Monetary Union and Its Malcontents

            In world news publications, reporting on government finance is once again reaching a fever pitch.  During the past few years, Ireland, Portugal, the United States, and several other countries have experienced economic recessions and expanding public deficits.  The last months of 2011 have seen some of the most severe developments, in southern Europe. In early November, fiscal problems in Greece dealt a crippling blow to former Prime Minister George Papandreou’s leftist PASOK administration.  Papandreou resigned amid criticism at home and enormous pressure from other Eurozone member states abroad—altogether, not the smoothest of exits.  Papandreou leaves a government fighting to control inflation in an economy that has spooked private lenders, many of whom hold Greek government bonds that could prove worthless in the aftermath of current shifts.  Yet, depending on the events of the coming year, the dumping of these bonds may be only the beginning of a full-fledged banking panic.

            The recent resignations are part of a new arc in a complex story often given the “Euro Zone Debt Crisis” moniker.  This term highlights the dramatic aspect of the situation, especially as employed in news media during upheavals among political leadership.  Former Italian Prime Minister Silvio Berlusconi dominated the most recent headlines, stepping down in a storm of political dissent and a stagnant national economy.  In Rome and other Italian cities, thousands of demonstrators turned out to celebrate his resignation and to protest his personal scandals as well as his administrative policies.  Changes in the executive leadership of Italy, Greece, and Portugal (in early March 2011) reflect the frustration that runs throughout the European Union and the global financial industry.  In some ways, examining the geographic and historical context of this “debt crisis” is akin to the efforts of institutions such as the European Banking Authority (EBA) toward a partial audit of the European financial industry—a task requiring unprecedented banking transparency and the collection of massive datasets.  While the EBA has made significant progress in this direction, larger questions remain.  What caused economic downturns in Euro Area countries such as Greece and Italy, while other member countries have enjoyed steadier growth?  Who will shoulder the fearsome debt burden?  Most importantly, can political action prevent the buildup of such dangerous crediting structures in a regional monetary union?

            Silvio Berlusconi blames the rules of the Euro Area itself for the Italian government’s inability to check its debt-to-GDP ratio.  “[Italians] must be united to confront a crisis that was not born in Italy,” he said according to a Bloomberg report.  “It wasn’t born because of our debt, or because of our banks.  It wasn’t even born in Europe.  It’s a crisis that became a crisis because our common currency doesn’t have the support that a real currency must have.”  Speculation on Berlusconi’s trustworthiness and integrity aside, his claims touch upon issues central to the history of the European Economic and Monetary Union (EMU).  A small dose of the Euro’s much-needed support might be seen in bailout loans furnished to Ireland, Portugal, and most recently Greece.  Italy will probably be next in line for emergency debt restructuring and loan extensions from the European Central Bank.  With billions of Euros in debt forgiveness and new loans moving around—including a bailout package for Greece to the order of 109 billion Euros—what more will be required before the EMU will have what Berlusconi calls a “real currency?”

            Under the original terms of the EMU charter and the requirements of the 1992 Treaty of Maastricht, Euro Area countries retained centralized administration of monetary policy; in 1998, these policies were built into the massive European Central Bank (ECB), an institution that has proven crucial in keeping governments afloat during recent years.  However, the ECB was established to control inflation in Euro Area countries, not to restructure their budgets.  Even the monolithic ECB would be powerless to hedge a panic in Italian money markets, where a densely traded mass of government and corporate equity could crash explosively.  For this reason, the ECB relies upon a regional network of corporate lenders and national banks whose combined capital ratios might survive such a default.  The sheer size of the Italian accounts reduces this chance of survival, but to dismiss the possibility now goes beyond speculation.  Above all, it is important to keep in mind the crucial pieces of private-public directionality in the bailout loans and debt plans, as these exchanges will dictate the eventual calling—or default—of billions of Euros.

            Examining the geography of debt in the Euro Area brings a telling dynamic to the fore: the greatest differences are found between the “core” Euro countries of France, Germany, the Netherlands, and Belgium, and the “periphery,” mainly composed of Greece, Italy, Spain, Portugal, and Ireland.  The peripheral economies have experienced wild swings since they joined the Euro Area, thanks to a veritable “capital flow bonanza” of investment that has by now come to an abrupt halt.  These periods of intense growth during the 2000s allowed some peripheral countries to attempt a difficult balancing act, torn between financing budget deficits and implementing the anti-inflationary measures of the 1997 EMU Stability and Growth Pact.  Just as German bankers and finance officials voiced support for the Stability and Growth Pact during the 1990s, national banks and private lenders in Germany demand that the governments of today’s indebted Euro economies impose fiscal austerity to fix their budgets.  Protests against such strict policies have flared up in these countries, reaching turbulent peaks in Spain and Greece during the summer of 2011.  In describing the geography of debt exposure, anti-austerity protests, or government ousters in the Euro Area, a sharp dichotomy emerges between creditors in the core and borrowers in the periphery. Social unrest continues alongside what appears to be a large-scale economic panic, and most analysts now insist that the EMU must take more drastic measures in order to protect the value of the Euro.

            If the EMU and its member governments can avoid the massive credit defaults that appear to threaten Greece and Italy, the Euro may survive in a more or less unchanged form—although newer, country-specific monetary controls will likely be necessary.  In this case, most of the troublesome public debt held by lenders must eventually be repaid, although a useful projection of this possibility suffers from a striking lack of banking transparency.  Unsurprisingly, estimates of the core financial sector’s exposure to debt from peripheral governments indicate that the largest French, German, and Belgian banks carry billions of Euros in bad assets.  Last summer, “stress tests” by the European Banking Authority partially revealed the mess of shaky government bonds that could cause painful bank runs in otherwise stable economies.  Clearly, many possible outcomes could arise in such an enormous process; perhaps the safest assumption is that financial institutions in the core will extend enough credit to prevent peripheral countries from leaving the Euro in favor of cheaper currencies.

            How compelling, then, are the differences between the EMU core and its periphery?  In most predictive scenarios, the core Euro Area countries seem to bear responsibility for the debts of peripheral governments.  However, even if the largest core banks experienced panics, such events would pale in comparison to huge capital losses resulting from rising interest rates in peripheral countries.  Already, stark geographic differences in the costs of the current crisis can be found between the two zones.  These disparities are not likely to shrink as the sovereign debt crisis unfolds.  Thanks to the rules of the EMU, states with large deficits will probably find few options outside continuing membership in the Euro Area, further debt restructuring and austerity, and (perhaps) higher long-term interest rates.  The terms of such developments seem to lead countries such as Greece and Italy into a bitter macroeconomic Catch-22.  The more stable core economies may be able to sustain growth during a regional slowdown, but peripheral countries will be left in dire economic straits: dependent upon monetary regulation, solvency guarantees, and emergency backing from the very institutions pushing for even more strict unification of the EMU.

 

By Daniel Towns

mrtowns@stanford.edu

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