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At their meeting on 11 March Heads of State and Government of the euro area decided to adopt a Pact for the Euro whereby they commit their countries to take “all the necessary measures” to pursue four objectives. The first is to foster competitiveness by monitoring unit labor costs and by implementing economic reforms designed to increase productivity and to ensure that costs developments are in line with productivity and that productivity. The second objective is to foster employment through labor market reforms designed to promote flexicurity and life-long learning. The third is to enhance the sustainability of public finances and to ensure the full application of the Stability and Growth Pact by implementing reforms of pensions, health care and social benefit systems. The last objective is to reinforce financial stability of the euro area through both national and EU level measures.

The Pact will formally be adopted by the European Council of 24/25 March, where non-euro area countries will have the opportunity to decide whether they intend to adopt it as well or not. At the same time euro area countries will have to specify the first measures they pledge to implement under the Pact for the coming year.

There is no doubt that the Pact is a useful – and perhaps even a major – step in the direction of the kind of economic pillar that the European monetary union has been lacking so far. In particular, if properly implemented, the Pact will help preventing future crises. At the same time, however, it must be understood by Heads of State and Government that the Pact is both a relatively easy step and above all a minor one when it comes to solving the current crisis that has plagued the euro area for more than one year.

The Pact was relatively easy to adopt because, although it foresees some immediate actions by governments, most of the necessary measures will only be implemented gradually and their political costs are easily bearable by current political leaders. On the other hand, solving the current crisis would involve taking measures that carry much bigger political costs for current leaders. Here is why.

The current crisis is essentially a debt crisis. Since the run-up to the euro and especially after joining the euro area, the four peripheral countries – Greece, Ireland, Portugal and Spain – have spent and lived beyond their means by accumulating huge (private and/or public) debts and running large current account deficits, i.e. by borrowing from other countries, mostly France and Germany. Given the high level of financial interdependency within the euro area, the private and public debt difficulties of the peripheral countries therefore also translate into problems for other euro area countries. Bruegel estimates show that peripheral banks hold about €340 billion of peripheral sovereign debts, and that banks in the rest of the euro area are exposed to peripheral countries to the tune of about €400 billion, 60 percent via exposure to banks and 40 percent via the holding of sovereign debt. By far the biggest exposure of euro-area banks is to Spain (53% of the total exposure), through both sovereign and banking channels. The second largest exposure is to Ireland (18% of the total), mainly through the banking channel, and to Portugal (16%). Exposure to Greece is the smallest (13 %) and is almost entirely through the sovereign channel.

All debt crises are politically difficult to solve because they involve making choices about who will ultimately bear the burden of the accumulated debt, between the borrowers, the lenders and the taxpayers. The problem is difficult enough when the debt is held domestically, but it becomes very tricky when, as is the case in the euro area, it is held internationally and there are no explicit burden-sharing arrangements. As a result euro area leaders have been trying to postpone restructuring banks and sovereign debts as much as they can, thereby prolonging the crisis. Their plan seems to be to lend money to peripheral sovereigns facing difficulties and hope that their taxpayers will be able to foot the bill of the accumulated debts.

This plan may work for some countries, but it is unlikely to solve Greece’s problem with a public debt expected to reach 150 percent of GDP within a couple of years. Certainly markets do not believe it will as shown by the fact that yields on Greek sovereign debt have climbed back to the extraordinary high levels they had reached in May of last year, just before the EU/IMF loan. Most observers have, therefore, come to think that Greece will have to restructure its debt at some point in time. The question is simply when.

Now is clearly not the time because there are still too many fragile euro area banks and sovereigns that would risk suffering collateral damages from a restructuring by Greece. The priority must be, therefore, to restore their economic and financial health. The implementation of rigorous and credible stress tests - followed by bank restructuring when and where (not only in the peripheral but also in the core euro area countries) needed - should be our leaders’ main concern at the moment. Their other major concern should be to ensure that the debt burden of other peripheral countries remains sustainable. Lowering the interest charged by EU loans would help. Another useful action would be to frontload and refocus EU structural funds earmarked for spending in these countries, so that money can be mobilized to support a new growth strategy. The long-promised comprehensive solution to the euro area crisis cannot avoid some difficult political choices. The sooner they are made the better it will be for the common good of the euro area.