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A View from the Precipice of the Euro Crisis

Options for Resolving the European Debt Debacle

SOURCE: AP/Nikolas Giakoumidis

Antonis Samaras, leader of the conservative and probailout New Democracy party in Greece, speaks during an election rally in June. His party's victory in the recent elections means Greece will likely remain in the eurozone for now.  

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"Drachmageddon" has been avoided. The election of the probailout New Democracy party in Greece should keep the country in the eurozone—at least for now—but the region’s debt crisis is far from over. Markets reacted positively to the election results, but this has proved short lived. Spanish 10-year government bond yields rose to 7.14 percent, pushing the nation’s implied borrowing costs to their highest during the euro’s lifetime. Italian 10-year bond yields also rose to 6.08 percent. (Seven percent is widely seen as an unsustainably high cost of borrowing.)

As leaders gather for the meeting of the Group of 20 developed and developing nations in Mexico this week, the main agenda item will be the need to create a lasting strategy to save the euro and end the crisis, which is causing turmoil in financial markets. Ahead of the summit the Obama administration called on European leaders to prepare an "immediate plan to tackle the crisis and to restore market confidence." More specifically, the White House has called for a clear roadmap for deeper financial and fiscal integration in Europe to emerge from the G-20 meeting.

Bringing the crisis to an end is in the United States’s interest. Exports to the European Union account for 21 percent of overall U.S. exports, and EU imports account for 18 percent of total imports, according to figures by the Office of the U.S. Trade Representative. Breaking up the eurozone—and the resulting reduction in demand—would hurt American companies that do business on the continent, not to mention the impact that a break up could have on U.S. banks exposed to European debt, currently around $767.5 billion. Even if the euro doesn’t fall off the precipice, the fear of that happening is enough to hurt growth. But resolving the crisis is not so much a problem of economics as one of politics.

German Chancellor Angela Merkel says that the solution to the crisis requires “more Europe,” meaning deeper fiscal and political integration. In a fiscal union, in which individual member nations of the European Union would give up control over their nation’s budgets, decisions about the collection and expenditure of taxes would be taken by common institutions, much like it is in the United States—where fiscal policy is determined by the federal government, which is empowered to raise taxes, borrow, and spend. But concrete movement toward deeper political and fiscal union is a distant dream, not least because it requires a referendum in many member states, whose citizens are wary of more encroachment by their European peers into domestic financial affairs.

In the absence of a fiscal and political union, French President Francois Hollande has suggested that European countries share their debt though Eurobonds. While the public debt of some of the eurozone’s members is unsustainable—the so-called PIGs (Portugal, Ireland, and Greece) and Italy have public debt in excess of 100 percent of gross domestic product, the largest measure of economic growth—the overall situation is much healthier because the eurozone government debt-to-GDP ratio is 87 percent.

Under the Eurobonds proposal, rather than individual governments borrowing money on their own, the entire eurozone would borrow money together as a unit. Spain and Greece would, in effect, pay the same interest rates on their debts as France and Germany. Since the eurozone as a whole is economically sound, this would calm the panic about individual countries. If Portugal had to pay the average interest rate of eurozone members, its annual debt payments would fall by €15 billion, or 9 percent of its GDP.

But the German government is strongly opposed to this “mutualization” of debt because it gives rise to “moral hazard.” Once the debts of countries are underwritten collectively by all the members of the eurozone, countries no longer have an incentive to make the difficult structural reforms necessary to keep their public debt in check. If the borrowing costs of the PIGs are subsidized by Germany, there’s less need to worry about racking up more debt in those more-troubled countries.

Germany’s preferred solution is to see bailout countries tackle their unsustainable debt levels through austerity measures involving cuts in public spending and structural reform. But is this the best approach?

Take Greece, for example. The austerity measures enforced on it by the EU-International Monetary Fund bailout have had a devastating effect on its already-weak economic recovery: In the first three months of 2012 alone, its economy shrank by 6.2 percent. Greece has been in a recession for four years, and its economy has contracted 20 percent. The official unemployment rate is well-above 20 percent, and youth unemployment is nudging 50 percent. The economic conditions have caused social unrest, bringing citizens to the breaking point and causing them to question whether Greece would be better-off outside the eurozone.

Austerity is particularly painful for countries that use the euro. Members do not have the option of printing more money or devaluing their currency in order to make exports cheaper, so they have been forced to try and achieve the same results through “internal devaluations”—a euro euphemism for reducing labor costs—through drastic cuts in public expenditure.

These deep spending cuts have caused higher unemployment, lower tax revenue, and increasing social expenses such as unemployment benefits and health care. This creates a self-reinforcing cycle, in which deeper cuts are required to offset the revenue lost as a result of the shrinking economy.

Europe is proving what the Hoover administration already showed in the 1930s—that cutting spending in a recession is counterproductive. Head of the International Monetary Fund Christine Lagarde and financial commentators such as George Soros and Paul Krugman have made that same point.

It’s not just the bailed-out economies that are feeling the pain. In May French voters showed they were fed up with austerity, and they elected Socialist President Francois Hollande, who has promised to balance cuts in public spending with a robust growth plan.

The crisis is starting to hurt Germany, as well. In April German industrial exports fell at their fastest rate since November 2011, as orders from abroad slowed down. European countries can no longer afford to buy German products in the volumes they once did.

So what can be done at the G-20 meeting to resolve the crisis, given these major political hurdles? Here are two suggestions.

First, the debate needs to move beyond austerity to focus on growth. President Hollande—buoyed by the recent success of the Socialist party in the parliamentary elections in France—has made a serious growth pact a condition of the European Union’s new fiscal discipline treaty, which European leaders agreed to enter into in December 2011 and will meet to finalize later in June.

A draft plan to be put before the G-20 by the French government wants European leaders to commit to a €120 billion ($151 billion) growth package that will come from a combination of €4.5 billion ($5.66 billion) in project bonds; jointly financed spending on infrastructure such as transportation and energy projects; €55 billion ($69 billion) of unused EU structural development funds; and a €10 billion ($13 billion) capital injection into the European Investment Bank—a lending institution that supports economic development in weaker states—which would potentially enable the bank to increase lending by €60 billion ($75 billion). The money from the growth plan would be used to finance projects that create much-needed jobs.

President Hollande says the measures should be expanded before the end of 2012 by creating a financial transaction tax, which could be used to fund measures to create jobs, especially for young people.

Second, in order to calm the market panic and ease the immediate budgetary crisis of the bailout countries, European leaders need to reach some type of agreement on debt mutualization. Although the German government has ruled out full-blown mutalization in the form of Eurobonds, other options are on the table.

For instance, five leading German economists, known as the “wise men,” have suggested a Debt Redemption Fund. Under this proposal national debt of up to 60 percent of GDP would continue to be the responsibility of individual eurozone countries, as specified by the Growth and Stability Pact, which governs fiscal policy within the zone. Debt above 60 percent of GDP would be pooled in the Debt Redemption Fund, with eurozone members having joint liability for that debt.

Countries receiving the EU-International Monetary Fund bailouts would be allowed to pool their debt only after the successful conclusion of their austerity programs. Therefore the problem with this proposal is that it does little to solve the immediate problems of Greece and Portugal, and commits other countries to a crash course in fiscal adjustment—even Germany’s public debt is 81 percent of GDP.

Also being considered are “Eurobills,” which would mutualize short-term government debt with

maturities of less than 12 months up to a maximum 10 percent of eurozone GDP. European leaders should give serious consideration to the Eurobills because they would help with crisis management, as well as minimizing the risk of moral hazard associated with full-blown mutualization.

If Spain and Italy were to use their entire 10 percent quota of Eurobills, it would cover around half of their refinancing needs for 2012, which would means that financial markets would remain an important mechanism to provide price signals and incentives for fiscal discipline on longer-dated debt. Eurobills would allow a country such as Italy to save €5 billion a year ($6.3 billion) by lowering the cost of its debt. These savings would give countries some breathing room to implement their fiscal reforms.

The commitment would be limited to 12 months so other members could refuse to renew or rollover loans if countries are found to be behaving irresponsibly. Eurobills could not be used to bail out insolvent countries due to their limited size and magnitude. As such, they would not violate the spirit of the monetary union treaty that created the euro, which specifically prohibits government bailouts by the European Central Bank.

The G-20 will be another crossroad in this two-year debt crisis. Although the Greek elections may have brought some respite, continued uncertainty about the future of the euro is creating financial turmoil that is damaging to growth. President Barack Obama has said that the European leaders have it in their capacity to resolve the crisis. As the world’s largest economy and most dynamic financial market, the United States can still play a role at the G-20 in helping broker a deal, particularly by focusing European leaders on taking decisive action to stimulate much-needed growth.

David Lutton is a visiting scholar at the Center for American Progress and the Center for European Studies at Harvard University.

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