The Self-Fulfilling Prophecy of the Euro Crisis
Ralitsa Kovacheva, June 1, 2012
"Over the last year the crisis in the euro area went through its most acute phase to date. At its centre was a dangerous feedback loop between sovereigns, the banking system and the deteriorating economic outlook. As banks in Europe hold large amounts of domestic sovereign debt, concerns about the sustainability of sovereign debt spillt over to the banking sector. In turn, banks’ limited capacity to absorb losses added to the sovereign risk as governments were perceived as ultimate backstops for ailing financial institutions. Finally, feeble growth prospects – weakened further by private and public deleveraging – increased the concerns about debt sustainability and banks' profitability, led to higher debt refinancing costs and endangered debt sustainability in a self-fulfilling way."
This very clear explanation of the euro crisis is the beginning of the European Commission’s assessment of the 2012 national reform programmes and stability programmes to the Member States whose currency is the euro. On 30 May the European Commission presented recommendations to all the 27 EU countries in the framework of the process of coordination and supervision of budgetary and economic policies - the European semester. A separate paper is devoted to the euro area as a whole. From the working document of the Commission it is clear that the
focus of attention shifts again onto the financial sector, whereas the euro area should go towards a "banking union with integrated financial supervision and single deposit guarantee scheme”, as European Commission President Jose Manuel Barroso explained. The Prime ministers of Italy and France, Mario Monti and Francois Hollande, have already declared their support for this idea.
The working document of the Commission clearly states that many eurozone countries have taken steps to restructure their financial sectors (Cyprus, Germany, Spain, Greece, Ireland, Portugal), but without the necessary ambition and comprehensive approach (Germany and Slovenia). As is known, Spain is the country facing the most acute problem with its banking system. It had to save its third largest bank Bankia. The cost of this operation only, however, will be 19 billion euros, given that the Spanish government had initially announced it would inject into the financial sector no more than 15 billion euros as a whole. Issuing very conservative estimates of the cost of recapitalisation and then correcting them upward, "was probably the worst way of doing things," ECB President Mario Draghi said in the European Parliament. He supported the EC`s call for a banking union in the euro area, that would allow systemically important banks to be supervised by a central authority rather than national regulators.
The European Union has already made attempts to achieve a common regulation of the financial sector. As of the 1st of January 2011 a new supervisory structure entered into force that includes the European Systemic Risk Board (EBSR) and three supervisors: the European Banking Authority, the European Securities and Markets Authority and the European Insurance and Occupational Pensions Authority. However, the bank stress tests clearly have demonstrated that the European Banking Authority does not have enough power and as before it all depends on national regulators. Separately, two years ago the European Commission presented its ideas for the creation of bank resolution funds, aimed at dealing with problematic banks without overloading the public budgets.
The concrete Commission`s proposals will be ready soon but their adoption is not certain, given the serious disputes among member states on the subject. Given the crisis developments however, it is obvious that if the countries fail to agree on a strong common regulation and supervision of the financial sector, as well as clear rules for dealing with troubled banks, the crisis will continue to spill over from the states to banks and vice versa. And this will surely make the forecast for an end of the euro a self-fulfilling prophecy.
However, "to sever the link between banks and the sovereigns, direct recapitalisation by the ESM [European Stability Mechanism] might be envisaged," the document says. The eurozone rescue fund is allowed to provide loans for bank recapitalisation, but only to governments and under certain conditions. In the European Parliament Mario Draghi said that it was currently being examined whether it was possible the fund to finance banks directly without the intermediation of governments. The idea enjoys the support of the European Commission, the IMF and some member states, notably France, while meeting outright opposition of Germany.
Last autumn, the European leaders agreed on a common bank recapitalisation plan, according to which banks should raise alone the necessary funding from private sources and to be supported by national governments only if needed and only when this proves impossible, recapitalisation in euro area countries could be financed through a loan from the rescue fund.
Fiscal consolidation is on track
Fiscal consolidation in the euro area has been ongoing and this year the deficit is expected to decline to the limit of 3% and to continue to decrease. However, debt will reach a peak of 90% in 2012 before starting to decline, but there are large differences among countries in terms of indebtedness. "The main challenge for fiscal policy is to pursue fiscal consolidation in a growth friendly manner," the Commission reiterates. However, this is not the case everywhere. Only a few Member States have safeguarded their expenditures on R&D (Italy) and education (Germany). Others (Portugal, Italy) have prioritised capital expenditure, notably by enhancing the use of EU structural funds, the EC notes. Tax increases have also not always been done according to the recommendation not to increase the tax burden on labour - Italy has managed, but Austria, Spain and France have not. No country has complied with the last year`s recommendation of the Commission opportunities for additional revenue from environmental taxes to be sought.
According to the EC, the short term negative impact of consolidation on growth could be reduced if efforts are perceived as permanent. In other words, if markets see steady pursuit of stability it will return their trust and prevent countries from excessive market pressure. This argument is easily illustrated by the Greek example – in the course of two years the country failed to convince the markets that it was making sufficient and sustained fiscal consolidation efforts and therefore the pressure on it remained strong. However, the measures taken by Spain and Italy, met a positive response from the markets, although both countries are subjected to growing concerns. According to the EC, to ensure the growth-friendly nature of consolidation there should be differentiation of the pace across countries, clear focus on curbing age-related spending (pension costs in the euro area are 12% of GDP and are projected to reach 14% by 2020) and accompanying reform of budgetary institutions.
The Spanish exception
The document specifically states that the Stability and Growth Pact provides a flexible base of rules that allow an objective-based differentiation between countries according to the various fiscal and macroeconomic conditions. That is why Spain, for example, was given one year delay to cut its excessive deficit, provided that Madrid controls excessive spending at regional level and presents a reliable two-year budget plan. Spain has met its fiscal targets and if the deficit was larger, it was because of lower growth. Spain is the only country in the euro area projected to have negative growth this year (except the rescue programme countries), he recalled.
However, France is warned that it should "reinforce and implement the budgetary strategy, supported by sufficiently specified measures, for the year 2012 and beyond to ensure a timely correction of the excessive deficit", as recommended by the Council. Commissioner Olli Rehn explicitly said that he expected the French government to present concrete measures to meet its target, which in Rehn`s view was fully achievable.
Eurobonds
have surprisingly found a place in the Commission’s analysis as a tool to foster budgetary discipline and solidarity in the euro area. "Even if common issuance were not to play a role in managing the sovereign debt crisis, such an instrument would contribute to efficient financial integration," the Commission points out. It is different from the call for an urgent introduction of Eurobonds as a way to deal with the crisis, supported by the European Parliament and some member states led by France. Moreover, the Commission notes that the effect of Eurobonds would be positive only if they do not lead to a deterioration of financial discipline, so successful application of the new economic governance framework is a crucial precondition. The Commission recalls that different options of common bonds were outlined in its Green Paper that has been consulted with the stakeholders. The Commission will come forward with proposals following the analysis of the results of the consultation.
Macroeconomic imbalances
7 of the 17 eurozone countries have to tackle macroeconomic imbalances, which in the Commission`s words are not excessive, but should be corrected. Only Spain is experiencing “very serious” imbalances which need to be “urgently” addressed - quite understandably, given that it is about the financial sector and a significant level of private sector debt. Belgium needs to increase its external competitiveness and reduce its large public debt. Huge debt is a problem for Italy too, along with permanent loss of competitiveness since the introduction of the euro. France and Finland should also take care of their competitiveness. The biggest problem of Cyprus is its public finances and financial sector, and of Slovenia - high indebtedness of the corporate sector and banking stability.
The analysis again does not cover the countries with current account surpluses, but the Commission promises to pay special attention to them in the fall. At this stage it only indicates that there are large differences in the surplus structure among countries and an additional analysis was needed of the nature, strength and direction of interlinkages between deficits and surpluses in the euro area. The recommendation for the euro area says that the surplus countries can contribute to rebalancing by boosting domestic demand. Germany, though not with the largest current account surplus, but a thorn in the flesh, is particularly praised for increasing wages for the first time in 12 years. All eurozone countries are invited again to reform their labour markets and remove unjustified restrictions on services and regulated professions.