A special characteristic of the “Euro crisis” is the institutional straitjacket of the monetary union. A comparison with highly-indebted G7 member states, such as Japan, the United Kingdom, or the United States reveals that the countries of the Eurozone are less flexible in their bond purchase programs (whether through the European Central Bank or individual states). In addition, the US has a rather unique status due to the “safe haven currency" of the US Dollar. These initial observations beg the question: What’s the impact of the Eurozone’s unique institutional framework on the Euro crisis?
The founding of the European Monetary Union (EMU) has fundamentally changed the framework of European fiscal and monetary policy. The debt of all member states is now denominated in euro, without the possibility of a respective (national) central bank defining the means to repay the debt. The states of the Eurozone simply supposed that the risk of default was eliminated by institutional rules, such as the no-bail-out clause and the “Stability and Growth Pact” implemented in 1997. But already in the 1990s, experts realized that the no-bail-out clause was not credible. In situations of severe turmoil it was expected that the rules would be abandoned. Not surprisingly, the worries turned out to be justified. In 2005, after several states had violated the Stability and Growth Pact, the agreement had to be reformed. In 2010, the no-bail-out-clause was abolished during the sovereign debt crisis in Greece.
The existing shortcomings of economic governance within the EMU have been discussed since 2003. Since the beginning, the enforcement mechanism of the stability pact had been identified as too weak, and the sanction scheme had been criticized as inconsistent. In reality, the institutional framework established no disciplinary effects. Although Greece constantly exceeded the 3%-of-GDP deficit and 60%-of-GDP debt ceiling rules, policymakers didn’t demand obligatory austerity measures. Today, more than ten years later, in the heat of the crisis, policymakers are demanding such mandatory austerity programs. There is no doubt that these measures are necessary. However, the reaction and implementation comes far too late. Policymakers and market actors, such as rating agencies, have failed to submit strong warning signals far earlier.
During normal periods, the players in the financial markets – banks, insurance companies, and rating agencies – did not differentiate sufficiently between the creditworthiness of the various countries of the Eurozone. This is astonishing, since fiscal policy has remained a domestic prerogative. The introduction of the Euro did not change the fact that individual countries remained responsible for their respective fiscal policies. It remains an unsolved mystery why market opinions were inconsistent and irrational. Maybe it was due to the misunderstandings of financial investors, or the result of the lacking credibility of the no-bail-out clause.
Fortunately, since 2010, the financial markets have responded with a differentiated assessment of the creditworthiness of sovereign bonds in the Eurozone. However, the relatively abrupt reversal of sovereign yields has produced a situation where trust declines very abruptly – which is a fundamental problem in the Eurozone today. The self-reinforcing and systemic effects are highly contagious; they create temporary liquidity problems and have evolved into an enduring solvency problem in some countries. This can be attributed to the fact that a country’s solvency depends firstly and substantially on the interest it has to pay for its debt and secondly on its expected GDP growth rate.
Given the current turmoil and uncertainty coupled with the reinforcing processes, we are facing a confidence crisis in the euro area. This can be illustrated nicely with a reference to Standard & Poor’s justification to downgrade Italy on September 20th of last year. The rating agency argued that Italy could be expected to pay higher interest, and that austerity measures would weaken the country’s economic output. Both factors increase the debt level. However, this simple argument leads to a vicious cycle: higher debt always implies higher interest payments and lower growth. Simply put, this assessment is always true in an aging society and justifies a downgrade at all times. In the current crisis, the downgrades activated a domino effect with a further surge in bond rates.
Because of its institutional deficiencies, the Eurozone finds itself in a particularly tough position today, even when compared to other nations with similar debt levels.
Read more in this column Bodo Herzog: The False Appeal of Central Banks