Friday 22. October 2021

Economic and Political Causes of the Debt Crisis in Europe


Speech given by Emmanuel van der Mensbrugghe,

Director of the IMF Offices in Europe,

to the COMECE Bishops


COMECE Autumn Plenary 2011



More Europe, Not Less


Good morning. It’s great to be back in Brussels, among such a distinguished group.


Europe, of course, has a great legacy of economic cooperation and coordination. The process of European integration—culminating in economic and monetary union among sovereign nations— is the greatest collaborative economic venture ever undertaken on the continent.


But today, Europe faces serious challenges—in many ways, a defining moment. Talking more broadly, the Pope himself said, in his Caritas in Veritate in 2009, that: “growth continues to be a positive factor that has lifted billions of people out of misery. Yet it must be acknowledged that this same economic growth has been and continues to be weighed down by malfunctions and dramatic problems, highlighted even further by the current crisis.”


When it comes to sovereign debt, the euro area seems to be different from other advanced economies. Even with a level of debt in line with that of other advanced economies, it has been engulfed in a sovereign debt crisis. This, of course, is why I’m here to talk about the Economic and Political Causes of the Debt Crisis in Europe.


During this crisis, Europe has found itself in reactive mode, never quite able to get ahead of the crisis in a decisive way. It is imperative that it do so now. The clock is running out. And the solution is even greater cooperation and coordination.


To function effectively, the economic and monetary union will require some form of fiscal risk sharing, tighter monitoring of national policies, and an integrated pan-European approach to its financial system. Progress is being made on all these fronts, but rapid implementation will be key.



Let’s take a closer look at the factors that led to the current crisis.


What was the initial plan with the creation of a common currency? The Economic and Monetary Union (EMU) was founded on the premise that the benefits of a common currency would outweigh the costs of relinquishing national currencies. The plan envisaged in the Stability and Growth Pact (SGP) was to have European institutions keep a close eye on countries’ budgets via annual evaluations and to create enough fiscal discipline to leave room to deal with country-specific shocks. The coordination of national product and labor market reforms (for instance, opening up the electricity market or encouraging labor market participation) would align economies so that they would react more similarly to common shocks.


In practice, the introduction of the EMU corresponded to an external financial shock for a number of countries. In particular, southern euro area countries and Ireland (loosely referred to as the periphery) experienced a very specific shock: they witnessed a dramatic decline in borrowing costs after many years of much higher interest rates than their northern counterparts. This had immediate benefits for these countries: it allowed firms to finance their productive investment more cheaply and expand—certainly a welcome development. But it also led to a widespread belief that strong growth would be permanent. Households assumed they could afford much higher living standards, leading to credit-led buying sprees and real estate bubbles. And governments—along with their creditors—took for granted the revenues generated by the growth spurt, failing to save the debt-service savings brought about by the drop in interest rates.


Meanwhile, because the common currency eliminated cross-border transaction costs, financial integration within the euro area flourished—another benefit of the EMU. But inflows to countries in the periphery came mostly in the form of debt to banks, making them increasingly reliant on funding raised in the markets (the so-called wholesale funding), rather than on bank deposits, to finance domestic credit. Conversely, equity flows—such as  from cross-border mergers and acquisitions, where risks are shared and hence better monitored by investors—were small. National financial supervisors fell under the same optimistic spell. They became complacent about rising credit risks and allowed banking systems to grow disproportionately to the size of the economy. As a result, the risk grew that the banking sector would become increasingly unaffordable for governments to support in a financial crisis.


In the absence of a pan-European supervisory body, risks related to the growing interconnectedness of national financial systems through large cross-border loans to banks were overlooked.


With readily available intra–euro area financing, diverging trends in competitiveness were easily dismissed. While Germany and neighboring euro area countries were retooling their production model by integrating eastern Europe into their supply chains to compete with lower-cost manufacturing powerhouses in Asia, countries in the periphery seemed oblivious to rising costs, as overheating led to large wage increases. For a long time, policymakers and foreign private investors alike ignored the fact that the dramatic deterioration in the periphery countries’ external position was financing mostly unproductive spending (for example, real estate investment), so that the accumulating debt could prove hard to pay back.


How did things unravel? Basically, European countries experienced what economists call a hard landing.


Until the euro area came into existence, sovereign debt problems were primarily external debt problems. The nominal value of domestic debt could usually be preserved, albeit often at the cost of a bout of inflation. With the establishment of the euro area, this mechanism disappeared. Member countries’ domestic and external debt were indistinguishable and there was no (domestic) central bank to inflate problems away.


The opposite is also true, however. In the euro area, countries retained control over fiscal policy and there was no common euro area treasury, including to back the European Central Bank’s operations. The founders of the euro area were very much aware of the need to preserve fiscal discipline, and counted on a combination of administrative tools (the SGP) and market discipline. But both mechanisms were eroded: the SGP was watered down and markets fell asleep at the wheel. On top of this, no mechanism was in place to monitor, even less correct, divergent competitiveness among member countries and address structural growth problems. The overall plan worked well during good times, but fell apart when the global crisis hit.


The fall of the U.S. investment bank Lehman Brothers in September 2008 set the stage for a dramatic reversal of fortune in the euro area. The crisis unfolded in five episodes, all of which are still being played today:

  • First, operations of wholesale funding markets came to a sudden halt, making it harder for banks in the periphery to continue financing credit-driven growth.
  • Once credit dried up, fundamental competitiveness problems and structural impediments to growth came to the fore, particularly in Greece and Portugal. Fiscal revenue dried up, revealing weak underlying public finances. Private investors started scrutinizing deteriorating balance sheets, and ailing banks increasingly needed fiscal support, especially in Ireland. As a result, the private debt problem morphed into a sovereign debt crisis.
  • With banks still heavily financing their national sovereign debt, concerns about fiscal solvency inhibited confidence in the peripheral banking sector, setting in motion a pernicious feedback loop that persists to this day. Soaring credit costs priced both sovereigns and banks out of private funding in Greece, Ireland, and Portugal.
  • Most recently, the crisis engulfed Italy and Spain, which saw the cost of their sovereign debt climb during the summer of 2011.
  • Contagion did not stop at the borders of the periphery. Banks in the core euro area that had funded the booms in the periphery also came under scrutiny. Growing uncertainties about exposures and asset quality delayed the recovery in confidence that was essential for recovery in the euro area as a whole.

After looking at how the crisis erupted and took ground in Europe, I would now like to turn to policy actions and how they have played out so far. One key element was the interaction between national and regional level policies.


At the national level, the countries that had accumulated large imbalances, either fiscal or external, came under intense market pressures. As a result, they immediately started implementing significant adjustment measures, ranging from cuts in public spending to tax increases and measures to improve the functioning of their economy.


But the absence of proper euro area–wide crisis management institutions delayed decisions at the regional level. In May 2010, when it became clear that Greece would need external financial support, European leaders had to resort to bilateral loans. They later set up the European Financial Stability Facility (EFSF) to provide support to euro area member states in financial difficulty, which was tapped by Ireland in December 2010 and Portugal in May 2011. But because it is politically difficult to use taxpayer money from some countries to pay for the past profligacy of others—and indeed, the Maastricht treaty was written in the spirit of avoiding fiscal transfers across euro area countries—decisions regarding the EFSF have not been easy to come by. As the market turmoil persisted, the EFSF’s lending capacity was nearly doubled to €440 billion in spring 2011; when the turmoil threatened Spain and Italy, its mandate was significantly increased in summer 2011 to allow for precautionary lending and additional flexibility.


But the markets remain wary. Credit rating agencies’ downgrades have continued, and as of mid-August 2011 market confidence had not turned around. Debt sustainability remains challenging, and painful and protracted adjustment looms. Growth—an essential ingredient for fiscal sustainability—has proved more elusive than expected in the countries where the crisis hit the hardest. Markets are therefore worried that reform fatigue will set in before the adjustment is complete, in turn driving up funding costs, which itself jeopardizes debt sustainability.


Let me conclude with some early lessons from the crisis.


Economic and financial integration has brought benefits to the euro area that far exceed the costs. But the institutions underpinning the common currency have clearly been inadequate during the crisis, highlighting the need to delegate more country sovereignty to the center. As I said in my introduction, European integration is a remarkable success story, but it is incomplete. When the crisis shone a light on economic and financial integration, it also exposed the flaws. Putting a half-finished ship on the open waters is courting disaster.


I believe inadequate economic coordination made the crisis worse. Ominously, there were no instruments available to handle cross-border financial risks. There was a prevailing not-in-my-backyard mentality. When the crisis hit, countries looked inwards, reacting to domestic concerns, and disregarding the risks of cross-border contagion. And today, lingering problems in the periphery threaten the stability of the entire euro area. Incomplete financial integration is becoming a costly anachronism.


Let us not mince words—the peripheral countries today are in a critical situation. And there is no easy way out, no solution that does not carry a cost—for them and for their fellow countries in the eurozone. Certainly, we can all agree, the peripheral countries must themselves take the tough policy measures required to return to economic health. Yes, they must adjust. But at the same time, they cannot do it alone. The costs of adjustment cannot be borne solely by the citizens of those countries. That is not economically feasible; it is not politically feasible. The costs must be shared—including through necessary additional financing. Surely that is what being part of a broader economic union is all about?


So the only viable option for Europe today is a comprehensive and consistent solution, a cooperative solution, a shared solution. In the immediate future, we should acknowledge that there will be no quick fix. The current situation is critical but it is not fatal. Clarity is needed quickly on three issues: Greece, bank recapitalization, and building a firewall—leveraging the EFSF and possibly access to Fund resources. Beyond the immediate situation, we have also learned about what a sustainable solution would entail.


The first lesson from the crisis is that Europe needs stronger area-wide crisis managements, i.e., some kind of fiscal risk-sharing mechanism at the euro area level, to provide

assistance to countries facing sovereign funding pressures and to back up European Central Bank emergency operations.


The EFSF—and its successor from 2013 onward, the European Stability Mechanism (ESM)—presents a first step toward such a fiscal insurance plan, especially after its recent enhancements. Among the many ways forward, one option is that the ESM could evolve into a European debt management agency issuing common bonds conditional on prudent

national policies.


Second, Europe needs to fix unresolved financial sector problems. This is critical. The legacy of weak banks and high leverage risks smothering the recovery, especially given the importance of bank financing in Europe.


But there is a deeper point that transcends the current crisis: it is the need to complete financial integration at the European level—to help restore area-wide financial health and to break the close link between banks and national governments. That means harmonizing regulations and supervisory practices. It means establishing an integrated framework for crisis prevention, management, and depositor insurance, with a European Resolution Authority backed by an area-wide fiscal backstop. It means letting foreign banks bring fresh capital where needed and abandoning the costly and outdated model of “national banking champions”. There have been some positive steps, but more needs to be done—including on laying down clear rules for allocating losses to private stakeholders and sharing the burden of potential public support across member states.


The third major area relates to better fiscal coordination. This in itself has different strands: it requires more effective fiscal policy coordination and cooperation, and upgrading national fiscal institutions (fiscal rules).


Finally, boosting potential growth is paramount: this is the “E” of the EMU, which was forgotten by too many observers. Here, what is required is stronger macroeconomic coordination—essential in economic and monetary union, but not yet complete. Macroeconomic surveillance was very inadequate with a near exclusive attention on fiscal matters and an implicit view that current account deficits don’t matter in a monetary union. This crisis proved this wrong and better surveillance over internal and external imbalances is key. The new Excessive Imbalances Procedure—designed to detect and correct macroeconomic imbalances—can play an important role if it works effectively.


In conclusion, there is a simple message, which is that the global economy needs more cooperation today than ever before. Europe was an early leader in economic cooperation and coordination. It needs to assume that role once again. Putting in place a comprehensive approach to Europe’s problems is now a matter of urgency not just for the crisis countries, but for all the countries in the euro zone. It is a defining moment, and the time to act is now.


Thank you very much.


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