³Ô¹ÏºÚÁÏÍø

Bruegel Director Jean Pisani-Ferry analyses the events leading up to May 9 – a historic week for the European monetary union.  In this article, he questions the unprecedented decisions that governments had to take with, regard to the euro area debt crises, and the long-term repercussions of them.  The author questions if European policymakers have boxed themselves into a corner. If they only bought time with the decision to put up €500bn in loan guarantees available to finance assistance to ailing states and do they risk an even bigger catastrophe than the one they have avoided.

May 9 will go down in European monetary history as the day when long-held taboos were thrown overboard. After endless weeks of agony over what initially amounted to something like a €25bn assistance package to Greece, the members of the euro area suddenly decided to put up €500bn in loan guarantees available to finance assistance to ailing states. And in spite of having adamantly resisted so-called ‘unconventional policies’ throughout the financial crisis, the European Central Bank reversed its stance even more suddenly with the launch of a government bonds purchase programme.
The reason why these decisions were taken – and actually had to be taken, was that governments and the ECB had boxed themselves into a corner. Having squandered their credibility in a series of half-backed, belated and ultimately insufficient responses, they had no choice but to apply the so-called Powell doctrine and deploy overwhelming, potentially unlimited, force. This is what they have achieved by arranging three lines of defence, in a way that does not offer an easy target to speculators, but indicates to markets that there is no lo longer a one-way bet on offer. The markets’ initial reactions suggest the strategy is working; at least policymakers have regained the upper hand they had lost.
But the issue is: have European policymakers boxed themselves into another, even tighter corner? Have they only bought time and do now they risk an even bigger catastrophe than the one they have avoided? There are in fact two versions of the horror story – one that says that the damage has already been done and the one that the damage is still to come.
The first version claims that the price for the apparent victory against speculation has been a major about-face which calls into question the very principles upon which the stability of the euro is based. Monetary union in Europe was established on two pillars. One is a principle of no co-responsibility, which states that each country is individually responsible for its own finances; the EU treaty even prohibits the EU and its members from assuming the commitments of another public entity. The second pillar is the independence of the central bank and its dedication to price stability, which implies the strict separation of monetary policy from budgetary policy.
At first sight, the two decisions taken on the May 9 seem to contradict these principles. The decision to lend to member states in difficulty is seen by many, especially in Germany, as a blow to the no co-responsibility principle, the implication of which is that national taxpayers will in the end have to pay for other countries’ mistakes. And the ECB’s decision to purchase public assets is, in addition, seen as paving the way for an outright monetisation of public debts – ultimately another way to tax, through inflation, the same European citizens.
The about-face is undeniable and it is undisputable that this first reading of it could be right. But it does not need to be. To start with, to lend is not to give. The EU and the euro area states have not assumed responsibility for any one else’s debt – in the same way that the International Monetary Fund does not take responsibility for the debts of the countries it lends to. By the same token, the ECB’s purchase of government bonds does not need to result in a permanent expansion of money supply (it was actually announced by the ECB that it will be sterilised, and will therefore have no effect on aggregate money supply).
Nor is it not true that moral hazard has been introduced in a way that will give future governments an incentive to behave irresponsibly. The budgetary consolidation measures adopted in Greece at the request of the EU and the IMF are among the harshest seen in any country and it is hard to understand how Greece’s experience could be regarded by future euro area governments as an invitation to profligacy. On the contrary the European public, which has generally seen the IMF as a financial police force operating in the third world, has now learned that they, also, could one day suffer the same humiliating experience. Those who regard the EU-IMF intervention as a dangerous precedent should perhaps look at Asia where the countries which went through an IMF programme at the end of the 1990s are willing to pile up hundreds of billions of low-yielding dollar reserves as a way to self-insure against possible future shocks and make certain they will never have to turn to the IMF again.
Furthermore, the very fact that European partner countries and the ECB are intervening today to assist debt-ridden countries will be tomorrow a powerful justification for requesting budgetary responsibility throughout the euro area. This crisis indeed demonstrates is that sovereign defaults are not an imaginary threat, that debt crises have major spillover effects and therefore that the partner countries’ insistence on fiscal responsibility is both legitimate and essential. In this way the crisis is likely to make budgetary discipline in Europe more, rather than less imperative.
For all these reasons it is wrong to claim that the recent decisions amount to a blatant violation of the EU treaty. But, by the same token, it must be admitted that as long as the EU does not have a strategy in place for addressing the imbalances that are at the root of this crisis, the threat of budgetary co-responsibility and monetisation will not be dispelled. Actually, an integral part of the Powell doctrine is that for a war to be won there must also be a clear exit strategy, and this also applies to the present situation.
This leads us to the second version of the corner theory, which is that Europeans have only bought time and that the true risk is that they will eventually end up having to organise budgetary transfers or to monetising public debts. According to this view what matters in the European decisions is not that they inherently threaten stability but that they could in retrospect be seen as the watershed that ultimately resulted in this outcome.
This version of the story is much more convincing than the previous one, because it starts from the correct observation that there is still no clear solution to the problem of the ailing euro area members. If successfully implemented (which is far from certain in view of political and social obstacles) the Greek EU-IMF programme will in three years have stopped the flow of new public debt, but it will leave an economy with a debt ratio of nearly 150% of GDP. In addition price competitiveness, which is estimated to have deteriorated by some 20% since the country joined the euro, will have barely improved as the programme only addresses it through structural measures.
Greece’s budgetary follies are mostly genuine, but the competitiveness problem is common to other southern European economies like Spain and Portugal, and to a lesser degree also to Italy and France. And the more these countries remain uncompetitive, the more they will struggle with stagnation, insufficient tax revenues and looming budgetary problems, ultimately threatening sustainability. In this respect the just published European Commission forecast offers a frightening picture as it envisages that all euro area countries with the exception of Ireland will continue losing competitiveness vis-à-vis Germany in 2010-2011.
There is little hope that a country with an excessive public debt and an uncompetitive economy can by itself return to a healthy situation. The threat is that, by the very fact of addressing one problem, the other one gets worse as wage and price deflation, which are needed to restore competitiveness, mechanically increase the debt burden as a proportion of GDP. The risk is that some part of the euro area will become a sort of Mezziogiorno or Eastern Germany, permanently stuck in a state of underdevelopment and in demand for fiscal transfers and a monetisation of the public debt. So the real danger does not lie so much in the decisions taken, rather they stem from bleak prospects for adjustment within the euro area.
The debt problem is in principle the easiest to solve. Debts will have to be renegotiated so that creditors bear part of the burden. Europe is not willing to contemplate this solution today as there is a widespread fear that it would aggravate the situation of some fragile banks but it will need to address it seriously at the latest by the time Greece is expected to start borrowing from markets again, in early 2012. It may be needed before if the Greek government finds it politically necessary for the success of domestic adjustment to make foreign creditors pay. So the EU would be well-advised to create a mechanism for dealing with debt restructuring.
But the competitiveness problem is harder to crack, because there is no known approach for dealing with it in once you are in a monetary union. What countries which find themselves in an uncompetitive situation need to do is primarily to make their labour and product markets more responsive to excess supply. But even after structural reforms will have been implemented, the endogenous reaction of the price system is bound to take a desperately long time to bring about the required competitiveness adjustment. It will most likely need to be complemented by tax and administrative measures to engineer internal devaluation and thereby speed up the process.
It is in the interest of the euro area as a whole to help make this adjustment happen but it will not be easy. Recent times have indeed seen the emergence of a new and impossible trilemma: most of Germany’s euro-area partners – including the three main ones France, Italy and Spain – need to regain competitiveness vis-à-vis their big neighbour; Germany itself which, being wary of competitiveness vis-à-vis the rest of the world, wants to keep a lid on wage growth, implying price inflation below 2 percent; and the ECB’s stated objective is to ensure average inflation is at, or slightly below 2 percent. These three objectives are mutually incompatible because you cannot have German inflation below 2 percent, the partners’ inflation significantly below 2 percent, and the average at 2 percent. Something has got to give in.
For all the reasons already given, it would be very damaging for the stability of the euro area to keep some countries uncompetitive. To be forced to choose between large-scale fiscal transfers and a break-up is not a risk to be taken lightly. It would be very undesirable also to let the ECB repeatedly miss its target. The inflation objective is the cornerstone of its policy and a consistent undershooting would be as damaging for the credibility of the institution as a consistent overshooting. If these two constraints are taken seriously the logical conclusion is that as the economy picks up, German inflation will have to remain somewhat above 2% for some time, while the partners’ inflation will need to be significantly below this threshold.
This may not be a very pleasant scenario. But it is the one that is consistent with the proper functioning of the euro area, the ECB’s mandate and policy framework, and the avoidance of much more pleasant alternatives.

Versions of this op-ed were published in the German newspaper Handelsblatt and the French daily Le Monde