CASE Network E-brief 9.2010 - Euro Crisis or Debt Crisis?

CASE Network E-briefs
No. 09/2010 June 2010
Euro Crisis or Debt Crisis?
By Marek Dabrowski
The public debt crisis is not limited to Greece or to the
Euro area. In fact, several developed economies face
rapidly growing debt-to-GDP ratios, which raise doubts
about their long-term solvency. Thus, suggesting that the
Eurozone is undergoing a currency crisis or is in danger of
disintegration is not the right diagnosis (or at least
premature). However, if prudent fiscal policies, fiscal
discipline and far-reaching structural reforms are not
undertaken soon, both the EU and EMU may face serious
internal tensions and obstacles to future economic
growth.
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A currency crisis can be defined as a sudden decline in
confidence in a given currency, leading to a speculative
attack against it and resulting in its substantial
depreciation. Nothing like this has happened with the
Euro so far. True, the Euro lost a bit against the US dollar
and other currencies, but this remained within a “normal”
fluctuation range among major currencies over the last
few years. There is equally no desire by any country to
leave the Eurozone.
In this context the analogies to the demise of the
Argentinean currency board in 2001-2002¹ are wrong. The
direct cause of abandoning Argentina’s currency board
was related to insufficient foreign exchange reserves and
the Central Bank’s inability to defend Argentina’s fixed
exchange rate (peso to US dollar) against speculative
attack. In fact, Argentina did not have a true currency
board, which required 100% reserve backing.
The hypothetical exit of Greece (or any other country)
from the Euro would require the reintroduction of its own
national currency, while all outstanding private and public
liabilities would remain denominated in Euros. Therefore,
attempts to exit the Euro (which cannot happen
technically overnight as an ordinary currency devaluation)
would mean, in practice, an immediate default on both
public and most private debt, caused by soaring debt-to-
GDP ratios and total financial chaos. This would do
nothing to repair Greece’s debt woes or help any other
European economy. In today’s sophisticated and
interdependent economies, devaluation is neither
effective nor believed to be the universal medicine of
choice.
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Instead of speaking about the Euro crisis one should speak
about the public debt crisis. Greece’s current fiscal
problems are a surprise to nobody as they have
systematically accrued over the last 30 years (see Figure
1). Worse, the fiscal crisis is not limited to Greece. Several
other countries, not only those within the Eurozone and
the EU (see Table 1), have recorded a dramatic increase in
their public debt-to-GDP ratios over the last two years.
Due to years of fiscal indiscipline, scale of global recession
(automatic fiscal stabilizers) and poor design of fiscal
stimulus packages, the list of victims includes but is not
limited to Japan, US, UK, Spain, Portugal, Ireland, Italy and
Hungary.
The current public debt crisis is not a new phenomenon,
and as we mentioned above, is not limited to Eurozone
countries. The choice of monetary regime has a very
limited impact on fiscal accounts. Economic history gives
us several examples of public debt defaults both under
the gold standard, and fiat currencies, as well as under
fixed and floating exchange rate regimes.
Therefore, the debt crisis must be addressed by means of
fiscal and structural reforms. Public expenditures must be
reduced (including the most costly and wasteful spheres
of social transfers), taxes must be more effectively
collected and, in some cases, increased. All of these
measures are not easy and involve high political costs.
What is promising is that the Greek crisis changed the
intellectual perspective towards Europe’s fiscal policy
challenges. The previous calls for fiscal stimulus have
largely disappeared giving way to discussions on fiscal
¹ See e.g. Dadush, U. & Stancil, B. (2010): Greek Crisis: A Dire Warning From Argentina and Latvia, Carnegie Endowment for International Peace, International Economic
Bulletin, March 3, 2010 http://www.carnegieendowment.org/publications/index.cfm?fa=view&id=40275
www.case-research.eu

No. 09/2010 June 2010
adjustment (including such fundamental measures as
increasing the retirement age) and strengthening fiscal
discipline at both the EU and national levels. This can
help overhaul Europe’s public finances, which is
necessary to avoid future macroeconomic turbulences
and ensure economic growth.
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The EU’s fiscal surveillance rules are based on provisions
of the Treaty of the Functioning of the European Union
(TFEU, Article 126 and Protocol No. 12) and the Stability
and Growth Pact (SGP), i.e. secondary legislation.
Unfortunately, both lack the effective sanction
mechanisms with respect to those member states
(especially large ones) that breach the rules. Worse, in
2005 the SGP was watered down under collective
pressure by its major offenders.
After agreeing to a Greek rescue package, the European
Commission presented a set of measures aimed at
reinforcing the SGP. This included strengthening
Eurostat’s mandate to audit national statistics (in light of
negative experiences with Greece’s misreported fiscal
data), speeding up the Excessive Deficit Procedure (EDP),
particularly in respect to repeated SGP offenders, and
tightening financial sanctions such as suspending
Cohesion Fund transfers or more rigorous use of EU
expenditure to ensure better compliance with SGP rules.
The current focus of EDP on fiscal deficit criterion is to be
amended, with a greater emphasis on the level and
dynamic of public debt and long-term fiscal sustainability.
The Commission also offers the idea of the “European
Semester”, which should provide a mechanism of early
peer review (at the beginning of each calendar year) of
the Stability and Convergence Programs as well as
national draft budgets.
All of these proposals seem to go in the right direction,
but they will hardly make a substantial difference in
Treaty and SGP enforcement mechanisms. Instead, they
will pose a greater threat for smaller and lower-income
countries. The former have limited voting power in the
Economic and Financial Affairs Council (ECOFIN), the
latter are net recipients of EU budget transfers. Making
sanctions truly serious and potentially painful for all
countries abusing fiscal surveillance rules would require
(i) ensuring their automatic (instead of discretionary)
character; (ii) going beyond financial fines (which may be
difficult to enforce in difficult economic times and when
countries require extra financial support). Such additional
sanctions could involve suspending voting rights in
ECOFIN and perhaps in the Governing Council of the
European Central Bank (in cases where Maastricht fiscal
criteria are breached). However, this would require
changes to the Maastricht Treaty, which do not seem
realistic over the next few years.
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As fiscal policy remains mostly the prerogative of
individual EU member states, their national legislations
can play a crucial role in tightening fiscal discipline and
preventing a future public debt crisis. Several member
states have certain fiscal rules written down into their
constitutions and ordinary legislation. However, in some
cases they have never been tested in practice (like a 60%
public debt-to-GDP limit in Poland’s Constitution). Some
countries have set up special institutions in charge of
monitoring long-term fiscal sustainability (like the Fiscal
Policy Councils in Sweden and Hungary or the newly
created Office for Budget Responsibility in the UK). One
may expect that fears of future debt crises will push more
countries towards strengthening their national fiscal rules
and institutions, including internalizing the EU’s fiscal
rules. Germany’s 2009 constitutional amendment, which
limits opportunities to increase public debt both on a
federal and state (land) level, is a good example to follow.
Financial markets can also play a positive role in
increasing fiscal discipline on a national level. Almost non
-existent spreads between yields on government bonds
within the EMU and very low spreads in respect to other
EU members seem to be gone for good. More generally,
risk premia on government bonds will have to be
reassessed almost everywhere, against the increasing
danger of public debt crisis in many countries. At the
moment, financial markets seem to increasingly over-react
to default risk premia in peripheral EMU
economies. However, in the long-term, a more balanced
assessment has a chance to provide the right warning
signals to policymakers.
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It is no secret that the EU lacks the fiscal capacity to offer
a crisis resolution mechanism on its own. This applies to
both systemic banking and financial sector crises (as
happened in the fall of 2008) and sovereign debt or
balance of payment crises. Designing such a mechanism
is not easy both for legal and conceptual reasons. The
size of the EU budget does not exceed 1% of total Gross
National Income (GNI) of EU member states. Its
expenditures are strictly allocated to support major EU
common polices such as the Cohesion Policy, Common
Agriculture Policy, competitiveness, research, and
development aid. The medium-term budget perspective
requires a unanimous decision by all member states. In

No. 09/2010 June 2010
addition, Article 125 of TFEU prohibits any direct bailout
of member states.
However, in light of a potential Greek default, these
limitations and fears of creating moral hazard incentives
have to be put against the dangers of an uncontrolled
and highly devastating contagion effect. The latter could
involve not only the simple domino effect, i.e. flight from
government bonds in other EU/EMU member states such
as Portugal, Spain and Italy but also the next round of the
European banking crisis (due to banks’ high exposure to
public debt and the fragility of their balance sheets).
As a result, on May 9, 2010 ECOFIN agreed to establish
the European Financial Stabilization Mechanism which
consists of €60 billion of the EU’s own resources and
€440 billion of the Special Purpose Vehicle that is
guaranteed on a pro rata basis by participating member
states. More importantly, this mechanism is backed by
IMF resources. Greece became the first beneficiary of this
mechanism (closely coordinated with the standard IMF
stand-by loan and its conditionality).
This is, however, only a temporary and emergency
solution. In the long-term a permanent crisis resolution
mechanism needs to be set up on the EU level, in
addition to stronger fiscal surveillance rules. Greece’s
problems are only the tip, of a rapidly growing EU fiscal
liability iceberg. Leaving the rescue operations solely to
the IMF is not realistic because of its limited resources
and limits to policy conditionality. It will not calm the
financial markets in times of distress, as the recent Greek
episode (and danger of spillover) clearly demonstrated.
One proposal, which tries to offer not only a rescue
mechanism but also an orderly sovereign default
mechanism, calls for the establishment of the European
Monetary Fund. Another proposal suggests sharing
responsibility for part of the public debt within the EMU,
but this (like the blue bonds/red bonds mechanism) may
raise the risk of moral hazard and requires further
discussion.
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Part of Greece’s rescue package was provided by the ECB,
via government bond market intervention under the so-www.
Figure 1: Greece’s fiscal deficit (general government net borrowing) in % of GDP, 1980-2009
case-research.eu
2.4
7.6
5.8
6.5
7.6
10.3
9.2
8.6
10.4
13.0
14.5
10.4
11.5
12.4
9.0
7.0
6.8
6.0
3.9
3.1
3.7
4.4
4.7
5.6
7.5
5.1
3.1
3.7
7.8
12.9
15.0
13.0
11.0
9.0
7.0
5.0
3.0
1.0
-1.0
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: IMF WEO Database, April 2010

No. 09/2010 June 2010
called Security Market Program. Its official
justification was to provide temporary liquidity
relief to financial market segments suffering
distress. In terms of money supply, the effects of
this intervention have been sterilized by ECB term
deposits, however, it compromised the reputation
of this institution and raised financial market
doubts about its actual policy priorities in the
future. In fact, it may result in serious problems
for macroeconomic and financial stability in
Europe. In addition, long-term costs (in terms of
lost credibility) may well exceed the short-term
benefits coming from temporary bond market
relief. This is the shortest path from public debt
crisis (which has already happened) to an eventual
Euro crisis.
Table 1: Gross debt to GDP in EU, in %, 2004-2009
The opinions expressed in this publication are solely the author’s; they do not necessarily reflect the views of
CASE - Center for Social and Economic Research, nor any of its partner organizations in the CASE Network. CASE E-Brief Editor: Ewa Błaszczynska
Dr. Marek Dabrowski is
the President of CASE.
Since the end of the
1980s, he has been
involved in policy
advising and policy
research in Central and
Eastern Europe, Central
Asia, Africa and the
Middle East, as well as in numerous international
research projects on monetary and fiscal policies,
currency crises, international financial
architecture, EU and EMU enlargement,
European integration, European Neighbourhood
Policy and the political economy of transition.
Region/ Country 2004 2005 2006 2007 2008 2009
EU-27 62.2 62.7 61.4 58.8 61.6 73.6
Euro area 69.5 70.1 68.3 66.0 69.4 78.7
Austria 64.8 63.9 62.2 59.5 62.6 66.5
Belgium 94.2 92.1 88.1 84.2 89.8 96.7
Bulgaria 37.9 29.2 22.7 18.2 14.1 14.8
Czech Republic 30.1 29.7 29.4 29.0 30.0 35.4
Cyprus 70.2 69.1 64.6 58.3 48.4 56.2
Denmark 44.5 37.1 32.1 27.4 34.2 41.6
Estonia 5.0 4.6 4.5 3.8 4.6 7.2
Germany 65.7 68.0 67.6 65.0 66.0 73.2
Greece 98.6 100.0 97.8 95.7 99.2 115.1
Hungary 59.1 61.8 65.6 65.9 72.9 78.3
Ireland 29.7 27.6 24.9 25.0 43.9 64.0
Finland 44.4 41.8 39.7 35.2 34.2 44.0
France 64.9 66.4 63.7 63.8 67.5 77.6
Italy 103.8 105.8 106.5 103.5 106.1 115.8
Latvia 14.9 12.4 10.7 9.0 19.5 36.1
Lithuania 19.4 18.4 18.0 16.9 15.6 29.3
Luxembourg 6.3 6.1 6.5 6.7 13.7 14.5
Malta 72.1 70.2 63.7 61.9 63.7 69.1
Netherlands 52.4 51.8 47.4 45.5 58.2 60.9
Poland 45.7 47.1 47.7 45.0 47.2 51.0
Portugal 58.3 63.6 64.7 63.6 66.3 76.8
Romania 18.7 15.8 12.4 12.6 13.3 23.7
Slovakia 41.5 34.2 30.5 29.3 27.7 35.7
Slovenia 27.2 27.0 26.7 23.4 22.6 35.9
Spain 46.2 43.0 39.6 36.2 39.7 53.2
Sweden 51.3 51.0 45.7 40.8 38.3 42.3
UK 40.6 42.2 43.5 44.7 52.0 68.1
Note: Blue fields indicate countries where the public debt to GDP ratio increased by 15
percentage points or more in the period of 2007-2009
Source: Eurostat, http://appsso.eurostat.ec.europa.eu/nui/show.do?
dataset=gov_dd_edpt1&lang=en

CASE Network E-brief 9.2010 - Euro Crisis or Debt Crisis?

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