Can the European Crisis Be Contained? A safety net is needed to facilitate fiscal consolidation
Faculty Fellow, RIETI
Despite receiving significant financial assistance, Greece's fiscal crisis is far from coming to an end. Instead, it has spread to other countries such as Ireland and Portugal and brought Spain into a situation where the government had to ask for financial assistance for bank recapitalization.
Had the first rescue package for Greece, extended in May 2010, included appropriate fiscal crisis management measures, its fiscal crisis might neither have grown to the extent it is today nor had spread to other eurozone countries. Management of fiscal crises requires three sets of measures, namely, fiscal consolidation and restoring fiscal discipline, debt reduction, and building an effective safety net. Some of these crucial elements were lacking in the Greek rescue package.
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In Greece, the change of government in October 2009 led to the revelation of false reporting of fiscal data and the true, much larger size of the fiscal deficit than had been reported. The resulting loss of confidence in the government triggered the fiscal crisis. As market participants were awakened to the sovereign risk of Greece, yields on government bonds rose sharply. Given these developments, restoring the lost confidence in the Greek government should be the core of the three sets of measures. Thus, what is needed first and foremost is to restore fiscal sustainability, establish and impose fiscal discipline, and make it visible to investors.
Second, in order to deal with the fiscal crisis in a realistic manner, it is necessary to reduce the massive government debt to a manageable size by seeking the involvement of the private sector. This would alleviate the negative impact of fiscal consolidation and austerity on the Greek economy, while at the same time giving the government and people incentives to implement and endure fiscal austerity measures. Meanwhile, since private-sector financial institutions played a significant role as lenders in the process leading to the debt crisis, they should share the financial burden of the crisis together with the government as the borrower. This would prevent them from falling into moral hazard in the future.
Third, a safety net must be provided for private-sector financial institutions that have agreed to give up part of their claims. Apart from minimizing the impact of debt waivers on the creditors, it is expected that the presence of such a safety net would reduce the risk of a fiscal crisis developing into a financial crisis and prevent financial contagion to other eurozone countries. In the wake of the Greek fiscal crisis, the European Financial Stability Facility (EFSF) was launched in June 2010 as a transitory safety net, and it had been planned that the European Stability Mechanism (ESM) would be established in July 2012 as a permanent mechanism to take over the task.
The ESM is intended to serve as a mechanism to safeguard the financial stability of the eurozone as a whole and of its member countries by providing financial assistance to a member country having difficulty accessing financial markets. Specific assistance measures include: precautionary financial assistance in the form of conditional credit lines; indirect financial assistance for the recapitalization of financial institutions provided through governments (or direct recapitalization of financial institutions as proposed at the Euro Area Summit on June 19, 2012); and the purchase of bonds of a troubled member country in the primary and secondary markets.
Only when all of those three sets of measures are properly in place can a fiscal crisis start to be resolved. However, the first rescue package for Greece included only fiscal consolidation measures. At the time of adoption, it simply stated a plan to establish the EFSF by June 2010 and the ESM by July 2013 (subsequently moved up to July 2012) as safety net measures, failing to include specific debt relief plans. This is due to the "no bailout" clause in the Lisbon Treaty of the European Union (EU), which prohibits fiscal transfers between member states with an aim to prevent moral hazards.
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Since no safety net was in place at the eruption of the Greek fiscal crisis, asking for debt reduction was not an option, leaving fiscal consolidation and austerity as the only available way out. However, a tripod with only one leg cannot stand up by itself. That is, the management of the fiscal crisis was inevitably unstable and, as such, fiscal consolidation failed to make progress, delaying the solution of the crisis.
The failure to address the crisis in a timely manner caused Greece's sovereign risk to rise further, and the prices of its sovereign bonds continued to fall. As a result, the size of debt reduction for the country increased from the initial 21% of outstanding claims agreed upon by creditors in July 2011 to 50% in December 2011, and further to 53.5% in March 2012. Obviously, the delayed response caused the crisis to aggravate.
In a bid to quicken the response to the crisis, it was determined that the ESM should be established in July 2012, one year earlier than initially planned. However, the treaty establishing the ESM, signed in February 2012, had to be ratified by the respective eurozone member countries, and this, as it turned out, took a significant period of time. Particularly, in Germany, the constitutionality of the ESM was questioned, and it was decided that the matter would be determined by the Constitutional Court on September 12, 2012. Hence, the establishment of the ESM was postponed to October 2012. As shown in the Figure below, Germany is the largest contributor, accounting for 27%, and without its ratification, the ESM could not be established.
Source: Treaty establishing the European Stability Mechanism
In the meantime, Spain--its banking sector in particular--was dragged into a financial crisis. In June 2012, it was determined that the EFSF should provide loans (up to 100 billion euro), upon request from the Spanish government, for the recapitalization of financial institutions in the country. This function will be taken over by the ESM upon its establishment. However, the lending capacity of the ESM (set at 500 billion euro) is too limited, considering the size of financial assistance committed to Spain (100 billion euro) and that of the outstanding general government debt of Greece (280.4 billion euro as of the end of March 2012).
As aforementioned, the no-bailout clause of the Lisbon Treaty forced a delay in the initial response to the Greek crisis. As a consequence of prohibiting fiscal transfers, one of the conditions for an optimum currency area, the eurozone has embraced certain institutional flaws in crisis management.
In reality, what started as the Greek fiscal crisis is spreading within the eurozone and developing into a financial crisis, and member countries are making decisions on the fly while they run, scrambling to design and build an institutional mechanism for crisis management. Yet, even against this dire backdrop, Germany--the very country that should be taking the lead in restoring stability to the eurozone--is putting the brakes on the region's crisis management efforts by delaying its ratification of the ESM treaty.
Though belatedly, the September 12 decision by the German Constitutional Court that upheld the legality of the ESM paved the way for the ratification in the country, hence, ensuring its establishment in October.
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Will this bring the European crisis to an end? A clue to the answer to this question can be found by examining whether all of the three sets of measures critical to successful fiscal crisis management are properly in place.
While euro countries were dragging their feet in bringing the ESM into place, the fiscal crisis spread from Greece to other euro countries and is now poised to develop into a financial crisis. As a result, the overall economic conditions of the eurozone have deteriorated significantly. Dwindling tax revenues forced Greece and other troubled euro countries to take fiscal austerity measures that are more stringent and more unacceptable to their people. However, fiscal consolidation and restoring discipline remains the core of the three sets of key measures for crisis management all the same. Countries in a fiscal crisis have no choice but to endure severe fiscal austerity.
Failure to address the fiscal crisis in a timely manner and a resulting further deterioration of the crisis may lead to further declines in their sovereign bonds, requiring creditors to accept more debt reduction. Furthermore, a vicious cycle started by a delay in the establishment of the ESM may make things even worse and result in greater burdens, forcing the European Central Bank (ECB) to purchase more sovereign bonds and the ESM to do the same and provide more funds for bank recapitalization.
If non-crisis countries such as Germany keep stomping on the brakes out of fear of angering taxpayers, the cost of fiscal crisis management would increase and their taxpayers would end up paying higher costs. What is crucially important is to act quickly so as to minimize the cost of fiscal crisis management. The ESM should be established quickly to provide a safety net, one of the three requirements for fiscal and financial crisis management, and Germany must play the leading role as the largest economy in the euro area in enhancing the financing capacity of the ESM.
* Translated by RIETI.
September 20, 2012 Nihon Keizai Shimbun
October 25, 2012
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