Lorenzo Bini Smaghi: the future of the Euro
Why the Greek Crisis Will Not Ruin Europe’s Monetary Union
Foreign Affairs, August 10, 2010
When the euro was conceived two decades ago, few people expected it to have to weather a storm as great as the recent global economic and financial crisis. And many observers now think the entire European construct — its institutions and currency — has been so damaged by the crisis that it might not survive. A careful analysis of the problems within individual eurozone economies, particularly Greece’s, and in the architecture of the monetary union among them reveals what went wrong, how the EU has responded, and what the prospects of the euro really are.
Between 2008 and 2010, several things went wrong in Europe, the biggest of which was Greece’s financial crisis. For years, Greek fiscal policy had been unsound. Although private debt had been rising, the country’s overall debt-to-GDP ratio had not ballooned, because the Greek economy was growing. But that growth turned out to be unsustainable. When the global economic crisis hit, Greece’s deficit more than doubled. The problem was compounded by revelations that the government had grossly falsified and padded its budget in the run up to the 2009 parliamentary elections.
Unlike countries with national currencies, Greece could not address its problems through monetary policy. It can neither print money to inflate its debt away nor depreciate its currency to recover the international competitiveness of Greek goods and grow the economy out of debt. And unlike a subnational federal region in trouble, Greece, as a sovereign unit itself, could not have its falling revenues and rising social expenditures offset through simple fiscal transfers from the rest of Europe. Its labor force, moreover, is not mobile enough for excess to be exported elsewhere in the eurozone.
As far as the euro’s architects were concerned, this kind of problem should never have arisen. European financial markets should have put pressure on countries with excessive debt-to-GDP ratios, such as Greece, by charging them higher interest rates for loans. The European Central Bank (ECB) prohibits loaning money to service national debts, and its no-bail-out clause should similarly have discouraged overspending. Additionally, the eurozone’s Stability and Growth Pact, which was meant to enforce fiscal discipline in member countries through rules against running high deficits and debts, should have constrained Greek politicians. Finally, the Lisbon process, a 2000 development plan for the eurozone, should have increased Greece’s economic competitiveness and spurred real growth.
Between 2008 and 2010, several things went wrong in Europe, the biggest of which was Greece’s financial crisis.
Unexpectedly, however, European financial markets accommodated Greece’s public and private spending with relatively low interest rates. It was only when the global financial crisis gained momentum that the markets reacted and capital flows suddenly stopped. The Stability and Growth Pact was ineffective as well; member states proved unwilling to enforce restrictions against others for fear of being subject to restrictions themselves. Finally, the Lisbon process underestimated the true differences in the member countries’ economies and failed to adequately address them.
Once the Greek financial crisis was under way, there were two options for tackling it. The first was for Greece to implement fiscal and structural reform that would bring its debt and deficit under control. Greece, the International Monetary Fund (IMF), the European Commission (EC), and the ECB negotiated just such a plan in June, with the goal of turning Greece’s primary deficit of nine percent of GDP into a surplus of six percent by 2015. It rests on fairly standard IMF reforms: substantial expenditure cuts, increases in revenue creation, and improvements in tax collection. It also includes important structural reforms, such as pension reform and privatization, which are aimed at improving long-run debt sustainability and the performance of Greece’s labor and manufacturing sectors.