Zsolt Darvas

English

Research Papers in Economics

CESifo Forum 4/2011 3
Focus
THE TEN ROOTS OF THE
EURO CRISIS
ZSOLT DARVAS*
On 9 December 2011 euro area leaders once again
gathered in an attempt to find a comprehensive solu-
tion for the euro area sovereign debt and banking
problems – but once again they failed to convince
markets. Why is it so hard to overcome the current cri-
sis? The answer is that the euro area has deep-rooted
problems and for the most pressing ones no solution
has been offered so far. 
Let me raise ten important issues – the first four ones
relate to pre-crisis developments, while the other six
relate to issues highlighted by the crisis.
First, the rules-based Stability and Growth Pact
failed, resulting in high public debt in Greece and
Italy at the start of the crisis. Recent agreements,
including the 9 December agreement, try to fix this
problem with strong fiscal rules enshrined in national
constitutions and an intergovernmental treaty with
quasi-automatic sanctions. These institutions, if
implemented, could help once the current crisis is
solved, but are not sufficient to resolve current wor-
ries. For example, the situation could just be made
worse if Italy had to pay a fine now. 
Second, there was a sole focus on fiscal issues – and
a consequent neglect of private-sector behaviour.
This resulted in unsustainable credit and housing
booms in countries such as Ireland and Spain, and
the emergence of structural imbalances, such as
high current account deficits and eroded competi-
tiveness. A new procedure, the so called ‘Excessive
Imbalances Procedure’, was introduced with the aim
of assessing private sector vulnerabilities and help-
ing the countries to design remedies. Yet adjustment
within the euro area could take a decade or so and
hence quick improvements are not expected.
Third, there were no proper mechanisms to foster
structural adjustment. Some ycountries, such as
Germany, were able to adjust within the euro area on
their own (i.e. Germany’s competitiveness improved
considerably during the past 15 years), but others,
such as Italy and Portugal, were not. The new
‘European Semester’, a yearly cycle of mutual assess-
ment of fiscal and structural issues was introduced in
2010. This also aims to foster adjustment. This is use-
ful, yet the jury is still out on its effectiveness.
Fourth, there was no crisis-resolution mechanism for
euro area countries and therefore the euro crisis came
as a surprise without any clues about what to do
about it. For troubled sovereigns some temporary
arrangements were made: bilateral lending from euro
area partners to Greece and the setting up of two
financing mechanisms, the EFSF (European
Financial Stability Facility) and the EFSM (European
Financial Stability Mechanism). The European
Stability Mechanism (ESM), the permanent rescue
fund with firepower of 500 billion euros, will likely be
introduced in mid-2012. In the current circumstances
having a euro area rescue fund is a useful innovation,
even though in other federations, such as the United
States, similar funds do not exist. However the fire-
power, even if augmented with IMF lending (the
December summit committed to beef up IMF
resources by 200 billion euros), is not really sufficient
for big economies like Italy and Spain.
Fifth, the national bank resolution regimes and the
large home bias in bank government bond holdings
imply that there is a lethal correlation between bank-
ing and sovereign debt crises. When a government gets
into trouble, so does the country's banking system
(e.g. Greece), and vice versa (e.g. Ireland). This prob-
lem could be best addressed with a banking federa-
tion, whereby bank resolution and deposit guarantee
would be centralised, which would also require cen-
tralising regulation and supervision. A Eurobond, i.e.
pooling sovereign bond issuances into a common
bond for which participating countries would be
jointly and severally liable, would help to break this
lethal link. But Eurobonds would require a much
stronger political union between member states. * Bruegel, Brussels.
EURO CRISISCESifo Forum 4/2011 4
Focus
Unfortunately, neither the banking federation nor the
Eurobond is on the negotiating table. 
Sixth, there is a strong interdependence between
countries – much stronger than we envisioned during
the good years before the crisis. The fall of a ‘small’
country can create contagion and the fall of a ‘large’
country lead to meltdown. Italy, for example, cannot
be allowed to go bankrupt, because it would bankrupt
the Italian banking system, which in turn would melt
down the rest of the euro area banking system
through high-level interlinkages, and would also have
disruptive effects outside the euro area. The best cure,
again, would be the banking federation and the
Eurobond.
Seventh, the strict no-monetary financing by the
European Central Bank/Eurosystem means that euro
area governments borrow as if they were borrowing in
a ‘foreign’ currency. This is because a central bank can
in principle act as a lender of last resort for the sover-
eign, i.e. print money and buy government bonds (as
the Federal Reserve, the Bank of England or the Bank
of Japan did during the crisis). While the ECB has
also started such a programme, it is extremely reluc-
tant to do this and has said (so far) that these opera-
tions will remain limited. Lack of a lender of last
resort for sovereigns is not a big problem when debt is
low. For example, in the United States the Federal
Reserve does not buy the debt of the states of
California, New York, etc., but buys only federal
bonds. Even though California has been in deep
financial trouble for the past three years, its eventual
default would not have caused major disruption to the
US banking system. The reasons are that the debt of
the State of California is small, about 7 percent of
California’s GDP (local governments in California
have an additional 13 percent debt); moreover, this
debt is not held by banks, but mainly by individuals.
But Italy would be a game changer in Europe. The
remedy to this problem is clear: setting up a stronger
political and fiscal union which could provide the
basis for changing the statutes of the ECB. In that
case, the ECB need not purchase more government
bonds; just signalling that it could purchase may help.
But again, while there are pressures on the ECB to
purchase more right now, there are no real discussions
about what kind of political and fiscal integration
should make such a role desirable. 
Eighth, there is a downward spiral in adjusting coun-
tries, i.e. fiscal adjustment leading to a weaker econo-
my, thereby lower public revenues and additional fis-
cal adjustment needs. It is extremely difficult to break
this vicious circle in the absence of a stand-alone cur-
rency. In the United States, the automatic stabilisers,
such as unemployment insurance, are run by the fed-
eral government, which also invests more in distressed
states – but in Europe we do not have instruments that
could play similar roles and there are no discussions
about them.
Ninth, there is a negative feedback loop between the
crisis and growth not just in southern European
adjusting countries, but in all euro area countries. The
funding strains in the banking sector, the increasing
credit risks for banks due to weakening economic out-
look, and the efforts to raise banks’ capital ratios may
lead to a reduction in credit supply. But reduced cred-
it availability would dampen economic growth fur-
ther. Without effective solutions to deal with the cri-
sis, growth is unlikely to resume.
Tenth, the current crisis is not just a sovereign debt
and banking crisis, but a governance crisis as well.
The response of European policymakers has been
patchy, inadequate and belated, and they have thereby
lost trust in their ability to resolve the crisis. Some
observers have concluded that agreeing on a compre-
hensive solution is technically and politically beyond
reach. 
What are the scenarios in the absence of a truly com-
prehensive package? Until Italy and Spain can issue
new bonds on the primary market, which they could
do even after the 9 December summit, the current
muddling-through strategy could continue. Italy and
Spain’s current borrowing cost of 6–7 percent per year
is high, but if these rates persist only for a limited peri-
od, they will not necessarily lead to an unsustainable
fiscal position. The new governments of these coun-
tries could impress markets, leading to a gradual
decline in interest rates. In the meantime the ECB can
keep banks afloat. Yet even in this muddling-through
strategy, a miracle is needed to revive economic
growth, especially in southern Europe. But if markets
were to decide against buying newly issued bonds
from Italy and Spain, the pressure for a really com-
prehensive solution would be irresistible.

The Ten Roots of the Euro Crisis

http://www.cesifo-group.de/portal/page/portal/DocBase_Content/ZS/ZS-CESifo_Forum/zs-for-2011/zs-for-2011-4/forum4-11-focus1.pdf

The Ten Roots of the Euro Crisis

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics