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Faculty Interview: David Cameron on the Eurozone Crisis


Over the past two years, Greece, then Ireland, then Portugal, and then Greece again, have had to obtain large amounts of financial assistance from the EU and IMF. Recently, the crisis has spread to Italy and Spain, and some observers doubt the eurozone will survive. Where do things stand now?

Compared with the situation a couple of weeks ago, things have stabilized a bit, but it’s still quite precarious. There’s a new government in Greece, headed by Lucas Papademos, an economist and former vice president of the European Central Bank, that is supported by PASOK, New Democracy and another party. Greece will soon approve the second EU-IMF financing package that will provide €130 billion over three years on top of the €110 billion that was approved in May 2010. However, the economy is mired in a deep recession; unemployment has risen dramatically; the Greek public continues to suffer the consequences of the several rounds of deficit reduction measures and austerity packages required by the EU and IMF in exchange for the financing; there is still no agreement about reducing the debt that by now totals €360 billion and, all agree, is unsustainable. Even with a new government, Greece is in dire straits. It needs to clean up and reform its tax collection system, institute significant reductions in spending, and undertake wide-ranging reforms to make its economy competitive with the others in the eurozone. And it needs a very substantial amount of debt relief. Since 2007, its debt/GDP ratio has increased from 107 percent to 163 percent, and the new bailout will take it above 200 percent. It will receive another tranche from the 2010 bailout and will avoid defaulting on the €8 billion in bonds that reach maturity in December. How much longer it can hold on without a substantial reduction in its debt is uncertain. Certainly the bond markets, where the price of Greek 10-year bonds has dropped so low that the yield is now in the vicinity of 30 percent, are assuming Greece will default at some point.

What about Italy?

The problem in Italy isn’t the budget deficit, although there is one, and the former government headed by Silvio Berlusconi dragged its feet for months in approving a series of deficit-reducing measures. The real problem is the magnitude of its public debt – €1.9 trillion, equal to more than 120 percent of GDP and greater than the combined debt of Greece, Spain, Portugal, and Ireland. €300 billion of that debt matures by the end of 2012; €900 billion reaches maturity over the next five years. Meanwhile, the Italian economy is barely growing; the debt/GDP ratio, which was 103 percent four years ago, has been steadily increasing; and the government has failed to introduce the measures necessary to stimulate growth and increase the competitiveness of the economy.

The result is that, even with a modest deficit – about 4 percent of GDP – the debt/GDP ratio has been increasing steadily and the markets are questioning whether Italy will be able to pay bondholders the €300 billion due on the bonds that mature by the end of 2012 and the €900 billion due on the bonds that reach maturity over the next five years. In May 2010, the EU created the European Financial Stability Facility to deal with the possibility that the debt crisis would spread from Greece to other eurozone members. The EFSF, which can borrow up to €440 billion to lend to eurozone members, was used to provide, with the IMF, financial assistance for Ireland last November and Portugal in June. However, it’s not enough to stand behind €1.9 trillion of debt and it’s not obvious the EU will figure out a way, as it hoped several months ago, to “leverage” the EFSF’s resources into the €2 trillion it would need to do that effectively. While Italy is “too big to fail,” it would appear that it is also “too big to bail.” In other words, its future lies in its own hands.

There is, however, one very favorable development: Berlusconi is no longer prime minister. After the government suffered a number of defections on a critical vote in early November, a number of individuals in the governing coalition – most notably, Umberto Bossi of the Lega Nord – as well as many others, called for him to resign. He did so, and a few days later President Napolitano, who played an important role in the transition, named Mario Monti, a highly respected economist and former Commissioner of the EU for the internal market and competition, as prime minister. Monti subsequently formed a government consisting mostly of academics, lawyers and other professionals, which was approved by a large majority in both chambers of the Parliament and will remain in office until the 2013 elections.

There’s been some concern about Spain as well. What’s the situation there?

Spain has a larger deficit than Italy – almost 7 percent – but its debt/GDP ratio is much lower, about 70 percent. The real problem in Spain is not so much in the public sector, although the deficits of the regional governments are a real problem, as in the private financial sector. After the real estate and construction bubble in Spain burst in late 2007, the provincial savings banks, the cajas, as well as some of the large commercial banks that borrowed heavily in the boom and made loans for real estate and commercial development, found themselves owing large amounts to other European banks and sitting on non-performing loans. To its credit, the Zapatero government undertook early on, in the spring of 2010, a modest austerity program and, later, a program to consolidate and recapitalize the cajas. However, the austerity program resulted in continued economic stagnation and a sharp increase in the already-high rate of unemployment. As happened in Ireland in February and Portugal in June, the combination of sustained economic contraction, prolonged austerity, and high and rising unemployment, contributed to a huge defeat for Zapatero’s Socialist party at the hands of the center-right Popular Party of Mariano Rajoy on November 20. Indeed, the Socialists received their smallest share of the vote in any election since Francisco Franco’s death on the same day 36 years earlier.

What lies ahead? Will the crisis continue? Will the eurozone break up? What will the EU do?

I don’t think it will break up because all of the members understand that, for different reasons, the status quo is preferable to a smaller eurozone or no eurozone at all. The important thing to remember is that all of the eurozone economies are open economies; they are highly dependent on trade. And they are highly interdependent; on average, about 70 percent of their trade is with other eurozone members. Having a single currency eliminates what would otherwise be substantial impediments to trade, as well as to investment and travel. Returning to national currencies with varying exchange rates wouldn’t repair the underlying problems in the economies of Greece, Spain, Portugal, and Italy, and would create new ones not only for them, but for the stronger economies of northern Europe.

That said, it is the case that the crisis has brought the eurozone and the EU to a clear fork in the road. One fork involves more of the same – muddling through each crisis reacting to the markets, extending (assuming they have sufficient resources) huge packages of financial assistance, and demanding as the price of that assistance multiyear austerity packages that prolong and deepen the economic contraction and only add to the need for more assistance. The other fork involves repairing what is perhaps the single most important defect in Economic and Monetary Union. Despite the EU’s Stability and Growth Pact, the eurozone hasn’t been able to rein in the excessively large budget deficits of many of its members. Despite having as one of its entry criteria a debt/GDP ratio of less than 60 percent, many members have much larger debt/GDP ratios. Although it is certainly a monetary union – there is a single central bank responsible for monetary policy and a single currency – the eurozone is not, despite the E in EMU, an economic union. It’s not entirely clear what “economic union” means. But the failure to enforce strict adherence to the Stability and Growth Pact, coupled with the absence of any procedure to ensure that excessive debt-to-GDP ratios are reduced, suggests that an essential missing element has been the inability of the eurozone members to exercise some degree of collective authority over the fiscal policies of participating member states.

Many EU leaders understand that. As early as March 2010, the heads of state and government of the euro area expressed a view that the European Council must improve the economic governance of the European Union and increase its role in economic coordination. Since then, the belief has strengthened among many that the eurozone must transform itself into an economic or fiscal union. For example, in his Karlspreis address in Aachen in June, Jean-Claude Trichet spoke of the need to strengthen the institutions of economic union and suggested euro area authorities will need a much deeper and authoritative say in the formation of a country’s economic policies – possibly the right to veto its decisions – if they go astray. Not long ago, Wolfgang Schäuble, the German finance minister, said, “The time has come to accelerate the process of changing the political and institutional structures of the Union toward a political and fiscal union.” And offering a diagnosis that has become increasingly popular, especially in Germany, he said, “the answer to the crisis can only mean more Europe.”

In October, the heads of state and government of the eurozone agreed to strengthen the economic pillar of EMU and make the economic union commensurate with the monetary union. They asked the Presidents of the European Council, Commission, and the Eurogroup to identify possible steps toward that end, including possible limited Treaty changes, and to provide an interim report at their meeting on December 9, at which they will agree on “first orientations.” Those changes, if agreed by all and if substantial enough – two big ifs – may put the eurozone on the road toward “more Europe” and perhaps even fiscal union. Whether that will convince the markets that the eurozone can and will weather the storm remains to be seen.