The Eurozone Slides Into a Vicious Cycle

The Eurozone crisis is not over. This column argues that the bailout of Greece and the €750 billion Special Purpose Vehicle set up in May 2010 was the first step down the slippery slope. The first and only possible remedy is to reconstruct the no-bailout clause and let markets discipline governments; the EU has proven that it cannot.

It is amazing to observe European policymakers, having taken the wrong turn earlier this year, persevere in piling one mistake upon another. It all started when they decided that Greece could not be left to itself. Pressing on with this logic, they have brought the Eurozone to the point where it is contemplating a disaster of historical proportions.

Future historians will have to decide whether “saving Greece” was an honest show of solidarity or a crass attempt by the French and German governments to avoid another round of taxpayer-financed bank bailouts (see for example Baldwin et al. 2010). At any rate, this is when the disaster started.

• First Greece was told not to go to the IMF since fellow governments would help out with a generous loan of €10 or €20 billion. The promise was, in part, designed to impress the financial markets and to discourage them from pressing on the embattled Greek government.
• The markets laughed. The amount was laughable indeed and the promise was an encouragement to step up the speculative attack in anticipation of even higher profits.
• The amount was raised, step by step, and Greece was finally told to go to the IMF, but not alone. A joint IMF-EU rescue operation eventually lined up €110 billion and a new fund of no less than €750 billion was cobbled together to really impress the markets.
• Worse, the ECB was “invited” to purchase public debts, against its often-stated policy of never ever doing that.

In one go, the no-bailout clause was wiped out and the ECB lost an important chunk of credibility. The reason? To avoid at all cost contagious runs on other countries’ public debts and preclude any threat of sovereign default. But, alas, that didn’t work.

The current quandary

Here we are. Contagion is under way and it is now only of matter of time until sovereign debts are restructured. The failure is nearly complete and policy responses are getting worse and worse. The ECB now seems ready to massively raise its programme of debt monetisation.

This is not yet a direct threat to price stability, thanks to the painfully slow path to economic recovery, but the ECB has lost any right to lecture governments on the crucial requirement of fiscal discipline. Markets will love this move for a few hours or a few days and then they will concentrate on further attacks on more public debts.

It looks as if policymakers, including at the ECB, decide on their moves one step at a time. Don’t they see that their commitment to bailout all public debts feeds market speculation?

There is much money to be made, like earning an annual return of 10% on guaranteed paper denominated in euros. Of course, the spread reflects the market realisation that policymakers will eventually give in; total Eurozone public debt stands at about €7,700 billion. But, with the ECB now apparently willing to buy everything that the market will want to offload, the bet is relatively safe. In fact, irresistible.

This was not meant to be, and the looming disaster is not part the original Eurozone project.

• The no-bailout clause was designed to make sure that each government would face, alone, the consequences of fiscal indiscipline.
• By breaking this centrepiece of the euro construction, policymakers have opened up a possibly lethal crisis.

Their hope is that they will correct the situation by toughening the Stability Pact and by imposing a sovereign debt resolution mechanism that will make partial defaults possible and manageable.

A debt resolution mechanism is a good idea, but it cannot be forced upon a sovereign country. A decade ago, the IMF tried to design such an arrangement that could be activated when a country applied for emergency support, an extension of its conditionality instruments.

The current plan defended by Germany, apparently with French support, is to have some European judicial body – still to be described – impose a debt resolution mechanism on a Eurozone member of country in difficulty.

This would represent a serious transfer of sovereignty, so it requires a new Treaty, ratified by all member countries. But ask the Irish if they would vote yes. The current project is doomed, as is any serious toughening of the Stability Pact, for the same reason.

When the project flounders, which is a near certainty, the Eurozone will have effectively lost any mean of imposing fiscal discipline among its members. One can hope that the policymakers have already prepared a Plan B but, given how deeply confused they appear to have been so far, we shouldn’t be too surprised if they disappoint us once again.

What’s next?

What happens then? The monetary union will be unable to guarantee price stability. Some countries may conclude that this is not what they want and they can well start making preparation to recover control of their monetary policy. This is something that I thought was beyond the worst possibilities, because I thought that policymakers would be sensible. Alternatively, policymakers will come to their sense and recognise how deeply mistaken they have been.

It is suggested that the solution is a common fiscal policy. This is bound to please those who, like me, favour a Federal Europe, but it is just a superficial slogan.

What spending and taxing powers are European citizens – who will have to be consulted – willing to transfer to “Brussels”? A very successful monetary union might embolden them to look for more integration but the more the Eurozone is in disarray, the thinner become the ranks of federalists.

Likewise, the idea of issuing collectively-guaranteed public debt instruments is appealing but it is misleading as long as fiscal discipline is not guaranteed.

It is brutal, and may well be inefficient on occasion, but policymakers have now demonstrated spectacularly that they cannot be trusted to display good judgment when facing a complex situation.

References

Baldwin, Richard, Daniel Gros, and Luc Laevan (2010), “Completing the Eurozone rescue: What more needs to be done?”, VoxEU.org, June 2010.

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