Decision Time for the Eurozone

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Germany’s arguments for resisting calls to start issuing Eurobonds as well as expanding the eurozone’s bail-out fund and instituting a comprehensive system of economic governance are transparent and easy to understand. First, the rise in German borrowing costs and in direct and indirect fiscal transfers to poorer countries. Second, the moral hazard associated with relieving overindebted countries from the pressure to put their public finances in order. Third, treaty-related and constitutional difficulties in establishing rules and procedures that would simulate a “fiscal union”. Last but not least, the necessity to provide political legitimacy to the inevitable infringement of the sovereignty of overindebted countries by moving ahead with European unification that might eventually impact upon German sovereignty as well.

On the other hand, refusing to accept the growing consensus that fiscal union is the debt crisis’s ultimate solution exposes the eurozone, and Germany, to severe risks. Sticking to half-measures exacerbates markets’ impatience and provokes consistently heavier speculative attacks not only on the weaker peripheral countries, but also on core AAA rated countries - like France and, eventually, Germany herself - whose banking sectors hold large parts of peripheral debt.

Weakening banking conditions are emerging as a major threat to the eurozone’s recovery and stability. Moreover, in the event of sovereign defaults, the cost of bailing out the banks may far exceed the cost of issuing Eurobonds or instituting a reasonable transfer regime. Investors need to be reassured that debt servicing costs are under control while debt volumes and deficit limits are firmly monitored so as to minimize default risks and strengthen the banks laying the ground for sustainable growth.

In fact, the emerging systemic risk concerning the sustainability of the euro-project produces a vicious circle: the efforts of the overindebted countries to consolidate their fiscal position and promote reform do not lead to the deserved improvement in financial conditions which is essential for achieving recovery and overcoming the crisis. Since, in conditions of deep recession, further austerity is counterproductive, the objective of fiscal consolidation becomes increasingly difficult to attain creating thus the conditions for renewed speculative attacks.

In a wider perspective, economic and social turbulence in Europe’s southern frontiers will constitute a geopolitical risk while the eruption of a major default-related crisis within the eurozone may not be contained and, through a Lehman-like domino sequence, put at risk the entire edifice.

Dilemmas can be endlessly debated. The pros and cons can be evaluated in many alternative ways. It could be argued, for instance, that Eurobonds would allow members of the eurozone to pool their financial strengths and, by enhancing the attractiveness of the euro as a reserve currency, hold down borrowing costs to an extent that AAA rated countries are not overburdened. Legal problems could, also, in the short term be overcome by proper bond design that would include credit guarantees, repayment priority and the use of specific tax streams as collateral.

Ideas have been floated to limit moral hazard by assigning Eurobonds to 60% of GDP - the treaty’s ceiling for the ratio of debt to GDP. A more substantial constraint would be to establish a tougher discipline regime on fiscally profligate countries as part of a reinforced institutional set-up. Political problems, however addressed, should be set against the vulnerability of European banks. Germany’s banks are today the most highly leveraged of any of the major advanced economies while at the start of the crisis they had close to one third of all loans made to the public and private sectors of Greece, Portugal, Ireland, Spain and Italy. So long as the eurozone systemic risk is not addressed, sovereign defaults are not unlikely leading to extended bank bail-outs whose cost may reach unacceptable levels.  A full-blown banking crisis might, then, turn to depression in the eurozone and, perhaps, globally.

Europe-wide bank recapitalization is essential in the short term so as to contain the cost arising from eventual sovereign defaults. However, the time for postponing the cure of the eurozone’s deeper defects is not limitless. Of course, in the midst of so much uncertainty, it is remarkable that consolidation efforts on the part of the overindebted countries remain broadly on track while continued bond-buying and bank support by the European Central Bank offers a temporary palliative.

There seems, however, that the impasse is not far away. Winning time is not a solution. Eurobonds, a fully-fledged debt facility, enhanced powers of the European Central Bank to act as a lender of last resort and solid economic governance should be part of such solution. In the longer term, radical reforms in capital, product and labour markets will also be needed, complemented by a stronger and more cohesive investment strategy at the European scale, so as to reinforce competitiveness and restore growth prospects.

European competitiveness does not only have a global dimension. Large discrepancies exist within the eurozone, reflected in structural trade imbalances between the core and the periphery that lie at the heart of the debt crisis. Eurozone’s cohesion and future growth depend critically on creating a framework - through grants and loans - for investment capital to flow to the poorer countries so as to close the competitiveness gap.

To borrow a phrase from the financial world, the euro-project is too big to fail. Decisions should be reached sooner rather than later so as to shape events instead of being dictated by them.

ΔΗΜΟΣΙΕΥΘΗΚΕ: Παρασκευή 2 Σεπτεμβρίου 2011 από: project-syndicate.org

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