This week, the EU meets again to discuss how to shore up the euro zone. The summit is potentially important, but as with previous meetings, Europe’s leaders will almost certainly fail to take all the necessary steps to resolve the present crisis.
Watching Europe the past two years has been extremely painful. Last summer, I wrote about the political constraints that prevented leaders there from making the hard choices to end the crisis. Since then, an unfortunate cycle has repeated itself multiple times: first there is official denial, followed by the admission of problems and vague promises of solutions, a market panic, and finally a summit that does just enough to avoid immediate disaster without creating the conditions to end the crisis. The pity is that it could have been halted at far lower cost if leaders had simply agreed at one summit on the measures they later accepted at the very next summit. This remains the case as leaders descend on this week’s meeting in Brussels.
Before the present crisis is resolved, leaders of every country in the euro zone will have to accept painful measures that conflict with their cozy national myths, as well as hand over more power to authorities at the European level. There is real potential for political damage, so national leaders must be able to point to the clear alternative of economic disaster. In this sense, it is similar to the U.S. debate last summer on the debt ceiling: most experienced observers of Washington knew that a deal would be reached, but only under the market pressure that developed as politicians took us to the edge of the cliff.
The euro crisis will have to get substantially worse before the pressure will allow the necessary breakthroughs. Most likely, events will cause financial markets to lose confidence in Spain or Italy, making it impossible to raise funds from the private sector. The proposed banking rescue for Spain will not solve deeper budgetary and economic problems, leaving many possibilities for further deterioration to scare the markets. Meanwhile, Italy’s dysfunctional politicians will eventually want their toys back and allow the technocratic government to fall or be pushed aside. But no matter which country loses market access first, the problem will quickly spread to the other, since investors are concerned that it may not be politically feasible for the euro zone to bail out both large economies. Thus, aid for one could effectively come at the expense of eliminating a potential safety net for the other.
Spain and Italy losing market access would have severe consequences, including possible defaults and even exits from the euro. The euro area would have to convene an “ultimate summit” that will only succeed if each leader supports the steps that they have been avoiding so far. The good news is that there is probably a three in four chance that leaders will agree to a comprehensive and effective plan. The one in four probability of disaster at that summit simply reflects the complications of reaching agreement among so many leaders with varying national interests, even when they are all highly motivated to find consensus. The motivation is straightforward: if Europe is plunged into another deep recession immediately after the downturn triggered by the financial crisis, current governments will be thrown out. And such a recession is virtually certain if the crisis reaches that perilous stage and leaders do not act boldly.
An Agenda for Reform
The key leaders have subtly signaled where they would come out at an ultimate summit, even though they cannot yet propose a plan. Here are some of the most critical areas for action:
—Debt Guarantees: Germany and other fiscally strong nations will need to provide debt guarantees for weaker nations, with the possible exception of Greece (which may be allowed to default again and even exit the monetary union). The euro zone’s total debt load is a little lower than that of the United States, and Europe is digging the hole deeper at a far slower pace, with annual budget deficits of only about 3 percent of GDP. Debt backed by the full euro zone would be highly creditworthy and require a far lower interest rate than Spain and Italy are paying now. There are a host of possible mechanisms to provide this guarantee. The most straightforward is a “Eurobond,” which would have a full guarantee by all the euro-zone countries. Another version is the “Eurobill,” which is the same thing, but with a much shorter maturity. Debt could also be guaranteed through the joint European Stability Mechanism, which will come into force shortly. The key is committing to a straightforward method that truly puts all the resources of the euro zone behind the new debt.
—International Monetary Fund Aid: Europe does not absolutely need IMF funding, but it does need to credibly impose requirements on the countries requiring reform. A purely European solution has too many risks of winks and nods among European leaders, undercutting the stringency necessary for it to work. The IMF has much more clout when it brings money rather than just advice. Furthermore, outside money would also provide additional reassurance for the markets.
—The European Central Bank as a Stopgap: Until the complicated details of the debt guarantees are worked out and ratified, the ECB will have to go back into the business of buying the bonds of troubled governments when the markets are weak. If the national leaders show a clear commitment and the ECB acts when necessary, very few actual purchases may be needed.
—More Central Authority: Euro-zone governments will have to give up more sovereignty to authorities at the European level. Germany, other fiscally strong nations and the ECB will not commit funds unless they know that the risk will be temporary, with weak countries implementing reforms necessary to dig themselves out. The best assurance is a binding treaty commitment; Germany has pushed the so-called fiscal compact, which is now being incorporated in national constitutions. The reaction of Greek voters has underlined the difficulty of transferring sovereignty, but the forthcoming crisis will be so threatening that leaders in the troubled countries are unlikely to say no. (Again, with the possible exception of Greece, which can be allowed to leave as a last resort.)
—European Banking Regulation and Deposit Guarantees: Banks are too central to the functioning of a currency system for Europe to continue allowing so much leeway for national regulators. Even worse, the fact that deposit guarantees are at the national level has created an unhealthy dependency between sovereigns and banks, leading to a vicious cycle where weakness in one leads to problems for the other.
A Short-Term Fix
These steps can stop the short-term financial crisis. Markets will readily buy Eurobonds or their equivalents at low interest rates, which will reduce the burden of high debt levels carried by some countries.
Serious long-term problems remain, particularly with regard to the poor competitive position of many of the Mediterranean countries. But these are soluble over time, whereas if not checked firmly, financial pressures could destroy the euro zone much more quickly. Developed nations, including the United States, have become highly dependent on financial markets, because governments need their money. Until these long-term deficit problems are solved, it remains imperative to reassure government debt markets that their investments will be repaid.
Douglas Elliott is a fellow in economic studies at the Brookings Institution. He was an investment banker for two decades, principally at J.P. Morgan.