The modern specter that has gone through Europe, the specter of a complete economic and financial collapse of the euro area, has at last lifted.
Much work remains to be done, but the excessive and to some extent ideologically driven gloom of just a few months ago has dissipated recently, as the deployment of the European Central Bank's (ECB) balance sheet has helped stabilize the European financial system and sovereign bond markets. The ECB has made the difference, having agreed to begin buying Spanish and Italian government bonds in August 2011 and expand its balance sheet by more than 45 percent to more than €3 trillion and at a pace faster than that of the Bank of England, with its policy of quantitative easing.
The signs of progress are impressive. Italian and Spanish 10-year bond yields have dropped below 5 percent, the Greek parliament has approved the agreed package of "prior actions" for its bailout, Ireland and Portugal have gotten passing grades by the International Monetary Fund (IMF), Croatia has signed the accession Treaty to the European Union EU, Serbia has gained candidate country status, and the recent EU Council ended on time. Through the actions of the ECB, the European banking system is effectively funded through 2013, enabling the large peripheral sovereigns to issue new debt at increasingly sustainable rates. The dreaded "euro area debt rollover monster" of the first half of 2012 seems increasingly like a mythical creature. These are not bad developments for a currency and a continent pronounced dead daily by commentators and market participants since mid-2010. Perhaps a "euro coin as a rising sun" cover on the Economist is beckoning1 or even a "euro positive" editorial by the New York Times should be in the offing (figure 1).
In helping to save the day, the ECB has clearly been shaping its interventions to fit the bank-centered European financial system and to conform with its own legal framework and political circumstances. For example, the ECB Governing Council continues to foreswear "monetary financing," such as quantitative easing (QE), even as it deploys its balance sheet as other major central banks have to stabilize the European economies.
What took Frankfurt so long? Many are asking that question. Why did 10.7 percent of the euro area workforce have to become unemployed before decisive action was taken? As I have discussed before,2 the key concern has been "political moral hazard"—i.e., the aversion to acting forcefully at the beginning of the crisis because such action might not have forced EU elected leaders to take the necessary hard political decisions on reforming national economies and European institutions.
It is no coincidence that the ECB's decision to launch its 3-year long-term refinancing operations (LTROs) came on December 8, shortly after Prime Minister Silvio Berlusconi had been pushed out of office in Italy, the reformist Mariano Rajoy was elected prime minister in Spain, and as a new Fiscal Compact Treaty was headed toward agreement. Only when it felt confident about these signs of progress could the ECB feel comfortable about easing pressure on elected officials. In that sense, the shallow recession and rise in unemployment in the euro area is viewed as "collateral damage" in the central bank's eyes, a necessary short-term sacrifice to achieve long-term gains.
Of course, these sacrifices have been painful for many, but the political reality is that such costs and the political brinkmanship surrounding them are necessary for the achievement of structural reforms and economic integration. No other alternative was available.
I am frequently reminded by my Peterson Institute colleagues—most of whom are strongly pro-European integration—that the drawn-out crisis resolution in Europe has been costly, extending beyond Europe and damaging global economic prospects. The spillover for a time even seemed to dim the re-election prospects of President Obama. Occasionally, these colleagues play the historical trump card, saying that the United States fought a civil war to resolve many of the issues now in Europe, such as the battle between the central government and the rights of the individual states.3 These warnings are echoed by financial market participants (especially in New York and London), where the sentiment favors a rapid move toward eurobonds to avoid the risk of losing everything.
Ironically, this criticism is acute in the United States, even though Americans are still debating national versus state sovereignty. Despite much commentary about all powers going to Brussels, national sovereignty remains alive in Europe. Therein lies the reason why all EU Treaties are hundreds of pages long, after all. The European Union is a highly complex entity created through a byzantine political process that constantly weighs and refines the tradeoffs between member states' and the central authority. Although voluntary pooling of national sovereignty has proceeded in Europe further than anywhere else, countries remain reluctant to surrender every bit of sovereignty to the European Union or the euro area, unless they are coerced by circumstance.
In retrospect, the visionaries who designed the euro as a common currency in the late 1990s made a mistake in failing to set up a corresponding economic, fiscal, or political union. Yet, as I have explained elsewhere,4 their decisions must be seen as an attempt to respond quickly to the geo-political shock of German re-unification and the collapse of the Soviet Union. In their haste, European leaders took the Economic and Monetary Union they could get in the 1990s and left it to future generations to finesse the other issues. The so-called "locomotive theory" of European integration—i.e., the that introducing a common currency would secure real economic, fiscal, and political integration in Europe—has proven illusory. Political and economic integration in Europe will not just organically emerge. European countries will not spontaneously agree to the goals of binding fiscal rules, eurobonds, or fiscal transfers. Indeed, the failure of the "European Constitution" in 2005 showed that as EU integration has deepened, and populations have sensibly demanded a direct voice through referenda, the era of "voluntary" elite-driven European integration has ended. European populations are simply no longer willing to hand over more sovereignty to Brussels. The fact that 80 to 90 percent of Europeans identify themselves first and foremost as citizens of their countries rather than as Europeans suggests this is not likely to change soon. 5
Even if the European Constitution had been adopted in its original form in 2005, it would not have made any particular difference for the effects of the global financial crisis on the euro area economies. The institutions the euro area lacked after 2009 were not part of the original European Constitution. The point here is that the constitution's 2005 electoral demise signaled the end of meaningful "voluntary European integration" in normal times. As the global financial crisis hit and the Greek economy collapsed like a fraudulent house of cards, Europe's "half-built house" was not going to survive in its existing form, or probably any possible form built on the voluntary pooling of integration and sovereignty from 1957 to 2008. Instead the crisis forced European leaders to face the choice of abandoning the common currency or using the crisis to complete European integration. They chose the latter option, dreading the consequences of the former.
Despite the crisis, however, European nations have been slow to address both the euro area's institutional weaknesses and the domestic structural weaknesses of its most troubled members. Even in Europe, elected representatives are reluctant to supplant the budget prerogatives of sovereign states. None of them likes playing with fire or behaving irresponsibly. Brinkmanship is necessary to coerce them to action.
Multiple definitions exist for "brinkmanship." As previously discussed in this forum, it captures the political strategy of deliberately pushing a dangerous situation to the "brink" of disaster in order to compel the opponent into concessions. The economist and political scientist Thomas Schelling (in his 1966 classic Arms and Influence) describes it as "manipulating the shared risk of war…. exploiting the danger that somebody may inadvertently go over the brink, dragging the other with him." Such a strategy cannot succeed without an element of unpredictability or crisis. As the economist Frank Knight has said, brinkmanship does not rely on risk that can be quantified but on pure uncertainty. 6
Persistent crisis and repeated reliance on the potential "disaster scenario" of a collapse of the euro—in a steady stream of late night summit meetings of EU leaders since early 2010—has pushed euro area "fiscal integration" beyond what would have been politically feasible otherwise. We know—because it was tried repeatedly before the crisis—that it is inconceivable for the European Commission before the crisis to have acquired the fiscal surveillance powers that it now has. Establishing a fiscal solidarity-type institution like the European Stability Mechanism would have been no less feasible.
For all these reasons, perhaps, the commentary about Europe's response has too easily dismissed what has been achieved. Just as Congress needed a one-day drop in the DowJones Industrial average of 600 to 700 points to pass the Troubled Asset Relief Program (TARP) in 2008, Europe required a crisis before it could act.
Indeed, considering the path Europe has to travel to integrate properly, it is misguided to lament the length and depth of the euro area crisis since early 2010. In some ways, the Japanese experience since the early 1990s is instructive. The underlying reason for Japan's lost decades is that the country's ultra-high domestic ownership of government debt (roughly 95 percent) shielded policymakers from the need to take tough decisions, even as gross general government debt levels have approached 250 percent of GDP. One can only hope that the United States' "exorbitant privilege" of possessing the world's reserve currency, and its seeming ability to issue unlimited debt, does not allow for complacency over the need to pursue fiscal consolidation over the long term.
It can be argued that Europe's pursuit of reform in response to the crisis, rather than the demands of Europeans themselves, is undemocratic. But demands for European referenda to achieve "democratic legitimacy" are cynical and shallow. Such demands are almost always rooted in the desire to block reform while sounding principled. Witness the endless calls by British conservatives for a referendum on Britain's EU membership, while denying Scotland the same unconstrained right to dictate the circumstances of their own referendum on independence.
At issue ultimately is a discussion of the merits of representative vs. direct democracy. Can duly democratically elected governments hand over sizable parts of national sovereignty without asking citizens directly? In some countries like Ireland, the national constitution says no. But Europe's voters will eventually get a "direct vote" and an opportunity to "kick the bums out" at the next parliamentary elections. The lesson from recent decades of the "referendum era" of EU politics (since the Danes first rejected the Maastricht Treaty in 1992) is that European voters rarely do this, however. The record shows that referenda related to the EU Treaty—in which national parliaments support a "yes" vote—are frequently defeated. On the other hand, in national election results, EU voters invariably reelect the same people they overruled in prior referenda. They might now reject particular EU Treaties while reelecting the politicians that negotiated and supported such treaties. The lesson here is that leaders need not cater unduly to a confused electorate. Instead they should do what is necessary and face voters later.
Almost all national parliamentary elections in the European Union have voter participation rates around 75 percent. Only the EU Parliament suffers from low participation rates comparable to those of US Congressional mid-term elections.7 In a capable, resilient, and ultimately legitimate political system like that in Europe, which has repeatedly shown itself able to turn away from the brink at the last minute, crises are a blessing in disguise, as they make what was previously politically impossible possible.
One key element must be present for such brinkmanship to be a responsible political strategy, however—and that is "government capacity." Only when all participants agreethat the political will to reform is missing can brinkmanship succeed. If instead, the impediment to a solution is a country's basic incapacity to deliver a solution, brinkmanship will fail despite everyone's best intentions.
Greece is now at just such a point of decision. What seems to be missing in Athens is not political will but political capacity to institute the necessary reforms. In this situation, brinkmanship has probably run its course. Greece's problems demand a more traditional capacity-building agenda associated with developing countries, with which Brussels has little experience.
Historically, the European Union has assumed that new member states are capable of responsible action, and it has thus insisted that new members implement the full Acquis Communautaire8 (the full body of European Community laws) ahead of accession. The failure of member state governing capacity not only makes brinkmanship impossible, it also undermines the basic tenets of the operation of the European Union, such as the principle of subsidiarity, which holds that governing must take place at the level closest to the citizen.9
The proposal for a new European Commissioner for Greece to oversee reconstruction of its economy and set up a permanent presence of the ECB, the European Commission, and the International Monetary Fund (IMF) in Athens—advanced by Jean Claude Junker, the head of the euro group—illustrate the uncharted Hellenic territory facing European policy makers.
For all these reasons, inter-governmental brinkmanship should be conducted among developed economies, where such basic capacity can be assumed.
There must also be a general agreement on a political solution for brinkmanship to work. For Greece, despite the hisses of some—this has generally been present. No one has advanced a serious alternative to the IMF program.
What should we expect from brinkmanship going forward in the euro area crisis? Despite all the jockeying among the euro area, the IMF, and the G-20 over sharing the cost of a "firewall" to prevent contagion in Europe, the process will succeed. Last week the EU Council "confirm[ed] their commitment to re-assess the adequacy of the overall ceiling of the EFSF/ ESM [European Financial Stability Fund/European Stability Mechanism] by the end of the month [of March]." Before the April 20–22 IMF/World Bank Annual meeting, there will be more European money put into these elements of the firewall.
The entire G-20 process deserves high marks in this regard. Often ridiculed and facing a potential hiatus during the second half of the Mexican G-20 presidency in 2012, as well as during the chairmanship of Vladimir Putin in 2013, the G-20 has managed to ratchet up the political pressure on Europe to act as market pressures have eased, especially in Germany. Ultimately, Chancellor Angela Merkel is now likely to go before the Bundestag and ask for more money to save Europe, arguing that Germany cannot stand alone against the world. When that happens, the G-20 political brinkmanship can take credit.
For all the hard work by Greece, the troika, and private creditors, the bond swap implementing a debt write-down for private creditors will go through and probably trigger the "credit event" that brings credit default swaps into play. As discussed previous here on RealTime, such an occurrence will effectively take out the private sector from the "Greek question." The new long maturities (30-year) and low initial coupon (2 percent until 2015 and 3 percent from 2015–20) for Greek debt means that there will be no more private debt rollovers, including the one that would otherwise occur on March 20. You cannot have brinkmanship, in other words, without a brink ahead of you. The new setup means that Greece can no longer cause any direct financial harm to the private sector, though some concern about contagion remains.
For the troika, however, the issue of future Greek IMF program compliance and ultimate debt sustainability continues to linger. What happens in the hardly unlikely event that Greece fails to implement its future IMF program? The situation may well arise where the IMF chooses to walk out on Greece. Such a development might not mean anything for private creditors, but it could affect the rest of the euro area, where it might cost taxpayers even more money. Indeed that is what several EU leaders have insinuated, when talking about how Greece may need further assistance in the future.
Any future further financial assistance to Greece, however, will almost inevitably bring further euro area oversight over (and loss of sovereignty by) Athens, perhaps dressed up as Greek institutional "capacity building." This is what a new European Commissioner for Greece will mean.
Perhaps Greek voters won't mind this. After all, they despise their own elected leaders even more than the euro area or the IMF, and they shouldn't mind clipping their wings. Accordingly, further euro area financial assistance to Greece can be anticipated, resulting from broken Greek promises to EU leaders. Indeed, this is the most likely outcome and baseline scenario. It is not inconceivable, however, that a nationalist Greece will balk at a further loss fiscal sovereignty—even if it comes dressed as friendly "institution-building" from Brussels and Frankfurt—and opt for exiting the euro zone even if it invites economic disaster.
A final display of brinkmanship could occur in the coming Irish referendum on the new Fiscal Compact Treaty, and its implied attempt to extract more concessions from the euro area, perhaps surrounding the "technical negotiations" over the promissory notes issued at high interest rates to fund the Irish bank bailout. These notes could be refinanced by the ESM in the future, benefiting Ireland's net-debt situation.
Such frontloaded further financial assistance to Ireland would make sense to help it return fully to the financial markets in 2013. In its most recent review of Ireland, the IMF stated such a return to the markets "would demonstrate that strong policy implementation can succeed, and also avert the prospect of ongoing reliance on official financing, that would, itself, increasingly hinder the potential for Ireland to return to market funding."
Ireland is scheduled to try to return to the market in the second half of next year. The IMF must ensure that a country freeing itself of assistance is solvent and has that market access. If that happens, euro countries will have to step in and fill the breach. Now that Ireland is holding its referendum, the euro countries may wish to tilt the vote in favor of approval and give Ireland the aid it needs anyway.
The euro area should not miss this opportunity to show markets that Greece is a unique case.
1. Well, at least one can hope that the "euro as a crashing meteor" of November 26, 2011 is not reprinted. See http://www.economist.com/printedition/2011-11-26.
2. See http://piie.com/blogs/realtime-economic-issues-watch/brinkmanship-brussels-sturm-and-drachma-greece-and-europe and /blogs/realtime-economic-issues-watch/how-euro-brinkmanship-beginning-succeed.
3. Several reasons of course exist for the American civil war, but I will superficially contend that it at its nucleus was about the right of the South to secede from the Union to pursue their own slave-based economic model. As such, the center-vs.-periphery aspects are evident.
4. See Congressional Testimony at http://foreignaffairs.house.gov/112/70950.pdf and http://www.foreign.senate.gov/imo/media/doc/Jacob_Funk_Kirkegaard.pdf.
5. See a more detailed discussion in my PIIE Policy Brief here - Will It Be Brussels, Berlin, or Financial Markets that Check Moral Hazard in Europe’s Bailout Union? Most Likely the Latter!.
6. Frank Knight in his 1921 classic "Risk, Uncertainty, and Profit" introduced the distinction between "economic risk" and "uncertainty".
7. The average participation rate in the 2009 EU Parliamentary elections was 43 percent (See http://www.ceps.eu/files/book/1886.pdf), while in the 2010 US Congressional Mid-Term elections, participation was 41 percent (see http://elections.gmu.edu/Turnout_2010G.html). US elections in presidential election years typically have significantly higher voter participation.
8. The Acquis is the full body of EU law spanning everything that the EU regulates that new member states must implement prior to becoming EU members.
9. The principle of subsidiarity is the European functional equivalent of US states' rights issues. Stipulating that governing should take place at the level closest to the citizen at which is can be effective, it holds that the EU should only regulate issues that member states cannot themselves effectively deal with.