explicit decision on this issue of vital importance to eurozone citizens. But once they had asserted their political will, it was the responsibility of the ECB and its president to do "whatever it takes" to make the project a reality. The ECB proved itself to be up to its task.
The acute debt crisis faded from sight during the months following the September 2012 meeting of the ECB board (the power of the declaration of intent proved sufficient; the ECB did not have to make any actual OMT purchases). In hindsight, it is now clear that the Greek haircut, which was politically unavoidable and no doubt helped send a necessary message to reckless private lenders, should have been accompanied from the very beginning with the credible "Believe me; it will be enough!" commitment from an ECB empowered by the Eurogroup to draw a clear and powerful line separating Greece from the other crisis countries. When managing a debt crisis, the key to success is to be decisive and rapid when restructuring has become unavoidable, as it was in the case of Greece, and just as decisive and quick in building a huge protective wall around that part of the debt that can be preserved from restructuring. Eurozone leaders built that wall two years too late, with the delay having led to huge social costs. While some "pressure" on the countries in crisis to move ahead with fiscal consolidation and structural reforms may have been necessary, it is doubtful that the size of these social costs was required, let alone desirable. On the contrary, it may be argued that the social costs made, and continue to make, it more difficult to pursue vigorous structural reforms.
Excerpted from Europe's Crisis, Europe's Future by Kemal Dervis, Jacques Mistral. Copyright © 2014 THE BROOKINGS INSTITUTION. Excerpted by permission of Brookings Institution Press.
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Table of Contents
Foreword Javier Solana vii
1 Europe's Crisis, Europe's Future: An Overview Kemal Dervis Jacques Mistral 1
Part I Country Perspectives
2 Greece: Tax Anything That Moves! Michael Mitsopoulos Theodore Pelagidis 21
3 Spain: A New Quest for Growth Angel Pascual-Ramsay 45
4 Italy: Strategies for Moving from Crisis to Growth Domenico Lombardi Luigi Paganetto 64
5 France: Part of the Solution or Part of the Problem? Jacques Mistral 93
6 Germany: Constraints in the Crisis Friedrich Heinemann 110
Part II Cross-Cutting Issues
7 The Financial Sector: Key Issues for the European Banking Union Douglas J. Elliott 133
8 Building a Stronger Union: Social Policies in Europe and the Management of the Debt Crisis Jacques Mistral 148
9 Visions for Europe: Democratic Legitimacy and EU Institutions Kemai Dervis 176
Appendix. Economic Data for Selected European Economies, 2000-14 188