Latest European debt deal fails to solve strain on European unity

Since the euro-zone’s leaders met in July, market instability has continued based mainly on fears of a Greek default and concerns over rising bond yields for euro-zone countries on the fringes of solvency. Thursday night Europe’s leaders met again with the intention of finding a solution.  A hopeful, three-pronged approach to the market concerns was agreed, namely that (1) the European Financial Stability Fund (EFSF) would be more than doubled to 1 trillion euros (at the July meeting of euro-zone leaders the EFSF was increased to 440 billion euros); (2) banks holding Greek debt are to accept a write-off of 50% of debt (increased from the 20% proposed at the July meeting), and (3) European banks will be required to raise 106 billion euros in new capital by June 2012.

Though markets have reacted well to the deal, as with everything EU, it takes time for the summit-level agreements to filter down and be ratified by the individual euro-zone countries. Until that takes place, the deal is theoretical. Also theoretical is the increase in the size of the EFSF. Funding for the EFSF cannot come solely from the euro-zone countries themselves. To do so would raise their debt limits to such a level that many of them would suffer downgraded ratings meaning increased government borrowing costs. So the head of the EFSF is turning to China to discuss its terms for buying EFSF bonds.

The latest agreement among euro-zone leaders however has not resolved some of the key issues which strain the seams of the European project. The first issue is who takes the losses when debt has to be written down? European banks (mainly French and German), as well as the European Central Bank, are the largest holders of Greek debt. In the event of a default by either Greece or another ailing euro-zone economy, experts have predicted that some banks may not survive (nine banks failed the stress tests conducted earlier this year). Presently there is no European agreement on how those banks’ depositors will be protected in the event of such a default.  However, this issue is not being discussed because national leaders know that it implicates fiscal transfer between nations.

The second issue is the economic agenda. In northern European countries there is a strong preference for austerity, after all Germany implemented painful labour market reforms in the mid-2000s causing unemployment to soar to around 13% but ultimately leading to its stronger export position now. By contrast, in 2001 at the time of joining the euro, Greece went on a spending spree increasing wage levels and worrying little about labour market competitiveness.  But in the south, the Mediterranean countries need growth to be able to service their debt. Under the heavy hand of their rescuers they have been implementing austerity measures aimed at reducing their budget deficits and ultimately debt, but the spending cuts are unpopular and killing growth. As austerity kills growth, demand for unemployment benefits swells and imperilled government coffers are again depleted making the climb back to surplus all the more difficult.

The third issue is how to ensure fiscally responsible behaviour in the future. Germany wants to implement disciplinary measures imposing fines on governments running budget deficits. But such punishment is regarded as useless by some who argue that financially penalizing an indebted country only exacerbates the problem. Others don’t miss the opportunity to point out Germany’s hypocrisy since after its accession to the euro, it was cavalier (as was France) in its flouting of the agreement amongst euro-zone members to not exceed the agreed maximum debt to GDP ratio. Of equal concern is the effectiveness of this approach. While rigid discipline might punish profligate behaviour by spendthrift governments, what of those countries whose economies have collapsed for other reasons? Both Ireland and Spain had relatively well managed public spending but were crucified by the 2008 property crash.  It doesn’t appear that the sort of rigid discipline Germany wants would be universally useful to stamp out rampant debt accumulation in the south.

National leaders seem reluctant to tell voters what they don’t want to hear – that is that if the euro unravels, everyone will suffer.  As an export-lead economy, Germany benefits from the increased competitiveness of the currency which is due to the presence of the Mediterranean countries in the euro. If they were to leave, the value of the euro would shoot up leaving Germany’s exports uncompetitive. Likewise, the south does not seem to realize that they don’t have a choice but to stay either. If they were to leave, their currencies would be so highly devalued that inflation would skyrocket leaving them in a potentially worse situation than they currently find themselves in under austerity.

This all leads to the inevitable conclusion that Europe needs empowered and strong decision makers for all of Europe. National politics, riven with ideological divisions, and cultural rivalries amongst states, has meant that domestic governments have become ineffective for making decisions which require coordination of multi-national interests. It remains to be seen how long it will take leaders and voters to accept the inevitability of a more powerful and centralized European government.

Eye on Europe

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