Given the raft of gloomy economic data, it is hardly appropriate to be optimistic about the prospects for the sustainability of the monetary union in Europe. But in one key area some progress is being made. The root causes of the crisis have been identified and actions are being taken to address them. This week, on 12 September 2012, a little-known German constitutional court took a huge decision and cleared the country’s participation in a new bailout fund. About a week ago, the ECB reversed an earlier decision and announced that it would serve as a lender of last resort in government bond markets.
Lesson to Europe from Asia
An important lesson to Europe from of the Asian financial crisis of 1997/1998 is that in managing a crisis it is critically important to distinguish between the symptoms/triggers and the root causes, and to focus on the latter rather than the former. Otherwise the patient may be given the wrong medicine, which could worsen the disease.
In contrast to the Latin America debt crisis, the Asian crisis had little to with unsustainably large government borrowing and current-account deficits. Several countries (e.g., Thailand and Malaysia) had relatively large current-account deficits, but these were because of large amounts of short-term capital coming into these countries. The root cause of the Asian crisis was the weaknesses of domestic banking sectors, which had recently been liberalised and encouraged to borrow from abroad. In such a crisis, the appropriate remedy would have been to inject liquidity in the economy through easier monetary and financial policies – exactly the opposite of what the IMF did, at least initially.
Macroeconomic stabilisation prescribed by the IMF not only failed to address the root cause of the crisis but, critics contend, also pushed the countries into deep recessions (Krugman 1998). Rather than implement austerity measures, the crisis countries in Asia should have been encouraged to adopt “stable or even slightly expansionary macroeconomic policies” to counteract the macroeconomic consequences of the crisis (Sachs 1997).
Henning and Khan (2011) write “Asian countries were convinced that the Fund misdiagnosed the problems the countries were facing and imposed excessively harsh and inappropriate conditions for the financing it was providing. Despite the fact that the Fund later on acknowledged the mistakes is has made during the Asian financial crisis, and changed its views, the damage had been done and the mistrust of the Fund by the Asian countries lingered”.
Root causes of the crisis
The EZ is experiencing multiple and often overlapping crises. Greece, the southern EZ, and Ireland are experiencing a fiscal crisis mainly because of overspending by the public sector in the form of unsustainable wages and pensions. Ireland and now other countries are facing a banking crisis because of public sector guarantees to banks which financed the property bubble. Most countries in the region are also experiencing a competitiveness crisis vis-à-vis Germany, which has successfully enhanced its economic efficiency through structural reforms. But what were the root causes of the crises and what is being done to address them?
The root causes of the EZ crisis were the flaws in the design of the monetary union (Kirkegaard 2011, Bergsten 2012). The EMU, launched in 1999, comprised the euro (the single currency) and the European Central Bank (ECB) for a common monetary policy. It did not contain a fiscal union, and other institutional mechanisms for coordinating structural policies. Both the Werner Report of the 1970s (European Commission 1970) and the Delors Report of the 1980s (European Council 1989), which served as the blueprint, had developed a three-stage roadmap comprising closer economic coordination among members, binding constraints on member states’ national budgets, and a single currency.
But in their haste and eagerness to accomplish a full and irrevocable European unity, the ‘founding members’ had felt that the two convergence criteria enshrined in the Maastricht Treaty – a 3% limit on annual fiscal deficit and a 60% limit on gross public debt to GDP ratio – would be adequate for the purpose. In practice, these thresholds were neither binding nor fixed. The Eurozone was, therefore, launched as an experiment between a set of countries that were quite diverse and far less integrated than required by the optimum currency theory of Professor Robert Mundell (1961). It was hoped that a monetary union would lead to an economic union. But this did not happen.
The institutional flaws have now been identified and are being fixed. A key design flaw in the Eurozone was the absence of the lender of last resort in government bond markets (De Grauwe 2011, Wyplosz 2011). When a country issues sovereign bonds in its own currency there is an implicit guarantee from the central bank that cash will always be available to pay out the bondholders. The absence of such a guarantee in a monetary union – where bonds are issued in a currency over which individual countries have little control – makes the sovereign bond markets prone to liquidity crisis and contagion, very much like banking systems in the absence of lenders of last resorts.
ECB as lender of last resort
Initially, given the no-bailout clause in the EU treaty, the ECB was reluctant to pursue the role of lender of last resort. Instead, the EZ set up the European Financial Stability Facility (EFSF) for the purpose. A permanent €500 billion European Stability Mechanism (ESM) is targeted by the end of the year, and this week’s German constitutional court approval was a key step forward. The establishment of the ESM is critical as the EFSF is running out of money (having bailed out Greece, Ireland, and Portugal) and is due to expire in less than a year.
But there has been a dramatic turnaround in the ECB. In July, the ECB president Mario Draghi promised to do "whatever it takes" to protect the euro. He delivered on 6 September when he announced plans to make the ECB the lender of last resort in government bond markets. Under the new program dubbed the Outright Monetary Transactions (OMT), the ECB will buy existing government bonds in the secondary market without announcing any limits in advance. The OMT will primarily benefit fiscally troubled countries, such as Spain and Italy, which are facing difficulties financing their debt. To prevent moral hazard and ensure that countries continue their adjustment policies, the ECB will require that a country seeking to benefit from the OMT must first apply to the EZ’s bailout funds, the EFSF and the ESM, where tough conditions are imposed. The ECB will also continue to sterilise its purchases so that there will be little impact on money supply.
Fiscal compact and banking union for crisis prevention
In the area of crisis prevention several bold actions are being taken. First, in March 2012, EU members (except the Czech Republic and the UK) agreed to set up a new fiscal compact. Once in force, the compact will require all ratifying members to enact laws on national budgets to meet the two Maastricht convergence criteria, except this time it will be enforced by the European Court of Justice (ECJ) which means that any member may bring enforcement proceedings against another member in the ECJ if they fail to meet their obligation. The target is to make the compact effective on 1 January 2013 if it is ratified by at least 12 members.
Second, a banking union is also being established. This requires establishing a Europe-wide financial supervisor – Brussels has proposed ECB for the task. It also requires setting up a deposit guarantee scheme, and a resolution regime to ensure that unsecured creditors rather than taxpayers pay the cost of future bank failures.
A number of bold actions are being taken to refocus the experiment that the ‘founding fathers’ of the Eurozone began in 1999. These, however, fall short of a full-fledged fiscal union with taxes and expenditure handled by a common authority, deeper integration including high labour mobility, and a political union such as the ‘United States of Europe’. This is because each of them requires politicians to give up powers which many of them regard as sacrosanct. Whether the reformed Eurozone, or Eurozone II, will be enough to save the single currency system remains to be seen.
Bergsten, F (2012), “Congressional Testimony: The Outlook for the Euro Crisis and Implications for the United States”, Peterson Institute of International Economics.
De Grauwe, P (2011), “The European Central Bank as a Lender of Last Resort”, VoxEU.org, 11 August.
European Commission (1970), “Report to the Council and the Commission on the Realization by Stages of Economic and Monetary Union in the Community”.
European Council (1989), “Report on the Economic and Monetary Union in the European Community”.
Henning, CR and MS Khan (2011), “Asia and Global Financial Governance”, Peterson Institute of International Economics Working Paper 11-16.
Kirkegaard, JF (2011), “Congressional Testimony: The Euro Crisis: Origins, Current Status, and European and US Responses”, Peterson Institute of International Economics.
Krugman, P (1998), “The Confidence Game: How Washington Worsened Asia’s Crash”, New Republic Online, 5 October.
Mundell, R (1961), “A Theory of Optimum Currency Areas”, American Economic Review, 51(4):657-665.
Sachs, J (1997), “The Wrong Medicine for Asia”, The New York Times, 3 November.
Wyplosz, C (2011), “An Open Letter to Dr Jens Weidman”, VoxEU.org, 18 November.