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European leaders met on June 28–29 for the 19th time since the euro area debt crisis broke in early 2010. Once again, the leaders took decisions to do what is necessary to prevent a full-scale collapse of the euro area economy and financial system. Only time will tell whether they have put in motion what it takes to end the crisis. This uncertainty is for two reasons: One normally does not know whether an economy has passed the bottom of a crisis until three to six months after that point, and, in the European case, much more remains to be done, leaving considerable scope for slippage, reversals, and missteps.
The European Union summit was expected to address three topics: a banking union at least for the euro area; a better backstop for the countries in crisis; and promotion of European growth. On each topic, some progress was made. But was it enough?
With respect to the banking union, my take is that the proposed steps promise to break the vicious circle between banks and their weak balance sheets on the one hand and governments and their weak balance sheets on the other. This break would be achieved by allowing the European Financial Stability Facility (EFSF) cum European Stability Mechanism (ESM) to support banks and banking systems directly and create a single supervisory mechanism for the euro area. However, we will not know for months whether these initiatives will be implemented because the summit decisions are contingent on completing a negotiation over the next several months. In addition, we have the delicate problem of deposit insurance and whether prospective mechanisms to provide euro-area-wide deposit insurance will in fact cover banks in Greece. If they do not, the potential for an accelerated run on Greek banks remains and could likely spread to other euro area jurisdictions.
With respect to providing a backstop for countries in crisis, the summit agreed to loosen some of the policy constraints on Greece, Ireland, Portugal, Spain, and Italy on the terms of access to credit and support. However, the firepower of the EFSF/ESM has not been enhanced. Demands on the financial resources of those mechanisms have been increased in order to support banks and sovereign bond prices and to provide a lifeline for Cyprus, a recalibrated program for Greece, and a second program for Portugal. The Europeans have discussed granting a banking license to the ESM, or to the EFSF prior to the ESM's coming into full operation, which has not yet happened. This would enable the EFSF/ESM to leverage its capital with liquidity from the European Central Bank (ECB). I suspect that this step ultimately will be what it takes to turn the corner on the euro area crisis.
With respect to growth, the European Summit produced a Compact for Growth and Jobs. But let's be frank, there is nothing in that compact that promises to contribute to growth in Europe over the next 18 months. That is the relevant timeframe if the economic and financial health is to be restored to Europe. Indeed, the Compact calls for “differentiated growth-friendly fiscal consolidation.” These fine words will soon be put to the test as deepening recessions in euro-area economies push fiscal positions further into deficit.
For this reason, the ball is now in the court of the ECB. The political leadership of the euro area has taken several important decisions. The Governing Council of the ECB must follow through on those decisions when it meets on Thursday July 5 if they are going to have a chance of being implemented.
The ECB should take four decisions: First, the ECB should lower its refinancing rate by at least 50 basis points from the present 1 percent. In light of the ongoing euro area recession, this exercise of conventional monetary policy is long overdue. Second, the ECB should restart its long-term refinancing operations (LTRO) to try to reliquefy the euro area banking system and restart the moribund interbank market. Third, the ECB should at least signal a willingness to restart its securities market program (SMP) if necessary as a bridge to the use of the ESM to support the secondary market in sovereign bonds. Fourth, the ECB should at least signal a willingness to consider granting a banking license for the EFSF/ESM. Again, this would be an insurance policy and a potential bridge to a more operational fiscal union in the euro area.
Some view the euro area crisis through the lens of political economy and as a necessary step toward building a more complete European Monetary Union. Of course, all economic policy is a combination of the economics and the politics. The political economy of Europe over the past two and a half years has been dangerous on both political and economic grounds.
European political economy has been dangerous politically because of the exercise of brinkmanship, most prominently displayed by making an example out of Greece to coerce both the leaders of that country and other countries to shape up. Such brinkmanship threatens to undermine the cohesion of the European integration project. Certainly there should be no permanent place in that project for realpolitik, the exercise of raw power. Bullying is not cooperation. Nor is it an efficient, sustainable route to the promotion of a greater sharing of sovereignty.
European political economy has been dangerous economically because of the high price it has extracted within the euro area and imposed on the rest of the world. If someone had said in January of 2010 that the crisis in Greece, a country with a GDP of less than 3 percent of total euro area GDP and less than a half of a percent of world GDP on a purchasing power parity (PPP) basis, would be allowed to fester and spread to five other euro area countries, including Spain and Italy, with the objective of instilling economic and financial rectitude in the other members of the euro area and of laying the foundation for a more perfect European Union, most observers would have been appalled. The European sovereign debt crises illustrate what happens when a group of countries fail to effectively share sovereignty ex ante or to cooperate effectively in a crisis.
Starting in May 2010 the Europeans endeavored to create a firewall to prevent the spread of the Greek crisis to other countries. They should have developed a safety net for those countries that followed Greece into crisis because of the way the Greek crisis was mishandled. Either way, the economic costs of those failures are substantial and inexcusable.
Over the past year or so, the principal negative element affecting the global economy has been the euro area crisis. In April of this year, the International Monetary Fund (IMF) staff forecast in their World Economic Outlook that the level of world economic activity in 2013 would be 1.5 percent lower than they had forecast only one year previously. The associated loss of world GDP amounts to $1.1 trillion.1 The IMF forecast in April assumed that the Europeans would be successful in dealing with the euro area crisis, but over the ensuing three months, the crisis deepened.
For the euro area alone, the projected shortfall of economic activity is 2.5 percent or $730 billion, which is more than two times the total annual GDP of Greece in 2010 ($305 billion). Even for Germany, the projected shortfall economic activity in 2013 is 1.5 percent. The lack of cooperation in Europe, based largely upon in inability to recognize the needs of their common sovereignty, has been expensive. Put the other way, the benefits of having the ex ante basis for greater cooperation (which would have required the symbolic abandonment of largely useless sovereignty within the euro area) would have been significant if European leaders and the general public in Europe were prepared to take the necessary steps. Whatever the outcome of the European sovereign debt crises, the euro area faces a continuing decline. A reasonable prediction is a decade of stagnation with real growth averaging less than 1 percent per year.
Turning to the economic costs that the euro area crisis has imposed on the rest of the world, for the advanced countries as a group, the IMF's projected shortfall in 2013 economic activity is 0.9 percent, or $1.3 trillion. In other words, Europe has imposed a loss of about half a trillion US dollars on the other advanced countries. The projected shortfall in economic activity in 2013 on average for the emerging market and developing economies is also 0.9 percent; all subgroups, starting with Central and Eastern Europe and the countries in the Commonwealth of Independent States, are projected to have lower levels of economic activity. For the emerging markets and developing countries, there is no projected loss in the dollar value of their projected GDP in 2013 because of the 8.7 percent appreciation of these countries' currencies against the US dollar on average since 2010.2
My grandchildren have introduced me to a game called Forbidden Island. It is an unusual game in that the players must cooperate in order to win the game and escape the island before it disappears into the sea; either all win or no one wins. We are far from this type of common sovereignty in Europe. For this purpose it is not enough to declare that the shared objective is to preserve European Monetary Union and the euro. Declarations of determination alone will not save the euro area. Cooperative, concerted actions are required based on a common strategy.
The European leaders this time have offered a more hopeful approach than in the past in both form and substance, but Europe could still be headed in the wrong direction unless the ECB builds an appropriate bridge on the structure of the decisions taken at the June summit and the political process implements those decisions comprehensively and expeditiously.
Notes
1. In the growth rate calculations, I have cumulated the growth rates predicted by the IMF staff for the 2011 to 2013 period in April 2011 and April 2012 and taken the difference. In the estimates of lost GDP, I have calculated the percentage change in the level of GDP in US dollars from a base of 2010 to 2013 in the April 2011 World Economic Outlook (WEO) forecast and applied it to the base of 2010 in the April 2012 forecast, and taken the difference.
2. A calculation based on WEO projections of GDP on a purchasing-power-parity basis produces a global loss in 2013 GDP of only $904 billion, with a loss for the euro area of $239 billion (26 percent of the total). The loss for the emerging and developing countries as a group is $370 billion, 40 percent of the total.
