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The Need for a Long-term Perspective on the Eurozone Debt Crisis

As EU leaders attempt to steer through the ongoing debt crisis in the Eurozone, it seems that short-term, temporary fixes are the central focus, while long-term solutions that will help to prevent future crises have received far less consideration. This is not so surprising, as the immediate challenges posed by a possible Greek default or spreading contagion to Italy, the Eurozone’s third-biggest economy, surely warrant a great deal of policy makers’ attention. However, there is also a need to address long-term challenges to the stability of the Eurozone, which requires honest reflection on the difficulty of maintaining a monetary union between such a diverse set of economies, with little supranational economic governance.

It is important to remember, in this regard, that while the peripheral states of the Eurozone can be grouped together in their common affliction of lacking access to liquidity from the bond markets, they cannot be so easily grouped in terms of the roots of this affliction. To take two examples, Greece faces a debt crisis because successive Greek governments took advantage of the low interest rates afforded by Eurozone membership to borrow beyond their means. In the wake of the global financial crisis, the markets woke up and realised that lending to Greece as if Greece were Germany did not in fact make much economic sense, the result of which realisation was increasing spreads between German and Greek bond yields, to the point where Greece could no longer afford the punitive interest rates imposed on Government borrowing. In contrast to this, in Ireland, a housing bubble formed as the result of easy credit extended by banks to private borrowers, a trend exacerbated by the common ECB interest rate, which was inappropriately low for the Irish economy at that time. When the housing bubble burst, the Irish government responded quickly with a guarantee to rescue over-exposed banks from failure, thus transferring massive amounts of private debt onto the public balance sheet.

This description of the development of debt crises in Greece and Ireland does simplify matters, but the crucial point is that the roots of these crises were different and so any response by EU leaders should take account of these differences in addressing them. Further to that, one common factor between the debt crisis in Greece and that in Ireland is that both originated largely as the result of a full monetary union between states that had achieved little lasting economic convergence. Again, it was not appropriate to lend to countries with such different economies as Greece and Germany at similar rates, and it was problematic for booming Ireland to share an interest rate with slow-growing economies like France and Germany in the lead up to the financial crisis.

Pushing Policy Boundaries

Some commentary on Eurozone troubles makes reference to the Stability and Growth Pact (SGP), the main architecture for fiscal policy in Economic and Monetary Union (EMU). The SGP was originally agreed in 1997, as an assurance for Germany that, having met the convergence criteria necessary to qualify for EMU, fiscally profligate states like Italy and Spain would maintain sustainable budgets. Specifically, the SGP set a limit on government debt and deficits of 60% of GDP and 3% of GDP respectively, to be observed by all EU states, and providing for monetary sanctions against Eurozone members that breached this deficit ceiling. When, in 2003, the very state that had authored the pact, Germany, was in violation of the 3% deficit limit, the Germans sought reforms to the pact, with the support of other fiscal sinners, notably France. These reforms, agreed in 2005, were widely criticised as weakening the SGP to the extent that states could escape fines going forward by invoking almost any reason for breaching the 3% ceiling. While there is certainly some truth to such claims, even a strong SGP could not have prevented debt crises in Ireland or Spain, both of which states were well within the debt and deficit limits set by the pact up until the start of the financial crisis in 2007 (Ireland: 28.3% GDP and +0.2% GDP; Spain: 42.1% GDP and +1.9% GDP). Yet, to find where the pact failed supremely, look no further than Greece (103.9% GDP and -4% GDP).

I do not mean to initiate a debate on the pros and cons of the SGP, but rather to call attention to the inadequacy of existing policy parameters for Eurozone governance. If policy makers and commentators alike want to get serious about addressing the problems in the Eurozone, what should be at the forefront of their minds is how the distinct roots of the debt crises across peripheral states speak to the need for long-term solutions that address economic divergence across Eurozone economies. Proposals for Eurobonds backed by the whole of the Eurozone rather than individual member states or for expanding and institutionalising the European Financial Stability Facility are welcome, as is the idea mooted by ECB President Jean-Claude Trichet of establishing a Eurozone Finance Minister. Yet the political will for even these modest changes appears lacking.

What chances, then, for the bold idea of much deeper integration in the ultimate direction of fiscal federalism? Given that the United States Federal Government typically has a budget of around 35% of GDP, small by European standards, and negotiations over the EU financial framework for 2014-2020 look set to develop into an acrimonious debate over modest increases to the current budget (roughly 1% of GDP), I doubt the political viability of permanent, large-scale fiscal transfers across the Eurozone any time soon. But attention should be paid, nonetheless, to mobilising Europe’s citizens in support of much deeper economic integration, to the benefit of the Eurozone and its individual member states alike.

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