Financial crises feed on uncertainty. The longer uncertainty is allowed to linger, the greater the damage to confidence and the more difficult it becomes to repair. It is essential therefore that European policymakers move decisively to draw a line under the crisis.
This will be easier said than done. The Greek, Portuguese, and Spanish governments are struggling to build a consensus for fiscal consolidation. Ireland shows that doing so is possible. But street demonstrations across Southern Europe are a reminder that replicating its success will not be easy. Political consensus for fiscal consolidation is not built in a day.
And if fiscal consolidation is hard, structural reform is harder. Fiscal consolidation means belt-tightening, but pension and labour market reforms cut to the heart of national social and economic models. The reform of models will be an ongoing process stretching over years. Modest down payments will add a fillip to confidence, but they will not draw a line under the crisis.
More challenging still is the reform of EU institutions, since not just one but 27 national polities have to agree. To avoid similar crises in the future, Europe will have to build out the institutions of its monetary union. It will have to create a proper emergency financing mechanism – no more emergency meetings at 2 o'clock in the morning, and no more special purpose vehicles to finesse awkward statutory provisions. It will have to create institutions of fiscal coinsurance to provide temporary transfers to countries with strong policies but transitory budgetary problems.
The ECB, recent events remind us, is a lender and market-maker of last resort and not just the steward of a monetary rule. It will have to become more transparent. To protect its independence in what is a messy world, it will have to publish minutes and votes. This will mean significant changes in institutional practice. The ECB may not savour the prospect, but its legitimacy and credibility are at stake.
And Europe will need fiscal rules with teeth; it will need to move well beyond the Commission’s modest proposals that governments describe their budget plans to their EU partners prior to submitting them to their national parliaments and that the provisions of the Stability and Growth Pact should come into play before the 3% threshold for deficits is reached. The Commission will have to be strengthened to where it has veto power over those pre-legislative submissions. Application of the Stability Pact’s sanctions and fines will have to be outsourced to an independent European Fiscal Council.
Getting the agreement of 27 EU states on these reforms will not be easy. But the longer the delay in starting, the less confidence the euro will inspire.
What can Europe do now to draw a line under its crisis? Four things
- First, European regulators need to make public the detailed results of their bank stress tests and be ready to recapitalise those institutions whose positions are dangerously weak.
Uncertainty about which banks are holding how many Southern European bonds is allowing investor fear to take on a life of its own. Until investors are given the information they need to feel reassured about the condition of individual banks, the crisis will not pass.
- Second, policymakers need to provide more clarity on their €440 billion special purpose vehicle.
We need to know whether its bonds will be senior or junior to existing national debts. We need to know that the special purpose vehicle will be able to fund itself and provide assistance with the speed required by financial markets. The announcements of early May are not enough to reassure.
- Third, the untenable Greek situation needs to be resolved.
So long as European officials continue to assert, contrary to the facts, that Greece’s debt will not have to be restructured, everything else they say will similarly be dismissed as wishful thinking. Policymakers need to bite the bullet now and move forward with restructuring Greece’s debt if only to restore their own credibility.
- Finally, more needs to be done to support growth, besides simply allowing the euro to weaken, while other difficult adjustments are taking place.
Some of us were saying this as long ago as April this year (Eichengreen 2010). But just because the point is familiar doesn’t make it less important. Drawing a line under the crisis requires Germany to support aggregate demand while its European partners undertake fiscal consolidation. Budget balance is an admirable goal for an ageing German society, but it is a goal for 2012, not 2010.
Further action by the ECB is also overdue
The argument for not cutting policy rates to zero has been that it is better to keep room to cut in reserve for a rainy day. Well, it’s raining. And since 100 basis points are unlikely to make a big difference, it is time, long since time actually, for the ECB to get serious about quantitative easing. Without growth, the pain of adjustment and consolidation will quickly become unbearable. The only pain relievers on the horizon are Germany and the ECB.
This crisis has been allowed to fester for too long. Fortunately, there are concrete actions that Europe can take to bring it to an end.
Eichengreen, Barry (2010) Remarks at the Ninth annual Munich Economic Summit.