Where the Euro Goes From Here
Europe could find its way to a stronger recovery and a safer monetary system -- if only it could start from somewhere else. The legacy of the recent economic crisis makes a tough problem nearly insoluble.
What went wrong before and after the European financial breakdown of 2010 is by now reasonably clear. Another excellent new e-book from VoxEU (the European policy portal run by Richard Baldwin of the Graduate Institute, Geneva) collects articles by economists who've followed the story. There's a strong consensus on the causes of the crisis. Governments could have avoided much of the damage if they had recognized the dangers and acted earlier. Now, the damage is done, and applying the lessons is very much harder.
Two things stand out. First, the crisis has undermined confidence in the integrity of the single currency. Exits from the euro area are no longer unthinkable. That will make fending off the next crisis more difficult.
Second, the breakdown has left many euro-area countries deeply in debt. This makes them more vulnerable, and narrows their fiscal-policy options should something go wrong again -- as it will. Rules to prevent excessive debt are still needed, to be sure, but this time round they'll come too late. And trying to reduce debts too quickly now may be self-defeating, because doing so will stifle an already weak recovery.
What can be done? One broad approach would aim for closer fiscal and political integration. Pool risks for better mutual protection against economic shocks; surrender some policy-making sovereignty in return. Closer union would also shore up the single currency's credibility. But the problem is obvious: Europe's voters are disenchanted with the European project. Heaven knows they have reason to be. More Europe is the last thing they want right now.
Absent closer political union, restoring the euro's credibility will take years, and a crisis or two in which exits aren't advertised as a possible remedy. On debt, though, a faster alternative strategy -- aiming to draw as sparingly as possible on goodwill toward the EU -- might be available.
First, deal with the start-from-somewhere-else problem by improving the debt positions of the most vulnerable countries. Once that's done, impose stronger market discipline on borrowers, public and private. Make it less likely that big financial imbalances will emerge to begin with; and make it more likely that, if they do, the system will be strong enough to cope.
For a plan along these lines, see a recent report by Giancarlo Corsetti and others: A New Start for the Eurozone: Dealing with Debt.
On debt, this paper recommends a buyback scheme. Governments of countries with excessive debt would commit a long-term stream of future taxes to a new system-wide stability fund. For this purpose, they might raise value-added tax and dedicate the proceeds to the fund; in any event, some such long-term commitment would be vital. The fund, to be run as part of the European Stability Mechanism, would buy debt using these revenues and by borrowing on its own behalf (using the promised future revenues as collateral). In effect, the fund would securitize the tax increase and use the proceeds to retire debt.
Europe would then be in a better place to fix the defects that first caused debt to get out of hand. The core of the issue is the moral-hazard problem -- the incentive to lend carelessly that arises when lenders expect to be protected from the consequences of their recklessness. The answer, essentially, is to make the no-bail-out rule more credible, by strengthening financial systems so that they can take default in stride. If you borrow too much, you go bust, and your creditors (and nobody else) are out of pocket.
As Corsetti and his colleagues point out, in this respect a currency union creates its own problems. To address them, they recommend limiting banks' exposures to the debts of their own national governments. In addition they want the ESM to change the way it lends to distressed borrowers: Make debt restructuring a condition of support for governments that lose access to market borrowing.
Up to now, Europe has resisted debt restructurings -- maybe its biggest mistake. The prospect of a write-down helps to focus creditors' attention on risk, where it belongs. And without that threat, the no-bail-out rule lacks credibility. If a country is bankrupt, it must print money, restructure its debts, or get a bail-out. The euro rules out the first. If Europe expects to be believed, it can rule out one of the remaining options, but not both.
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