Today Eurozone leaders will meet in Brussels. On the agenda is nothing less than the survival of the euro. Officially, it is about Spain: Spain’s economic and financial woes show the urgency. Moody’s drastically downgraded Spanish banks this week; bank runs could be a possibility and are likely to spread to Italy and other countries - even to France.
For two years, the Eurozone has been in peril, and the half-life of the supposed breakthroughs announced after each Euro summit has shortened drastically. After the recent 100 billion euro bailout proposal for Spanish banks, it took the bond market only three hours to conclude that this will only worsen rather than solve the problem by burdening the already over-indebted Spanish state with the rescue credits.
It is high time to end this crisis now.
It is by now crystal clear what many economists have predicted early on: The austerity-cum-limited financial-support strategy has failed completely. Instead of solving the financial problems of the problem debtors, it has led to higher sovereign debt ratios; more rather than less speculation; and dramatic economic costs in terms of lost output and extremely high unemployment figures in Spain and elsewhere. Finally, the strategy has seriously undermined the political support for “Europe” in both problem and “rescuer” countries.
The crisis will go on as long as it is unclear whether the Eurozone will protect the common currency and its member countries by all means or not. If not, either a break-up of the Eurozone or a huge restructuring of sovereign and bank debts, or – in case of failure – even both will be necessary.
To keep the Eurozone alive, it is also clear what is needed - and sooner is better than later:
A lender of last resort for the Eurozone
This lender can only be the European Central Bank (or the permanent rescue fund, European Stability Mechanism, equipped with a banking license), which has the unlimited firepower to backstop government debt. Unsustainable interest rates on sovereign debt must be brought down immediately. Failure to do so will sooner or later lead to extensive sovereign debt restructuring in many countries. The losses would clearly exceed the financial and political resources of the rescuer countries. Germany’s Angela Merkel has admitted this already.
A European banking union
A unified European banking market regulation, supervision and crisis resolution mechanism, now known as “banking union”, is needed to backstop bank runs in Spain, Italy and elsewhere. In particular, it is most important to install a Eurozone deposit insurance now to avoid a contagious bank run that would affect not only Spain, but also Italy or even France. It would be a big mistake to burden the Spanish state with the rescue finds and turn a banking crisis into an even bigger sovereign debt crisis. The case of Ireland sends us strong warnings and teaches us important lessons. While deposits should be guaranteed, it is also clear that the holder of bank bonds and equity must face losses. Spanish and European banks need to be restructured, recapitalized and – if need be – even nationalised.
A big step forward towards a fiscal union
A first issue is to change the suggested fiscal compact into a realistic and workable one that ends the austerity bias of the current strategy and provides a growth perspective. A wisely designed fiscal compact that limits deficits and helps reducing debt overhangs over the medium term will also help to allow the ECB (or the ESM) to backstop government debt without creating moral hazard problems. A gradual introduction of eurobonds, eventually allowing for some light versions of eurobonds (such as “project bonds” or short-term eurobills) is also part of this move.
Restoring the competitiveness of problem countries
The Eurozone can no longer require the debtor country to deflate painfully. In addition, Germany must accept somewhat higher inflation and thus lower trade surpluses.
Until now, the Eurozone under the leadership of “Merkozy” has stifled all ideas that eventually could have ended the crisis. The main argument has been “moral hazard” and the associated hope that the pain of austerity will bring reform gains in the problem countries, which otherwise would not occur.
But the pains have by now increased so dramatically and are traumatic for many young people in countries such as Spain, where youth unemployment stands by 50%. Moreover, they are inflicted on those who are not responsible for the situation. The narrative of the crisis widely told and unfortunately widely believed in Germany and elsewhere in Nordic countries tells the story of irresponsible governments which need to be disciplined by strict austerity requests in return for funds.
But to paraphrase from Tolstoy’s Anna Karenina: unhappy countries are all unhappy in their own way.
The Greek tragedy fits the tale. But before the outbreak of the global financial crisis, Spain and Ireland had the lowest debt-to-GDP ratios within the Eurozone. Their problems are rooted in the banking sector, not at least caused by excessive lending by banks originating in Germany and elsewhere in the North. And next to banks it is the construction errors of the Eurozone plus the mishandling of the crisis that created and increased the problems in many countries.
Three major things are different on today’s summit.
First, the situation is more dramatic than ever, with Italy and perhaps France being the next potential candidate for a bank run. Second, with new French president, Francois Hollande, the view on the strategy as well as the corresponding power balance has changed. And third, Germany is gradually realising that the imposed austerity strategy will finally overburden Germany itself, and that it has to be changed in the pursuit of its own self-interest.
The greatest problem for the Eurozone leaders today may be how to communicate why and how they will depart from past strategies, and thus to create support for “more Europe” in their respective parliaments and electorates. But maybe this kind of “brinkmanship” is necessary for German Chancellor Angela Merkel to engineer a U-turn.
As argued earlier, the Eurozone countries will have to decide how much national determination they are willing to trade off for effective European governance. The euro’s survival depends on it. Let us all hope that the Eurozone leaders will have the courage to end this crisis now.