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December 20, 2010 / Lukasz Cerazy

Heavy Debt Burden of the Euro-Area

Image: Idea go / FreeDigitalPhotos.net

Germany reiterated their stand on the Euro at the latest ministerial meeting in Brussels by saying that the Euro will not be allowed to fail and that no country will be deserted. This is a strong claim of intent and is exactly what is needed – a firm stand on the Euro by all countries that they will weather the storm together. Any other indication would mean that the already sceptical capital markets would make lending much more difficult for the most troubled countries, which then quite possibly would face default and worsen the situation for the whole of the EU. Making emergency funds available now is a relatively low price to pay compared to the dissolution of the Euro, weakening currencies in many parts of the continent and casting doubt about the entire European project. Much has already been achieved in Europe with the single currency its most obvious manifestation. The Euro is still a young currency, which has had relative success up until the crisis but the lack of mainly fiscal harmonisation has meant that the euro zone was hit asymmetrically by the latest recession. The crisis is going to be a turning point for the EU and the Euro, a point from where we can expect more and better integration and harmonisation to make sure that Europe is better equipped to deal with any future crisis.

The crisis has its roots in the roles of monetary and fiscal policies in the Euro zone. Countries belonging to the Euro have given up their monetary sovereignty to the European Central Bank (ECB), which controls money supply and the interest rate for the whole area. This means that individual countries are unable to make monetary interventions and control their exchange rate and balance of payments. The role of the ECB is to ensure price stability in the region by having a target of 2% inflation. In normal conditions this ensures solidity for the European economy and provides a healthy environment for growth. However, this also means that monetary policy cannot be used as a tool for managing or controlling an economy, especially one that will respond asymmetrically. The other tool to govern an economy is fiscal policy, which individual countries still have control over and is a main cause of the sovereign debt crisis. Expanding fiscal spending has the aim of boosting demand and economic growth, however, it comes at the cost of running a public deficit and increasing national debt. Some of the economies in the Euro zone systematically and prolongedly ran this type of policy without being able to perform structural reforms, increase taxation or reduce public spending in times of healthier economic growth.

The diagram below shows the level of public debt in chosen European countries and for the Euro area as a whole. (Values for years 2011 and 2012 are forecasts – Economic Outlook by OECD (2010)).

Public Debt as Pct. of GDP

There is a common trend for most of the members represented in the chart, which shows a slight debt level reduction up to 2007, followed by a period of huge debt accumulation showing the effects of the credit crunch and following recession. The chart clearly shows why there is cause for concern and why certain countries have needed assistance and other are in danger of going down the same route. Ireland has, most remarkably, gone from quite low levels of debt followed by a huge increase. The sudden accumulation of debt was primarily created because of a large deleveraging movement both in the public sector but most prominently in the private sector. Ireland was full of toxic debt and had significantly overheated the economy with the financial sector at the heart of it. Huge capital flows swept Ireland when it entered the Euro and created a bubble that burst in 2007 leaving the economy unable to service its debt and in need of international assistance. Both Greece and Italy are running at very high levels of public debt and Greece had to be bailed out in May 2010 after failing to service its debt. The condition for the bailout was implementation of austerity measures, which will seriously affect the countries economy in years to come. Italy’s situation has not become better after the internal political stalemate; however, the country is perceived not to be in any immediate danger because of its high levels of reserves, but that sentiment may quickly change and put even more pressure on the Euro if Italy fails to meet any of its obligations.

The level of public debt in the Euro area as a whole is too large because it is consistently above 60%, which is the maximum allowed by the stability and growth pact signed by all 16 Euro members. The problem got really serious for countries like Greece and Ireland when their credit rating was downgraded by rating agencies and still poses a real threat for countries like Portugal and Spain; however, some of the panic might have been averted by the statements made at the last ministerial meeting. It is clear that the levels are contrasting and reflects a lack of fiscal harmonisation and direction. However, investors quite happily looked at the Euro countries as one, ignoring the fundamental fiscal, financial and institutional differences between the individual members. Leading up to the crisis the true risk was not reflected by credit yield spreads, which meant that Greek, Irish or Spanish bonds where viewed to be much safer than they actually were. During the earlier part of the crisis yields eventually began to diverge and investors became very much aware that these bonds were not as safe as for instance German bonds. The difference in cost of burrowing for member states is a significant issue for the Euro area, which it must seek to address. These are all symptoms of an unsustainable arrangement in Europe that will need to change.

Image: Matt Banks / FreeDigitalPhotos.net

The problems date back to before the creation of the Euro and the Maastricht Treaty agreement, which sets the rules for entering monetary and economic union. From the outset individual countries were tied by their path dependence and had contrasting domestic institutions and economic compositions. Countries like Italy did not actually fulfil the fixed conditions, but were still allowed to become a full member of the union and others have since diverged from the treaty systematically. Germany, one of the loudest voices when it came to instilling discipline among the members, broke itself the agreements but did not suffer any of the consequences. There are, never the less, clear rules or penalties for countries that do not adhere to the agreement but there is no efficient enforcement in place leading to haphazard governance. This is a clear area that needs improvement and better policing, but is still not the key to the solution.

The real issue that needs to be addressed is better fiscal integration, which eventually leads to member states giving up some or all of their sovereignty. The possible solutions that are on the table are federalisation of the Euro zone or a complete fiscal union. The latter is less realistic to pull through now and is already receiving huge opposition because individual nations will loose their ability to intervene. The second one is more likely to be successful, however, it will not be an easy task of creating agreement. Historically, this has been the case throughout economic development where towns did not want to give up their powers to a regional rule and later regions resisted a national chain of policy-making. In either case members must realise that this is a necessity in order to make the whole project work. It is an ambitious project that is aiming at centralising more decisions, which means giving it up locally. That is never going to be populistic and individuals in power will resist throughout that process but the vision of creating a better European economy must overbalance the individual or national sentiment.



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