Time for Decisive Action in Europe

Daniela Schwarzer

In the debate on the euro area’s future, the ”big options“ have now been tabled: fiscal union, euro bonds, a European economic government – or even all three together based on a sound democratic legitimization. It is absolutely right that the European Monetary Union will only be able to survive if it moves closer to a political union. But this fundamental debate does not help to solve the current crisis in the euro area. And time is running short.

The immediate task is to calm down financial markets. This has to happen in parallel to beefed-up efforts to solve the most urgent problems in the euro area’s periphery. Here, debt levels have to be made sustainable, growth needs to be nurtured – at a time in which the euro area risks falling back into recession.

Steps towards a political union are evaluated positively by most market participants. But they know how high the obstacles are on the way there: a substantial reform of the EU Treaty, a change of Germany’s basic law, the conduct of referenda in many member states.

In the current situation it is insufficient to define a long-term objective towards which the governments navigate in troubled waters without clear determination. What the euro zone needs is a stable bridge on the way towards the big solutions for the European Monetary Union.

If no feasible way forward is identified by the euro area governments, market participants have to assume that good options become impossible to achieve. And the more they expect that risks can materialize, the more probable this gets.

A solution that could potentially calm markets would have to fulfill three criteria. First, it would have to bring as much transparency and reliability as possible. Even if a realistic scenario for the future contains bad news, such as the need for debt restructuring in Greece, it is better to be blunt and outspoken, in order to enable market participants to cope with the situation. It would secondly have to be implemented swiftly. The euro zone summit of July 21st, 2011 is an unfortunate example of how the signaling function to the markets of good solutions evaporates if the implementation drags behind. Thirdly, such a solution should surprise markets by its bluntness and manifest willingness to act. Many investors still seem to wait and hope for a demonstration of political determination. There is (still) a chance that a politically surprising move translates into reactions that may revise market trends before the Eurozone reaches a critical point in its existence.

For the time being, the only institution that can act rapidly in the euro area is the European Central Bank. It hence has to be at the heart of the crisis management strategy. This includes the action that may need to be taken on Greece. The ECB could limit the destabilising effects of a haircut by providing large amounts of liquidity and by continuing to intervene in the bond markets, while the governments recapitalize their banks. Temporarily, the ECB would assume two functions that are beyond its mandate: By threatening to drop the secondary bond market purchases, the ECB would continue to exert strong pressure on the governments to proceed with reform and austerity measures. Secondly, the ECB would implicitly bear the risk that the long-term solution of a fiscal union may fail. Because in the end, the question will be whether the debt of peripheral Eurozone member states which the ECB holds will be subject to a substantial haircut.

An alternative would be that the ECB opens up a credit line for the temporary rescue mechanism EFSF, which would allow the rescue fund to hand out a considerably larger credit volume. This could be an important signal to the markets that Italy and Spain would also be backed in case of a deterioration of their situation and hence speculation against those countries is futile. The amount of member states’ guarantees to the EFSF would not have to be increased, but the risk that credits are not repaid would rise.

Neither of the two scenarios would actually let the governments off the hook. In the end, they pay the price for crisis management failure. In the immediate term, they bear the responsibility that all necessary steps for recapitalizing the banking sector are undertaken. This remains a crucial step in order to decelerate the crisis at least for some time and to limit potential contagion effects. Meanwhile, the time should urgently be used to push long-term solutions. As early as the second half of 2011, growth rates in the Euro area are likely to fall considerably. This will not only make the political context in which far-reaching measures need to be decided upon more difficult. Also, deficit and debt forecasts may again need to be revised upwards. It is hence high time, maybe even the last chance, that governments make a final attempt to overtake markets and provide the necessary conditions for the euro area to survive in its present form.

September 28, 2011 | Posted in: Uncategorized | Comments Closed

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