Europe's Tragedy Nears the End of Act One, but the Drama Continues
Knowledge @ Wharton
May 24, 2012
What a difference a year can make. When a group of European Union experts met at a workshop in Italy's Tuscan hills in the spring of 2011, the center of attention was Greece and its ever-growing sovereign debt crisis. Could it, should it, default on debt repayments? And what would happen then? The delegates wondered whether the result might be a meltdown not just of the Greek economy but of Europe as a whole.
Flash forward a year, and Greece is still a hot topic. EU experts gathering in Italy at a workshop on April 26 -- co-organized by the Wharton Financial Institutions Center and titled, "Governance for the Eurozone: Integration or Disintegration?" -- focused on the region's other crisis-ravaged economies: Spain, Portugal, Ireland, Italy and Belgium.
'New EU Emerging'
According to Brigid Laffan, a panelist, "a new EU is emerging from the crisis." As the European politics professor at Ireland's University College Dublin asked, "The question is how much more do the eurozone states have to do in order to save the euro?"
Plenty, it seems. Against a backdrop of what Laffan called "the politics of austerity" -- in which German Chancellor Angela Merkel and former French President Nicholas Sarkozy called the shots -- a number of experts at the workshop said they see a need for more, not less, integration across the EU. That integration, they noted, goes well beyond the EU-wide fiscal discipline debates taking place today, to address the region's economic imbalances that are believed to be behind many of its current woes.
Two things are increasingly clear, according to Franklin Allen, finance professor at Wharton, echoing the discussions he co-chaired at the workshop, which was held at the European University Institute (EUI). First, "that there is not nearly enough concern for the human cost of the policies that they are trying to pursue" -- unemployment in the eurozone is now around 11%, with around 50% of people under 25 in Spain and Greece jobless. Second, that there is "a low likelihood that they will succeed in anything over the next several years."
That may feel like an eternity for Europeans who have already endured enough hardship -- and precipitous drops in their standards of living -- since the crisis began in 2007 and deep government spending cuts took hold. As Charles Goodhart, emeritus banking and finance professor at the London School of Economics, noted at the workshop, "Austerity without growth is a recipe for depression, despair and growing social and political dissonance." Just ask the Greeks.
One of the biggest events since last year has been that Greece has indeed defaulted -- albeit in a de facto way, with a so-called "public-sector involvement" debt swap in which the creditors taking part faced losses of more than 50% of their principal.
It was, perhaps, not a bad thing. "It showed you could have a default without Armageddon," said Allen. "The official [European Central Bank] view, and that of many people, argued that if Greece defaulted, it would be like the world ending. But that wasn't true.... That was a big positive."
Even so, Greece continues to muddle through the crisis under the 130 billion-euro rescue package put together by the the European Central Bank (ECB), the EU and the International Monetary Fund (IMF). Greeks have had to undergo a series of adjustments in order to receive that bailout while its economy languishes. Indeed, Bloomberg reported May 15 that Greece's economy contracted 7% in the fourth quarter of 2011, compared with a year earlier, "when the country was already deep into recession." Overall unemployment is three times higher than it was before the crisis at 20.9%, homelessness is on the rise and almost half of all homeowners say they will not be able to make their mortgage payments this year, Bloomberg also reported.
Following what turned out to be a chaotic, anti-austerity national election on May 6, leaving an indecisive victory, the Greeks continue to struggle with a troubled economy. The new interim government in place until June elections did not immediately rule out a second -- and this time, a hard -- default, reneging on agreements to pay 436 million euros to bondholders who shunned the first debt swap earlier this spring. The payment, however, was made, thus avoiding the possibility that Greece would be cast out of the eurozone.
Greece is hardly alone. With the help of new mechanisms, including the European Financial Stability Fund (or the EFSF, set up last year by eurozone countries to provide loans to cash-strapped members) and an array of social and economic reform measures, policymakers in Spain and the eurozone's other "periphery" countries, too, have spent the past year trying to fix their broken economies -- amid lots of controversy.
The question policymakers should be asking, but too often aren't, is, "Are there financial backstops that provide enough time and incentives that will allow structural reform?" noted Pier Paolo Padoan, deputy secretary-general of the Organisation for Economic Co-operation and Development, during a presentation at the workshop. "If there's a negative answer to that question, you're in trouble."
Determining how fiscal austerity -- requiring national governments to keep budgets under control and maintain tax revenues -- can go hand in hand with growth is a tall order. The fear in some circles is that the impact of austerity may, in fact, be worse than that of any current or future economic downturn. What national policymakers need to question is whether fiscal consolidation will lead to "a good equilibrium between public debt and growth," Padoan said.
French President-elect François Hollande believes it cannot; Merkel does. "We in Germany are of the opinion, and so am I personally, that the fiscal pact is not negotiable. It has been negotiated and has been signed by 25 countries," Reuters quoted Merkel as saying following Hollande's election. "We are in the middle of a debate to which France, of course, under its new president will bring its own emphasis. But we are talking about two sides of the same coin -- progress is only achievable via solid finances plus growth."
Is this impasse cause for despair? Not according to Padoan. Timing -- in terms of when such reforms take place during an economic cycle -- is important, as is market confidence that the reforms make sense, even if the full impact is not realized for the next 10 to 25 years. Padoan pointed out that the pace of reform -- "has been accelerating. Why is this good news? Not because it generates pain, but because the time when we will start to see the benefits is closer than you think," he said.
The hope is that the eurozone's so-called periphery countries will regain the competitiveness they lost in recent years. In his presentation, Frank Smets, research director general at the ECB, explored the damaging effect that the rise of unit labor costs has had on countries such as Ireland. "On average, it was [in these countries] 1% to 2% higher than the market over this period, much higher than Germany, for example, which had one of the lowest increases in unit labor costs," he said.
One Bank, Many Mandates?
Another striking aspect in the debates about the eurozone crisis has to do with the many institutions involved and which of those has the responsibility, and credibility, to knock the crisis on its head. Arguably the most intriguing institution in that regard is the ECB.
Just what is the ECB's role in this crisis? According to workshop participants, its role in the banking sector is more straightforward. Since the crisis began, the ECB has opened a spigot of lending to support banks in Greece and other nations. Europe's banks -- even those with relatively healthy balance sheets -- have helped themselves to the ECB's cheap money (three-year bank refinancing known as the Long-Term Refinancing Operation). Sometimes they have been tapping the ECB to rekindle their own lending in the hope that their loans to retail and wholesale customers will help local economies, or purchase sovereign debt. But more often, banks are using those loans to prop up their own businesses as new, more stringent regulations kick in, requiring them to keep higher amounts of capital in reserve for a rainy day. Meanwhile, consumer demand and productive capacity are so slack that it is questionable whether there would be much demand for loans by businesses even if the funds were fully available.
But does the ECB have a responsibility to go further by remaining as it has been recently -- a lender of last resort to provide financial stability and prevent countries like Greece from going bankrupt? It's a different matter with countries, participants at the workshop noted. For one thing, countries have a wider range of levers to pull, including raising taxes, than banks do if their coffers run low. For another, the EFSF, and the future European Stability Mechanism slated to succeed the EFSF, can play that role. "The ECB cannot solve solvency issues [of countries]," stated Guntram Wolff, deputy director of Bruegel, a Brussels-based think tank.
But the argument is far from straightforward. In a paper presented at the workshop titled, "The European Central Bank: Lender of Last Resort in the Government Bond Markets?," Paul De Grauwe of the London School of Economics, noted, "Failure to provide lending of last resort in the government bond markets of the monetary union carries the risk of forcing the central bank into providing lending of last resort to the banks of the countries hit by a sovereign debt crisis. And this lending of last resort is almost certainly more expensive." Indeed, his research found that bank liabilities in the eurozone were about 250% of GDP in 2008, while the eurozone's government debt-to-GDP ratio was about 80%.
As he put it, the ECB is like "a fireman who has the means to catch the arsonist before the fire." The ECB is the only institution capable of stopping the eurozone implosion but it doesn't want to do it. Until this changes, he stated, "the eurozone will walk from one crisis to another."
Much Talk, Little Action
It is not only the institutions, but also the leaders behind the crisis that are cause for concern. Assessing the political landscape of the eurozone, Russell Cooper, economics professor at the European University Institute, said Merkel and the other crisis kingpins, "talk and they talk and they talk. That's not the issue. The issue is credibility."
The truth is that's there is a woeful lack of solidarity among leaders in the EU, as the workshop's panelists and delegates pointed out. National interests have and will get in the way, noted Goodhart of the London School of Economics during his discussion about the U.K.'s role in the EU.
"My country will try to prevent centralizing rules," he said. "It may well be that any move to a central currency will be stymied. Anyone wanting one will have to assume that the U.K. government will nix it."
Could this now change? With Germany dominating crisis negotiations -- with France in tow -- other countries have been marginalized, Laffan observed. For now, "nothing can happen unless Germany wants it to happen. It can determine the pace of response, and which policy solutions are used. That is why we can see no transfer union [allowing governments to move payments among themselves] and, to date, no eurobonds [which proponents say would allow eurozone governments to issue jointly guaranteed bonds that do not differentiate between the creditworthiness of the issuers]."
Now that France has seen a change in leadership, "might it not be a good time for the country to look at the reflex action that it has had toward that relationship? Could France, post-Sarkozy, with Italy and the U.K., create not an alternate coalition, but at least another coalition?" Laffan asked. "France has a really serious decision to make as to how it projects itself and positions itself."
Summing up a widespread view at the workshop, Laffan noted that the tragedy that is unfolding across Europe is "probably only looking at the end of the first act. The drama is going to continue."
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