With undisguised relief, the officials and diplomats who prepare European Union summits are saying that Thursday’s one-day event in Brussels will be the quietest so far this year – no bail-outs, no emergency statements, no panic. Yet with Spanish government bonds under increasing pressure and a majority of banks and companies in Spain shut out of international capital markets, Europe’s financial troubles are clearly far from over.
The Greek public finances debacle that metastasised this year into a broader European sovereign debt crisis continues to hold risks for the stability of the global financial system. As a result, one focus of Thursday’s discussions will be a redesign of Europe’s 11-year-old monetary union, a step rendered necessary by the existential threat that arose in late April. As Herman Van Rompuy, the EU’s full-time president, told the Financial Times: “We were on the edge of a breakdown. At a certain moment it could have become a world crisis.”
Seen from the US and Asia, however, Europe’s difficulties do not merely illustrate the dangers of financial contagion in a globalised world. They point to the decline of Europe’s weight in the international economy and to the flaws of the political and economic structures that underpin the ideal of ever closer European unity – for example, the lack of fiscal self-discipline, the yawning gaps between the economic performances of individual eurozone countries, and the underdevelopment of the single European market.
This diagnosis contains bitter truths of which many prominent European politicians and thinkers are aware. “Any serious discussion on reform must start from an analysis of what went wrong in the euro area. A simple answer is that the rules are good but that implementation has been weak,” says Jean Pisani-Ferry, director of the Brussels-based Bruegel think-tank.
Any complacency that Europe established the perfect monetary union in 1999 – and complacency there certainly was in the euro’s first years – has vanished. In a striking reversal of attitudes held just two years ago, it would almost be politically incorrect now for a European politician, central banker or high-level bureaucrat to challenge the view that something was rotten in the eurozone from quite early on. Suddenly, conventional wisdom holds that stronger institutions, stronger enforcement procedures and a stronger will to introduce unpopular reforms are essential. Summing up matters, Jean-Claude Trichet, president of the European Central Bank, speaks of the need for a “quantum leap” in eurozone economic governance.
If there is more realism on Thursday, there is also greater willingness to act – notwithstanding differences among EU member states, especially the pivotal duo of France and Germany. Broadly speaking, the measures either already agreed or under preparation to strengthen the eurozone fall into three categories: tighter fiscal rules, efforts to boost competitiveness and economic growth, and the installation of a crisis resolution mechanism to avert or at least to cope more effectively with Greek-style emergencies.
Of these three areas, the crisis resolution scheme is the most advanced. In the early hours of May 10, EU finance ministers announced a €750bn ($920bn, £623bn) plan to protect eurozone countries that might in future be unable to finance themselves in credit markets. As intended, the plan’s dimensions impressed those who had questioned whether Europe was up to the task of saving its common currency. But as the dust settled, financial markets fretted about the lack of detail regarding the central element: a €440bn stabilisation fund, involving the participation of all 16 eurozone countries plus Poland and Sweden, keen to show their goodwill.
Less than six weeks later, most of the substance is clear. The fund, known as the European Financial Stability Facility, will be run by Klaus Regling, a former head of the economic and financial affairs division of the European Commission, the EU’s executive arm. The EFSF will be headquartered in Luxembourg with a three-year lifespan. EU policy-makers intend that it should receive a top-notch, triple-A credit rating, though this remains to be agreed with the rating agencies.
The EFSF is expected to start operations in a few weeks, as soon as national parliaments representing 90 per cent of the fund’s shareholding have approved it. At that point, all eurozone governments will be obliged to issue guarantees for the EFSF’s debt instruments. If a country should need emergency funds before then, it can turn to a €60bn balance of payments facility that is under the European Commission’s authority and uses the EU budget as collateral. This, plus the availability of up to €250bn in International Monetary Fund loans, makes up the €750bn package.
Nevertheless, some questions are unanswered. It is unclear whether the EFSF will borrow in the markets even before a country officially submits a request for emergency support. It is also uncertain what interest rates will be attached to EFSF loans. In a eurozone-IMF €110bn rescue plan activated for Greece last month, the interest rate was set at about 5 per cent.
By and large, though, the EFSF is Europe’s most impressive response to the sovereign debt crisis. “This important step should provide beneficial breathing space for eurozone member-states currently suffering from a difficult standing in capital markets,” says Thomas Mayer, Deutsche Bank’s chief economist.
By common consent, Europe has little chance of digging itself out of its hole unless it raises its annual economic growth rate from today’s level of roughly 1 per cent. Indeed, Mr Van Rompuy has made his presidency’s rallying cry a call for the EU to double growth or risk the collapse of its social and economic model, mixing dynamic capitalism with generous state-funded services and the avoidance of extreme inequalities of wealth. To this end, EU leaders will on Thursday adopt a 10-year “strategy for jobs and growth”, the successor to the Lisbon agenda of reforms launched in 2000.
The Lisbon agenda was such a disappointment that a EU experts’ report, published in November 2004, remarked witheringly that it risked becoming “a synonym for missed objectives and failed promises”. Yet political leaders appear to be turning a blind eye to the lesson that the EU should be wary of setting grand goals that many governments do not take seriously once they are outside EU conference rooms. The latest initiative sets five headline targets for raising employment participation rates, boosting investment in research, cutting greenhouse gas emissions, improving education levels and lifting millions of people out of poverty.
According to a draft summit statement, all EU governments must “rapidly finalise their national targets according to their national decision-making procedures and in close dialogue with the Commission”. Like many EU projects, there is little inherently objectionable about the targets, but doubts persist about how to make governments keep their promises when the 10-year plan arouses such tepid enthusiasm outside Brussels.
For example, it would be impossible under EU treaty law to impose financial penalties on a country that failed to put more teenagers through a full secondary education – one of the new scheme’s goals. European policy-makers counter that annual EU-level evaluations of a country’s performance will make a big difference. Laggards will come under pressure from fellow governments, and at times also markets and public opinion, to redouble their efforts, they say.
This is a good example of how the crisis has concentrated the minds of EU decision-makers. Whatever their dislike of markets’ herd-like behaviour, they embrace the view that markets can play a constructive role in prodding governments towards economic reform. To some extent, they are making a virtue of necessity: the EU cannot crack the whip over large areas of national economic policymaking because it has no whip to crack.
Even where coercive mechanisms do exist under EU law, however, it is far from clear that they are effective. Fiscal policy is a case in point. Under the stability and growth pact, the 27-nation bloc’s fiscal rulebook, eurozone countries can be fined for repeatedly ignoring advice on cutting budget deficits. But that has never happened, partly because – in the immortal words of Romano Prodi, the former Commission president – the pact was “stupid”: it would make matters worse by imposing fines on countries already in difficulty.
Instead, EU governments are working on plans for much earlier and more rigorous assessments of national budgets, so that a country’s public finances do not spiral out of control because of overoptimistic assumptions about economic growth, inflation and so on. These proposals are sensitive because they are open to the interpretation – aired recently in Germany, the Netherlands and the UK – that a government may come under pressure to alter its budget before it submits the draft to its parliament.
As this suggests, even the biggest crisis in the EU’s 53-year history has not served to eradicate concerns about protecting national sovereignty. For eurozone countries, however, more effective mutual surveillance of budgets seems the bare minimum needed to improve economic governance. Germany would like its partners to go further and emulate a constitutionally enshrined limit on budget deficits it adopted last year.
As Angela Merkel, the centre-right chancellor, stated in Berlin on Monday, Germany is also pushing proposals such as withholding EU aid funds from fiscally irresponsible countries, suspending their voting rights or even expelling them from the eurozone.
The trouble is that most or all of these German proposals are unenforceable without changing the EU’s Lisbon treaty, which took effect last December. Few countries have the appetite for the arduous negotiations that would be needed to rewrite Lisbon. Other reforms, such as requiring non-interest-bearing deposits from countries that fail to meet budgetary objectives in buoyant economic periods, may therefore stand a better chance of seeing the light of day.
With the spread of the debt crisis, most EU countries have come to recognise it as a collective failure with its origins in poor economic governance, bending of rules, and overindulgence in the public and private sector. The next question is whether, having identified the disease, the EU can get the cure right too.
In Spain and elsewhere, a lot of bad loans are still buried out of sight
The integration of bond markets that followed the euro’s introduction in 1999 was for many years hailed by European Union policymakers as a sign of progress towards full economic union. But Europe’s debt crisis illustrates a more sobering point: integrated bond markets can distribute risk beyond national borders as easily as butter spreads over warm toast.
Consider a report published last Sunday by the Bank for International Settlements, which collects information from the world’s central banks. According to BIS data, banks headquartered in the eurozone had a total of $1,579bn at the end of 2009 in exposure to Greece, Ireland, Portugal and Spain – the four countries at the centre of the debt crisis.
French and German banks accounted for no less than 61 per cent of that. Including guarantees, it came to $493bn for French institutions and $465bn for their German counterparts. In Spain alone, French exposure was $248bn and that of Germany $202bn.
But public sector debt accounted for a mere 16 per cent of the total exposure of eurozone banks to Greece, Ireland, Portugal and Spain. In other words, the banks made their loans overwhelmingly to private individuals, companies and other institutions rather than to governments.
All told, the data make a compelling case for the emergency action that the EU took with the International Monetary Fund in early May by rescuing Greece with a €110bn financial support plan. The threat facing the French and German banking sector was simply too great. But there is undoubtedly an awful lot of bad debt still buried out of sight in Spain and elsewhere.
As some of Europe’s stronger financial groups are suggesting, one way to ease market concerns would be to conduct rigorous stress tests on banks and publish both the results and the methodology used.
Clarifying the condition of individual banks would help to dispel exaggerated fears that Europe’s banking sector as a whole is undercapitalised and riddled with dodgy assets. A similar public exercise conducted in the US last year proved helpful for banks there – one reason why American authorities are quietly encouraging similar action now in Europe.
Even so, European banks are likely to have to raise more capital soon to comply with new international rules on risk-taking. The prospect unnerves European companies, which rely heavily on loans from banks rather than capital markets and fear a financing squeeze.