Crisis in Euro-zone—Next Phase of Global Economic Turmoil
|After 2008’s banking crisis and 2009’s recession, in 2010 the next phase of global economic turmoil is taking shape: a crisis in public finance. The troubles are most acute in Europe. Government deficits have ballooned to more than 12 percent of GDP in Spain, Ireland, and the UK, while government debt will hit over 100 percent across the European Union by 2014. The first country to buckle under pressure has been Greece. Greek markets crashed in December 2009 due to worries about the government’s ability to finance its enormous deficit. Because most EU countries now use the euro as a common currency, they can no longer finance their debt by printing money, or by devaluing their currency to make their exports more competitive and thus grow themselves out of the slump. Faltering countries could face sharply higher interest rates, problems refinancing their debt, and, ultimately, default—something that has not happened in a developed European economy since 1948.
On April 23, 2010, the Greek government requested that the EU/IMF bailout package (made of relatively high-interest loans) be activated. On May 1, a series of austerity measures were proposed. The proposal helped persuade Germany, the last remaining hold-out, to sign on to a 110 billion euro bail-out package for Greece.
Senior German policy makers had been insisting that emergency bailouts should bring harsh penalties to EU aid recipients such as Greece. However, such plans were described as unacceptable infringements on the sovereignty of euro-zone member States and were opposed by key EU nations such as France. There was also criticism against speculators manipulating markets: German Chancellor Angela Merkel stated that “institutions bailed out with public funds are exploiting the budget crisis in Greece and elsewhere”.
The Greek Tragedy
The Greek economy was one of the fastest growing in the euro-zone during the 2000s; from 2000 to 2007 it grew at an annual rate of 4.2% as foreign capital flooded the country. A strong economy and falling bond yields allowed the government of Greece to run large structural deficits. Since the introduction of the Euro, debt to GDP has remained above 100%.
The global financial crisis that began in 2008 had a particularly large effect on Greece. Two of the country’s largest industries are tourism and shipping, and both were badly affected by the downturn. To keep within the monetary union guidelines, the government of Greece deliberately mis-reported, in other words falsified the country’s official economic statistics. In the beginning of 2010, it was discovered that Greece had paid Goldman Sachs and other banks hundreds of millions of dollars in fees since 2001 for arranging transactions that hid the actual level of borrowing. The purpose of these deals made by several subsequent Greek governments was to enable them to spend beyond their means, while hiding the actual deficit from the EU overseers.
In 2009, the government of George Papandreou revised its deficit from an estimated 6% (or 8% if a special tax for building irregularities were not to be applied) to 12.7%. In May 2010, the Greek government deficit was estimated to be 13.6%, which is one of the highest in the world relative to GDP.
On March 5, 2010, the Greek Parliament passed the Economy Protection Bill, expected to save €4.8 billion through a number of measures, including public sector wage reductions. Passage of the bill occurred amid widespread protests against government austerity measures in the Greek capital, Athens. On April 23, 2010, the Greek government requested that the EU/IMF bailout package be activated.
On May 2, 2010, a loan agreement was reached between Greece, the other euro-zone countries, and the International Monetary Fund. The deal consists of an immediate €45 billion in low interest loans to be provided in 2010, with more funds available later. A total of €100 billion has been agreed. The interest for the Euro-zone loans is 5%, considered to be a rather high level for any bailout loan. The government of Greece agreed to impose a fourth and final round of austerity measures.
Without a bailout agreement, there was a possibility that Greece would have been forced to default on some of its debt. The premiums on Greek debt had risen to a level that reflected a high chance of a default or restructuring. Since Greece is on the euro it prevents it from inflating away a portion of its obligations or otherwise stimulating its economy with monetary policy. For example, the US Federal Reserve had expanded its balance sheet by over $1.3 trillion since the global financial crisis began, essentially printing new money and injecting it into the system by purchasing outstanding debt.
An alternative to the bailout agreement would have been Greece leaving the euro-zone. The overall effect of Greece being forced off the euro would itself have been small for the other European economies. Greece represents only 2% of the euro-zone economy. However, a default by Greece would have caused investors to lose faith in other euro-zone countries. This concern is also focused on Portugal, Ireland and Spain, all of whom have high debt and deficit issues. Italy also has a high debt, but its budget position is better than the European average, and it is not considered amongst the countries most at risk.
European Union leaders have made two major proposals for ensuring fiscal stability in the long-term. The first proposal is the creation of a common fund responsible for bailing out, with strict conditions, a EU member country. This reactive tool is sometimes dubbed as the European Monetary Fund. The second is a single authority responsible for tax policy oversight and government spending coordination of EU member countries. This preventive tool is dubbed the European Treasury.
The monetary fund would be supported by EU member governments, and the treasury would be supported by the European Commission. However, strong European Commission oversight in the fields of taxation and budgetary policy and the enforcement mechanisms that go with it have been described as infringements on the sovereignty of euro-zone member States and are opposed by key EU nations such as France and Italy, which could jeopardize the establishment of a European Treasury.
Some think-tanks such as the CEE Council have argued that the predicament some EU countries find themselves in is the result of a decade of debt-fuelled Keynesian policies pursued by local policy makers and complacent EU central bankers, and have recommended the imposition of a battery of corrective policies to control public debt. Some senior German policy makers went as far as to say that emergency bailouts should bring harsh penalties to EU aid recipients such as Greece. Others argue that an abrupt return to “non-Keynesian” financial policies is not a viable solution and predict the deflationary policies now being imposed on countries such as Greece and Spain might prolong and deepen their recessions.
Regardless of the corrective measures chosen to solve the current predicament, as long as cross border capital flows remain unregulated in Europe and Asia, asset bubbles and current account imbalances are likely to continue. Long-term stability in the euro-zone requires a common fiscal policy rather than controls on portfolio investment. However, in exchange for cheaper funding from the EU, Greece and other countries, in addition to having already lost control over monetary policy and foreign exchange policy since the euro came into being, would also lose control over domestic fiscal policy.
Role of Credit Rating Agencies
The international credit rating agencies, such as Moody’s, S&P and Fitch, have played a central and controversial role in the current crisis. The agencies have been accused of giving overly generous ratings due to conflicts of interest. Ratings agencies also have a tendency to act conservatively, and to take some time to adjust when a firm or country is in trouble. In the case of Greece, the market responded to the crisis before the downgrades, with Greek bonds trading at junk levels several weeks before the ratings agencies began to describe them as such.
Government officials have criticized the ratings agencies and the German Finance Minister has suggested that traders should not take global rating agencies “too seriously”. He has called for an “independent” European rating agency, which could avoid the conflicts of interest that he claimed US-based agencies faced.
According to the European Commission’s analysis, unless policies take up the new challenges, potential GDP in the EU could fall to a permanently lower trajectory due to several factors. First, protracted spells of unemployment in the workforce tend to lead to a permanent loss of skills. Second, the stock of equipment and infrastructure will decrease and become obsolete due to lower investment. Third, innovation may be hampered as spending on research and development is one of the first outlays that businesses cut back on during a recession.
Member States have implemented a range of measures to provide temporary support to labour markets, boost investment in public infrastructure and support companies. To ensure that the recovery takes hold and to maintain the EU’s growth potential in the long-run, the focus must increasingly shift from short-term demand management to supply-side structural measures. Failing to do so could impede the restructuring process or create harmful distortions to the Internal Market.
Preparing exit strategies now, not only for fiscal stimulus, but also for government support for the financial sector and hard-hit industries, will enhance the effectiveness of these measures in the short term, as this depends upon clarity regarding the pace with which such measures will be withdrawn. Since financial markets, businesses and consumers are forward-looking, expectations are factored into decision making today. The precise timing of exit strategies will depend on the strength of the recovery.
Exit strategies need to be in place for financial, macroeconomic and structural policies alike.
An immediate priority is to restore the viability of the banking sector. Otherwise a vicious circle of weak growth, more financial sector distress and ever stiffer credit constraints would inhibit economic recovery. Clear commitments to restructure and consolidate the banking sector should be put in place now if a Japan-like lost decade is to be avoided in Europe. As long as there remains a lack of transparency as to the value of banks’ assets and their vulnerability to economic and financial developments, uncertainty remains. In this context, the reluctance of many banks to reveal the true state of their balance sheets or to exploit the extremely favourable earning conditions induced by the policy support to repair their balance sheets is of concern.
It is important as well that financial repair be done at the lowest possible long-term cost for the tax payer, not only to win political support, but also to secure the sustainability of public finances and avoid a long-lasting increase in the tax burden.
Macro-economic stimulus–both monetary and fiscal–has been employed extensively. The challenge for central banks and governments now is to continue to provide support to the economy and the financial sector, without compromising their stability-oriented objectives in the medium term. The fiscal exit strategy should spell out the conditions for stimulus withdrawal and must be credible, i.e. based on pre-committed reforms of entitlements programmes and anchored in national fiscal frameworks.
While, it is important to decisively repair the longer-term viability of the banking sector so as to boost productivity and potential growth, this will not suffice and efforts are also needed in the area of structural policy proper. A sound strategy should include the exit from temporary measures supporting particular sectors and the preservation of jobs, and resist the adoption or expansion of schemes to withdraw labour supply. Beyond these defensive objectives, structural policies should include a review of social protection systems with the emphasis on the prevention of persistent unemployment and the promotion of a longer work life.
Future Crisis Prevention
Before the crisis broke there was a strong belief that macro-economic instability had been eradicated. Low and stable inflation with sustained economic growth (the Great Moderation) were deemed to be lasting features of the developed economies. It was not sufficiently appreciated that this owed much to the global disinflation associated with the favourable supply conditions stemming from the integration of surplus labour of the emerging economies, in particular in China, into the world economy. This prompted accommodative monetary and fiscal policies. Buoyant financial conditions also had micro-economic roots and these tended to interact with the favourable macro-economic environment. The list of contributing factors is long, including the development of complex–but poorly supervised–financial products and excessive short-term risk-taking.
Initiatives to achieve better remuneration policies, regulatory coverage of hedge funds and private equity funds are need of the hour. Regulation to ensure that enough provisions and capital be put aside to cope with difficult times needs to be developed, with accounting frameworks to evolve in the same direction. It is also essential that a robust and effective bank stabilisation and resolution framework is developed to govern what happens when supervision fails, including effective deposit protection.
Governments in many EU countries ran a relatively accommodative fiscal policy in the ‘good times’ that preceded the crisis. Although this cannot be seen as the main culprit of the crisis, such behaviour limits the fiscal room for manoeuvre to respond to the crisis and can be a factor in producing a future one–by undermining the longer-term sustainability of public finances in the face of aging populations. Policy agendas to prevent such behaviour should thus be prominent, and calls for a stronger coordinating role for the EU, alongside the adoption of credible national medium-term frameworks.
Structural reform is among the most powerful crisis prevention policies in the longer run. By boosting potential growth and productivity it eases the fiscal burden, facilitates balance sheet restructuring, improves the political economy conditions for correcting cross-country imbalances, makes income redistribution issues less onerous and eases the terms of the inflation-output trade-off.
The financial crisis has clearly strengthened the case for economic policy coordination in the EU. By coordinating their crisis policies Member States can help restore confidence and support the recovery in the short-term. Coordination can also be crucial to fend off protectionism and thus serves as a safeguard for the Single Market. Moreover, coordination is necessary to ensure a smooth functioning of the euro area where spill-over of national policies are particularly strong. Coordination also provides incentives at the national level to implement growth friendly economic policies and to orchestrate a return to fiscal sustainability. Last but not least, coordination of external policies can contribute to a more rapid global solution of the financial crisis and global recovery.
With the US adopting its own exit strategy, pressure to raise demand elsewhere will be mounting. The adjustment requires that emerging countries such as China reduce their national saving surplus and change their exchange rate policy. The EU will be more effective if it also considers how policies can contribute to more balanced growth worldwide, by considering bolstering progress with structural reforms so as to raise potential output.