Europe's Ongoing Crisis: It's not mostly fiscal

Perceptions of the European crisis differ greatly within and outside Europe. By the European crisis, I mean very high levels of uncertainty, low confidence in investment, and very high unemployment in Europe. Externally, the European crisis fiscal issues and sovereign debt largely have been the focus. I'm not pretending that fiscal issues are unimportant within Europe, but there are many other aspects to the European crisis.

I would suggest that there are five main dimensions to the European crisis. The first is the monetary dimension, particularly deflation. Next, there is the fiscal dimension, which involves questions of sovereign debt and sustainability. There is also a structural dimension: the notions that the economy is not dynamic enough, there is too much corporatism, etc. The financial stability dimension and the fragility of the banking system are important as well. Finally, there is a political and institutional dimension which is unique to the European Union (EU) as a union of sovereign member states, which boils down to the twin democratic and executive deficits. These problems are not independent and feed into each other. The European crisis is a very complex and, to a large extent, intractable situation, which may help explain why it remains unresolved. Policy responses have been substantial but are extremely slow and insufficient.

The European crisis is likely to join Japan's crisis of the 1990s as a historical example of a very slow response by the authorities. I suggest that there have been five distinct phases. The period before 2007 was one in which financial risk was accumulating and excessive risk-taking proliferated, particularly in the banking system. The first two years of the crisis appeared to have been imported from the United States and were discussed in terms of the subprime crisis. The impact in financial terms was broadly symmetrical between Europe and the United States as both had a high degree of exposure to the U.S. real estate market, but the policy responses were very asymmetrical. Even though the crisis was triggered by the subprime mortgage problem in the United States, the United States was much quicker to address its financial problems and basically resolved its systemic banking fragility, which persists in Europe to this day, by the end of 2009. Sovereign debt sustainability concerns first appeared in Greece in 2009, following the change in government and the revelation of fiscal and other difficulties, and then in mid-2010 started to spread to larger Eurozone/EU countries, such as Spain, Italy, and to a lesser degree France. There was a belated but decisive turning point in mid-2012 when the Eurozone member states decided to pursue a banking union which in turn created the space for what was called the outright monetary transactions (OMT) program of the European Central Bank (ECB), after ECB President Mario Draghi said in July 2012 that it would do whatever was necessary within its mandate to maintain the integrity of the Eurozone.

Since that turning point, there had been a slow recovery in the banking system but also a rising risk of deflation. We are in a phase which is more orderly from a market perspective but is not devoid of challenges and large risks.

One way of summarizing this complex sequence of events is to look only at sovereign debt. For France, Italy, and Spain, comparing sovereign bond spreads over the 10-year German Bund, we see limited volatility and contagion at the time of Lehman Brothers' collapse and then much more when Greece started to have big problems in early 2010. Volatility accelerated in mid-2011 when Spain and Italy were threatened—the former mostly due to problems in its banking sector and the latter due to a mix of governance issues and low growth. What is most significant is how much of a turning point mid-2012 was. There was a very turbulent trajectory, an escalation of volatility, and followed by a regular very smooth decrease in risk perception almost immediately for France and more gradually for Italy and Spain.

Understanding what exactly happened in mid-2012 that had such a dramatic impact would be very important. My understanding is that the political principals and the ECB as their policy instrument sent a very strong political signal about the integrity of the Euro area. This is also important for interpreting the situation in Greece, because exiting the Eurozone, which I still believe is improbable, would reverse this perceived defense of Euro area integrity. A Greek exit is a low probability in my view, but it would be a high-impact event, something for which no one is prepared and which could trigger a significant reversal of the positive trends.

With regard to monetary issues, deflation risk is rising in Europe. It's not only due to a healthy process of adjustment and price increases on the periphery. There are some beneficial adjustments, including a limited decrease in wages, but that's not sufficient to explain the deflation trend. One problem is the difficulty that the ECB faces in engaging in quantitative easing (QE) because of the treaty prohibition of monetary financing in the Eurozone. European quantitative easing has come late, in a way, but this delay is entirely linked with legal obstacles unique to the Eurozone's nature as a monetary union.

Turning to fiscal issues, the well-known issues that have been covered on a daily basis for several years in the international financial press started with the revelations with regard to Greek sovereign debt and sustainability in late 2009. Different contagion patterns emerged. The contagion sometimes spread through the banking system—in principle, a banking crisis resulting in sovereign debt. Perception of sovereign credit fragility was especially pronounced in the cases of Ireland and Spain. The perception of a risk of a breakup of the Eurozone increased risk throughout the zone due to the uncertainty. In the case of Cyprus, several Cypriot banks had built up very large inventories of Greek debt and were disproportionately impacted by the restructuring of the Greek government in 2012. A general expansion of fiscal concerns made more acute by the lack of fiscal union in the Eurozone really hasn't been addressed by policy initiatives so far.

Europe's structural issues are not the same as those of Japan, but they certainly echo debates here. The business environment is not favorable enough for dynamic enterprise development. With regard to labor law, the protection of employment both generally and in specific professions is a problem. The protection of corporate incumbents, which is often associated with economic nationalism in Europe, persists despite the overall European single market policy framework and competition policy. There is also harmful overregulation—in digital services, for example. U.S. President Barack Obama recently complained that EU internet services regulations were protectionist. Lack of access to finance for dynamic companies and economic actors is also a structural problem. As in Japan, the European financial system is dominated by banks. There are issues related to insufficient competition in the banking and financial systems. The debt restructuring and corporate insolvency frameworks are particularly non-conducive to growth, employment creation, employment preservation, and the financing of high-risk, high-potential companies. All of these issues contribute to Europe's structural problems.

Financial instability has been a huge issue. This echoes the Japanese situation in the 1990s but with some uniquely European aspects. One such characteristic is that the financial integration framework has created very problematic incentives for prudential authorities because of the combination of a binding legal framework for the single market and national banking policies. Until the recent banking union, banking supervision and banking policies in general were almost entirely national, and therefore the incentives became very distorted because the national authorities started worrying more about their competitive position than about financial stability; what could be called banking nationalism. This is accomplished through prudential instruments, so it is, in a way, a race to the bottom.

The excessive risk build-up before the start of the crisis in 2007 showed a lack of proper oversight by prudential authorities. From 2002 to 2007, aggregate bank balance sheets in Europe massively increased by more than 100% of the gross domestic product (GDP). The inability to carry out the necessary restructuring of the banking system for five years after 2007 was also a failure by the prudential authorities. I don't think Japan's situation in recent years is any way comparable to the harmful build-up of risks that I mentioned. In the United States, which is less bank-based, there was also a smaller accumulation of assets in the banking system.

Political or institutional issues are the last issue I will address. There is a mismatch between national and European competencies. Huge policy interdependencies have been created by the single market framework and the monetary union. The single market covers all 28 European member states, while the monetary union only covers the 19 Eurozone member countries. This creates significant collective action challenges in policy areas such as fiscal policy, structural policy, and banking policy in which decision-making remains national, but with massive spillovers from these national policies which affect the single market and the Eurozone. With limited exceptions, such as ECB monetary policy and European Commission (EC) competition policy, the European authorities have not been able to resolve these collective action challenges because they lack a strong executive mandate. This is an institutional rather than a leadership failure. The media naturally concentrates on the leaders, but I think that the lack of an appropriate response to the crisis doesn't just come down to inadequate leadership. It's really an institutional problem that could not be entirely addressed even with the best leaders, which we obviously do not have. This may be called an executive deficit for EU institutions, an almost complete inability to carry out executive action in key policy areas where collective action challenges exist at the EU level.

With regard to the monetary response, the ECB announced QE last month. The legal framework is quite robust. The ECB governing council has decided unanimously that QE is not a problem in view of the prohibition on monetary financing. In contrast to previous ECB interventions, the Deutsche Bundesbank isn't questioning the compatibility of this intervention with the European treaties, which is good. It is too early to assess the impact. The actual purchases of securities by the national central banks have not even started, but the initial reactions by both the marketplace and the public have been broadly positive, although there is more skepticism in Germany than in other member states.

Turning to fiscal responses, a number of assistance programs have been put in place, initially through bilateral loans and the temporary European Financial Stabilization Facility (EFSF) in 2010, and then though the creation of the more permanent European Stability Mechanism (ESM) in 2012 with a maximum lending capacity of 500 billion euros and a total commitment of 700 billion euros. Ireland, Portugal, and Spain have exited their programs. The Cyprus program is difficult but is broadly on track. The outlier is Greece. Some hope existed last year that Greece could return to market access, but this is no longer the case. Another fiscal response element is the introduction of a number of new fiscal rules, including the European Semester, a fiscal compact under which the member states commit to binding national fiscal frameworks in terms of fiscal councils, etc. and which allows the EU to control national budgets. I think there is still a great deal of cynicism in the policy community and in the marketplace with regard to whether these rules are binding. This is currently being tested by France, which did not comply with the rules last year but probably will not be sanctioned this year as a consequence. The EC has won some concessions from France in terms of limited fiscal adjustment and structural reform, but it's not a good sign that the new rules have been demonstrated to not be as binding as intended. A credible fiscal framework is lacking. The investment plan announced last year by new EC President Jean-Claude Juncker is a quasi-fiscal element to the policy response.

National structural reforms are a mixed bag. Spain and Portugal have enacted some significant structural reforms, but Italy and France have been laggards. The structural transformation has been disappointing even in Greece. Also, structural reform projects at the European level were announced by Mr. Juncker when he was elected. We will have a capital market union for non-bank finance and capital markets, a digital single market to create a more favorable environment for internet services and the like in Europe, and an energy union to remove obstacles to the cross-border integration of energy markets, especially gas and electricity, which also have some geopolitical overtones given the current situation in Russia. We should know more about these structural reforms within the next few months.

Progress has been most significant on financial stability. The first step was taken in 2011 with the so-called single rulebook, and new supervision agencies for the coordination of banking, insurance, securities, and market policy. This was followed by the Eurozone banking union, a very radical reform which pools sovereignty between Eurozone member (and possibly also a few non-member) states under the ECB. The so-called single supervisor mechanism enables the ECB to directly supervise 120 large banks which together form about 85% of the system and gives it indirect authority over all of the smaller banks. This really changes the incentives. Banking nationalism and the distorted incentives for national supervisory authorities are now a thing of the past. In addition, a new crisis management framework has been created with a new preference toward bail-in of creditors in bank restructuring, imposing losses on junior creditors. In principle, losses in bank resolutions are to be imposed on senior creditors from next year. The Single Resolution Board is another potentially significant European-level authority coming into existence this year which will operate with the Single Resolution Fund. However, national deposit insurance systems have been harmonized, but pooling at the European level has not been contemplated.

Many uncertainties exist with regard to future bank crisis management and the resolution framework. It's not clear how bail-in will work in practice. There is a possibility of direct bank recapitalization by the ESM, but this hasn't been tested yet. The Single Resolution Fund and the national resolution fund that are also being put in place are also untested. It's not clear how they will be used and what sort of guarantees will be given by the Eurozone or the EU to deposit insurance systems in countries that are stressed. The biggest uncertainty is what mix of national and European funding will be employed in a future banking crisis given that the perception will be one of supervisory failure by the ECB. After all, it's not clear that national taxpayers will want to spend significant amounts of money to rescue banks which have problems resulting from a pan-European supervisory failure.

Finally, with regard to the institutional responses, we have many new agencies on the European level dealing with financial services. It remains unclear how they will work together.

In summary, the scorecard is very mixed. The monetary reaction was belated, but QE is promising. The fiscal architecture is still insufficient and flawed. Structural reforms remain insufficient. Banking has undergone very significant change with still unfolding but promising effects. Fundamental questions remain unresolved in the institutional and political space.

Since the beginning of the crisis, the EU has lost about one-third of its share of the total market value of the 500 largest listed companies in the world, which is quite significant. The contrast with the United States is striking. The United States had lost a lot of ground in the pre-crisis years, but has regained most of it recently due not only to foreign exchange effects but also partly driven by fundamentals. The EU always conveys the feeling of giving too little, too late, but, at the same time, the EU is a radical political innovator. The EU institutions are unprecedented in terms of their supranational legal and political frameworks and they are also endogenous.

My assessment of the Greek situation, which is evolving hourly, is that both Greece and its European partners want to prevent its exit. I think it remains very likely that a compromise will be found that keeps Greece in the Eurozone, though maybe not this week or before the end of this month. If negotiations are ongoing when the current program expires, that will maintain confidence in the marketplace that a solution will be found. The big uncertainty in the short term is the banking sector. The ECB importantly said at the beginning of this month that the four large Greek banks, which are directly supervised by the ECB under the new framework, are pretty strong, to use the words of Daniele Nouy, the head of the ECB's new supervisory arm. There is no reason to believe that their assessments of the banks' solvency have changed dramatically between then and now or even that it would change over the next few weeks. Deposit outflow has been orderly and has been replaced on bank balance sheets by emergency liquidity assistance by the Bank of Greece as part of the Euro system, and therefore won't necessarily negatively impact solvency as long as European emergency liquidity assistance continues to be provided. The upper limit on the assistance was increased last week by five billion euros and probably will have to be increased again in the future.

Q1. I think there are two types of problems in Europe. If Europe is compared as a whole with China or the United States, it may be seen that Europe as a whole is having a problem. But comparing Europe with Japan, which has been struggling for decades, some parts of Europe are doing very well; Germany, for example, has been performing better than Japan. Today's European problem looks like an inequality problem, center versus periphery, or north versus south. Is Europe as a whole having a problem or is there an inequality problem among the member nations?

VÉRON
My perspective is obviously European because I look at economic and financial issues, and there are huge interdependencies between the countries. The coverage of Europe in the media and the perception among European citizens are much more fragmented between the member states because of political and language differences. Europe is a strange hybrid where you have something much stronger than just an international organization because the legal and political frameworks are much more closely integrated. As for whether integration accords with national self-interest, many people in the United Kingdom think that its national interests would be better served by leaving the EU. I disagree with that assessment, but I respect the debate. I think that things are quite different on the continent. The five largest countries in the EU other than the United Kingdom—Germany, France, Italy, Spain, and Poland—all consider European integration to be a part of their national projects or national identities. When faced with tradeoffs between integration and separation, these countries have chosen greater integration. Euro skeptics exist to some degree in every member state. That's a healthy debate, but when looking at the behavior of essentially all member states except for the United Kingdom, there is a consistent pattern of integration. Greece is a big test case as well.

Q2. I thought you would focus on the balance of payments, which is most important to the crisis in the Europe area, but it was completely absent. The balance of payments is the problem. What do you think?

VÉRON
You're right that I should have mentioned it. My background is in financial systems, and that might make me more relaxed about current account imbalances, which I tend to see more as a symptom than a cause of the problems in the Eurozone. I'm skeptical about the idea that there should be an enforceable cap on imbalances for a number of reasons, including the fact that there are some very small EU members. I would relate it to EU structural reform and competitiveness. I failed to mention that indeed Germany has been doing very well in recent years on a number of indicators. I think we can question whether the German economy is completely sound, but one aspect is that the monetary union creates a huge advantage for an economy such as Germany because it doesn't have currency appreciation.

If there is a more integrated financial system and also greater integration in the labor market, there should be some balancing inside the Eurozone that would remove some of the most harmful aspects of those imbalances on the macro side. I also know that some of the reforms I've described as fiscal go a bit beyond fiscal aspects and actually include procedures for the correction of macroeconomic imbalances, but it has been very difficult to enforce. It can be argued that Germany has been noncompliant, but no action has been taken. I agree with you that one has to look at imbalances, but I am not sure how this should be integrated into a binding policy framework.

Q3. My question is about France and Italy. What is your view on why progress has been so slow in these important countries?

VÉRON
Structural reforms in both France and Italy have been disappointing. By the way, there hasn't been much structural reform in Germany either over the past few years. Some reforms would be apt, especially in terms of the services markets. France and Italy have very big problems. Both have sluggish growth and social cohesion and integration problems, which are partially linked with their structural reform agendas.

The question becomes whether the future will be better than the recent past. In Italy, there are some encouraging signs that the current government may have the ability to pursue greater reforms than its predecessors, including labor market, political, and judicial reforms. I'm not so optimistic about my own country (France). The signs of reform exist—the blocked vote in parliament yesterday for a limited set of structural reforms—but it's very tentative. Everything is very difficult; even to do a very minimal thing, the government has to use enormous amounts of political capital. That's not encouraging. The more optimistic view is that the beginning is the hardest part and once there is some reform momentum, it can gather pace and strength. Maybe that will happen, but I think it's too early to declare victory. The French economy is very diverse. It has a lot of resilience, which we saw during the crisis. The French state is decisive. This has positive aspects, but it also means that the country is far from a crisis point that would force radical change.