The Crisis of Sovereign Debts and the Process of European Integration

, by Ignazio Visco

The Crisis of Sovereign Debts and the Process of European Integration

The introduction of the euro has been a fundamental step in European history, a political event that testifies to the progress made on the road of integration, a profound economic and social change; but it has been, precisely, a step, not the conclusion of the journey, still long and difficult.

Of this was fully aware Tommaso Padoa-Schioppa, who has contributed so much to the realization of the monetary union. Tommaso Padoa-Schioppa was writing in the pages of the Corriere della Sera: “the macro-economic policy capacity [of the European economic and monetary union] is, except for the currency, embryonal and unbalanced. […] For the European Central Bank the real danger will not be its scarce independence, but its too great solitude […] as it operates almost in the vacuum, without a political power, a budgetary policy, a banking supervision, a control function over the financial markets. […] Is right therefore not only who applauds yesterday’s achievement, but also who points to its incompleteness, its risks, its temerity”. That same incompleteness is feeding, since 2010, the crisis of the eurozone’s sovereign debts.

In the absence of a political union, the area’s economic governance is based on a fragile union of market forces and rules of conduct. On the first ones, reliance was made for the economic convergence between member countries, and for the definition and implementation at the national level of the necessary structural reforms. To the second ones, resort was made to assure the pursue of prudent budgetary policies: already in the Delors Report of 1989 it was stated, in fact, that for public finance “the restrictions imposed by the market forces can be too slow and weak, or too quick and overwhelming”.

Economic convergence has been slow and difficult; in some cases distances have even widened. In many economies, delays and obstacles in adapting to the great global changes have weakened competitiveness and growth capacity. Made milder by the improvement of financing conditions following the introduction of the euro, the market pressure alone was not sufficient to support the necessary efforts of reforms. Measured on the basis of the unit labor cost in the entire economy, the losses in competitiveness recorded between 1999 and 2008 in the countries most harshly hit by the crisis range from about 9 percentage points in Greece and Portugal to 12 in Italy, 19 in Spain, up to 37 in Ireland. Considering only the manufacturing industry and the competitiveness indexes based on prices at production, losses in competitiveness range from 7 percentage points in Italy to 22 in Portugal (14 in Spain, 16 in Ireland and 18 in Greece).

The public finance rules agreed for the European area have not been always respected. In 2007, almost a decade since the start of the single currency, only a few countries were recording balanced budgets in structural terms – that is, neglecting the effects of the economic cycle on revenues and expenditures. In some cases, public debt was still at excessively high levels in respect to the product. Financial markets have long underestimated sovereign risks, confirming the doubts about their capacity to timely provide incentives to the adoption of virtuous behaviors: until the burst of the crisis, the differentials of State securities’ yields within the area were close to zero.

In that framework, after the financial crisis in the USA and the very serious global recession of 2008-2009, the final evidence of the non-sustainability of public accounts in Greece produced tensions that extended later to the economically weaker countries of the area, characterized by an excessive public and private indebtedness, an unbalance of their foreign accounts, low competitiveness, low economic growth. The tensions increased due to the burst of the real estate bubble and the ensuing bank troubles in Ireland. With the announcement of the involvement of private investors in the restructuring of the Greek debt, in the Summer of 2011, the financial markets suddenly realized the implications of the prohibition of rescuing actions to member States, imposed by the Treaty instituting the Union; there followed a very serious confidence crisis on the single currency’s capacity to withstand, with significant consequences on the real economy of individual countries and of the area as a whole.

To the determination of the differentials between State securities yields in the euro-area two components are contributing, one “national” and the other “European”, linked respectively to the weaknesses of the area’s individual economies and public finances (the “sustainability risk”), and to the incompleteness of the area’s institutional design, with the ensuing worries about a breakup of the monetary union (“redenomination risk”). Europe reacted to the sovereign-debt crisis with a strategy articulated on two fronts: on the one hand, the individual countries committed themselves to put in place prudent budgetary policies and structural reforms to support competitiveness; on the other, an articulated reform process of the Union’s economic governance was started.

The reform of the European governance, drawn up in emergency conditions with a not-always-linear process characterized by uncertainties, overlaps and redundancies, coupled with the efforts carried out at the national level, has anyway started to reconstruct the confidence relationship among member States. Before that, cohesion within the Union had been severely tested by the repeated violations of budgetary rules – not only the most recent events, but also the ones that led to the first reform of the Stability and Growth Pact in 2005 –, and by the difficulty to thoroughly appraise the conditions of the national financial systems, subjected to rules and supervision practices still widely differentiated. The strengthening of budgetary rules, above all in the preventive phase, and the extension of multilateral supervision to macroeconomic unbalances, have gone hand in hand with the institution of mechanisms for the management of sovereign crises, and have laid down the bases for going ahead with the banking union, for discussing again about the budgetary one, and for designing the political union.

Until two years ago, Europe was lacking the instruments for managing sovereign crises. The first interventions in support of Greece, and to a lesser extent Ireland, were carried out through bilateral loans. In May 2010, the European Financial Stability Facility (EFSF) has been established, a temporary instrument used also for Portugal and operative until the current year, whose issues of bonds are guaranteed by the member States. In July 2011, alongside the EFSF, the European Stability Mechanism (ESM) has been established, a permanent mechanism for the management of crises instituted by international treaty and endowed with a capital of its own; the ESM loans to Spain have been earmarked for aids to the banking system.

The overall lending capacity assured by those instruments, amounting initially to 250 billion euros, has been gradually raised to 1700 billions. The intervention mechanisms that when the EFSF started were limited to issuing loans in the framework of plans supporting countries in difficulties, have been gradually widened to include, subject to a suitable conditionality, interventions on the primary and secondary markets of public securities, the opening of precautional lines of credit, the financing of the re-capitalization of financial institutions.

Between 2010 and 2012, the European countries, directly or through the EFSF and ESM, have issued loans to partners in difficulties for about 280 billion euros. Italy has contributed with resources for about 43 billions, of which 27 for loans by the EFSF, 10 for bilateral loans, and 6 for building up the ESM capital; according to the official projections, Italy’s contribution will increase to 55 billions in the current year, and to almost 62 in 2014.

Once acknowledged the necessity to overcome the asymmetry between the oneness of monetary policy and the multiplicity of national budgetary and structural policies, a new program of gradual strengthening of the economic and monetary Union has been initiated. The Plan for a genuine and deeper economic and monetary Union, published by the European Commission last November, and the Report Towards a genuine economic and monetary Union, presented in June 2012 and updated the following December by the President of the European Council in close cooperation with the Presidents of the Commission, the Eurogroup and the ECB, define its stages. They lead to the banking union, to the creation of an autonomous capacity to collect resources (fiscal capacity) for the whole euro-area, to a common public budget, and prospectively to the political union.

The awareness of those dangers led, in the Summer of 2012, to the announcement by the ECB Directive Council of new intervention modalities in the secondary market of State securities (the Outright Monetary Transactions, OMT). Confronting the excessive rise of sovereign yields, when this originates from the re-denomination risk and distorts the transmission mechanism of the monetary policy, falls completely under the mandate of the Eurosystem.

The announcement of the OMTs has averted a financial collapse with potentially devastating consequences for the European economy: all the countries benefited from that, not only those in the midst of a sovereign debt crisis.

The management, at the beginning of the current year, of Cyprus’ banking crisis, arrived at a solution only after coordination difficulties between European and national authorities had come to the surface, has further stressed the importance of the banking union project, in order to break the spiral between sovereign debt and the condition of banks and credit. The creation of a single supervisor, hinging on the ECB and the national authorities, is a first step; it must be completed with a common scheme for solving the banking crises and with a common insurance for deposits.

In addition to the banking union, there must be the prospect of a budgetary union, and finally a political union. Interviewed by la Repubblica on October 6, 2008, Padoa-Schioppa noted: “Seeing a prophecy/warning become true, there is more bitterness than satisfaction. I spoke, at the beginning of the euro, of the dangers of “a currency without State”. It is clear that more European State was needed, not less European currency: without the euro, Europe would experience today days of catastrophe. One of the reasons for the discredit of the national leading classes and of the crisis of politics is that some people continue to nurture the illusion that the national powers are able to face problems (energy, climate, finance, security, immigration, primary goods) which are not national, but continental and worldwide”.

Those words, enunciated before the burst of the sovereign debt crisis, are very topical. We must continue to increase the coordination of economic and structural policies, and the incentives for reform, we must pass from a management of an inter-governmental type, based on the peer review of national policies, to the working out of veritable common policies. We must clearly define their outlines, and fix the timing for the realization of the project of a common public budget of the euro-area.

Economic and political reforms are not independent of one another: the confidence in the prospect of the economic and monetary Union would be given a great benefit by new concrete steps, even in a few sectors, in the direction of political integration. In an essay written forty five years ago (Technology and economics in the controversy over the gap between America and Europe), Nino Andreatta was already highlighting how important would be a serious estimate of “the negative consequences of the presence of a multitude of provisioning policies by part of the national administrations, policies that are producing an inefficient proliferation of research efforts in the individual countries and are slowing down the growth of market dimensions”. The reflection on the opportunity and the necessity by part of our national States to overcome the stage of contest and cooperation, and to pass to pooling together institutions and policies that have a significant impact on public budgets – in different fields like defense, scientific research, infrastructures (not only material ones) and other fundamental sectors of public activity – is going on for a long time, and is ripe enough for giving rise to concrete reforms.

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