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Greece is at the brink of default and the domestic political situation is fragile. A significant reduction of Greek debt appears inevitable (Darvas 2011). Greece thus depends on the willingness of the rest of the euro area to provide finance and political leaders in several of the major donor countries are under heavy pressure from their voters to discontinue support. Opinions are divided on when a debt restructuring (be it orderly or disorderly) will happen. Some argue that it could happen as early as September of this year. The official position is still that until 2013 no country of the euro area will default while after that default cannot be excluded.

A default would generate significant knock-on effects to other economies and there is a case to prepare well for that eventuality. In the financial area, the ESRB should try to prepare for the worst[1]. A central further determinant of contagion effects will be sound economic fundamentals. Only countries with sound economic fundamentals will be able to insulate themselves from financial market pressure and be able to avoid sudden stops in financing. To date, in particular Spain is perceived by the markets to risk difficulties with financing its debt. Strong and effective structural policy action has the potential to reverse such market perception.

Policymakers have shown their resolve to significantly step up the governance of the euro area.  The so-called “six-pack” consisting of 6 pieces of legislation is in the final stage of becoming effective EU law: the trilogue discussions between the European Parliament, Council and Commission close to final. The remaining differences between the Council the positions of the European Parliament as voted on June 23 should as soon as possible be resolved so that the package can be implemented early. The six-pack has a completely new “Regulation for the prevention and correction of macroeconomic imbalances” (EIP), which has the potential to revolutionize European governance.

So should the EIP be applied to Spain to insulate Spain from contagion? And if yes, when and how? The European Commission Staff Working Paper on Spain of 7 June highlights five major challenges, which are shared by the ECOFIN:

1.       Reduce the high structural deficit and improve the long-term sustainability of public finances.

2.       Stabilize the real-estate sector and ensure a well-functioning financial sector.

3.       Facilitate wage and price adjustment and enhance productivity to regain and sustain competitiveness.

4.       Improve the functioning of the labour market in particular as regards labour market segmentation and wage bargaining.

5.       Ensure a stronger contribution of the education and training system at all levels of human capital formation.

A number of important reforms have been passed or are in the process of being implemented. The commitment to fiscal consolidation is significant and deficit and debt figures have surprised on the positive side. Significant financial reforms have been enacted but the Commission finds that “the reform of the savings bank law does not fully address the problems created by the involvement of local authorities in the governance of savings banks”. This could be seen as not fulfilling the commitments under the Euro Plus Pact to finalize the restructuring of the sector by end of September 2011. Significant and potentially far reaching labour market reforms have been enacted and it will be important to evaluate progress made. Spain appeared to be lacking behind with the reform of the collective wage bargaining system, but recent government decision appears to solve this concern. Finally, competition in professional services remains limited putting a drag on growth dynamics. Overall, the Commission therefore comes to a positive assessment of the Spanish reform program but shortcomings are identified.

Several of the policy issues identified fall under the EIP. A well functioning real estate and financial sector would clearly qualify to be of relevance for the proper functioning of EMU (Art. 121) and would therefore fall under the new Regulation. Labour market and wage bargaining systems would also qualify. Finally, measures to boost productivity and increase human capital will be crucial for the success of reforms and therefore also for the functioning of EMU. Should a proper assessment reveal that the policy action taken is insufficient, the EIP procedure should be invoked.

 The Commission faces two options as regards timing:

·         Wait with any further EU policy pressure until the start of the regular European Semester[2] in January 2012. The main advantage of this option would be that the current reforms are allowed to have an effect. This option may also be more appropriate given the political situation in the country. However this option would not lead to policy recommendations earlier than by the summer of 2012.

·         Alternatively, the Commission could carefully monitor the enacting of policy measures in the next months. Should the Spanish government fail to deliver on a number of commitments, it could threaten to start the EIP procedure already in September or October of this year. The EIP procedure explicitly allows for an application outside the regular European Semester. The main advantage of this option is to increase pressure on an outgoing government not to stop reforms until the election in the spring of next year. If reform measures falls strongly short of what is needed, the Commission should also significantly step-up its contacts with all major political parties in the country to underline the urgency of the situation.

Decision makers will need to deliberate carefully, which option to choose. An important factor in the decision is the clear risk that Greek government debt may be restructured in early 2013. Gaining nine months to enact far-reaching structural reforms could be an important asset in the attempt to avoid contagion. A further issue to consider carefully is whether an early start of the EIP procedure would be perceived as a pre-program mode of surveillance, thereby triggering a bond market panic by itself. The relevance of this argument can be debated in a situation of markets highly attentive to policy action. One should nevertheless consider the option of using flexible credit lines (FCL) to support the reform and prevent self-fulfilling crises. Finally, policy action to boost growth and domestic demand is also needed in current account surplus countries but the degree of urgency is smaller. The European Parliament and the public at large should hold the Commission and Council to account on these policy options. Let’s make the EIP already a success in version 1.0 and not waste precious time.

[1] In Wolff (2011), I have argued that the European Systemic Risk Board should be working on the issue.

[2] For a discussion of the European Semester, see Hallerberg, Marzinotto, Wolff (forthcoming), The European Semester: how effective? How legitimate?, European Parliament Policy Paper.