Breaking the Deadlock: A Path Out of the Crisis
It is still possible – economically and politically – to find a way out of the euro zone crisis if policy makers separately address two problems: dealing with the legacy costs of the initially flawed design of the euro zone, and fixing the design itself. The former requires significant burden sharing and an economic strategy that focuses on stabilising the countries that are suffering from recession and capital flight. In contrast, fixing the design requires a financial (banking) union with strong euro‐area institutions and a minimal fiscal backstop.
I. The euro is drifting toward a breakdown of incalculable costs.
1. We believe that as of July 2012 Europe is sleepwalking toward a disaster of incalculable proportions. Over the last few weeks, the situation in the debtor countries has deteriorated dramatically. The sense of a never‐ending crisis, with one domino falling after another, must be reversed. The last domino, Spain, is days away from a liquidity crisis, according to its own finance minister. This dramatic situation is the result of a euro zone system, which as it is currently constructed, is thoroughly broken. The cause is a systemic failure that exacerbated a boom in capital flows and credit and complicated its aftermath after the boom turned to bust. It is the responsibility of all European nations that were parties to its flawed design, construction, and implementation to contribute to a solution. This does not mean that the costs of the crisis should be socialised across euro zone citizens: systemic failure does not absolve from responsibility individuals, banks, and supervisors who took or oversaw imprudent lending and borrowing decisions. But it does mean that the extent to which markets are currently meting out punishment against specific countries may be a poor reflection of national responsibility, and that a successful crisis response must be collective and embody some burden sharing across countries. Absent this collective constructive response, the euro will disintegrate.
2. European leaders recognise the need for a collective response. Yet, the euro zone has been drifting toward breakup for several months now, notwithstanding the incalculable economic losses and human suffering that this would entail. The cause of this has been the failure of surplus and deficit countries to agree on an action plan that both reassures financial markets and addresses the needs and concerns of the public in both sets of countries. Deepening recessions and high unemployment are tearing at the social fabric in the deficit countries and causing enormous and avoidable human suffering. Alleviating this suffering should be the first priority of euro zone policymakers. Moreover, the sense that there is no end in sight is undermining public support for fiscal adjustment and structural reform and fuelling capital flight. At the same time, growing crisis‐related liabilities and a view that reform in the deficit countries will only succeed under pressure have undermined public support in the surplus countries for a stepped‐up crisis response. Rising adjustment fatigue in the south has been matched by increasing support fatigue in the north.
3. Solving the current crisis is not a zero‐sum game. Instead, it is a win‐win choice for both creditor and debtor countries. 1 The economic and political losses that a euro breakup will bring about are likely to be an order of magnitude larger than the potential transfers required to solve the legacy problems. However, lack of trust between creditors and debtors is stopping them from arriving at mutually beneficial solutions. For example, if the deficit countries could credibly commit to fiscal rules that bring the ratio of national debt to GDP down to reasonable levels in the long run, then the surplus countries would have little objection to new debt issues in the short run to support countercyclical fiscal policies in the deficit countries, since these additional debts would be temporary and could be repaid. The problem is that it is difficult for the deficit countries to make a credible long‐term commitment to fiscal prudence since that would bind future voters. What is needed are creative ways to solve this problem by making support available in sufficient amounts, but also under safeguards and conditions that are both perceived as fair by debtor country voters and credible by creditor country voters and the financial markets.
4. Although they contained steps in the right direction, the measures announced by euro zone policy makers on June 29 and again on July 9 did not meet this threshold. Agreeing on a timetable for creating a single euro area banking supervisory body and subsequently allowing direct bank recapitalisation from the ESM would help to address critical shortcomings of the euro zone design and the crisis response so far. However, the summit did not present a convincing plan to stop the downward economic spiral in the deficit countries. Stabilising bond yields based only on existing ESM resources and investment projects financed mainly by existing E.U. structural funds and the EIB do not add up to a convincing package. Furthermore, the summit offered no shared vision for the long run beyond the agreement on common European banking supervision. But such a vision is needed to restore the credibility of the currency union in the eyes of both investors and the general public, and hence to restore confidence in government bond markets and stop capital flight from the deficit countries.
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