How Should the EU Exit the Crisis?

Άρθρο της Προέδρου της "Κοινωνικής Συμφωνίας" Λούκας Τ. Κατσέλη

Prof. Louka T. Katseli

University of Athens 

President of “Social Pact”

Four years into an unprecedented financial and economic crisis, Europe is at a critical juncture. Economic activity is practically stagnant. The EU-27 unemployment rate has exceeded 10 percent. Inequality and poverty rates are increasing to record levels.

Europe is becoming rapidly segmented. A sharp divide is developing between surplus countries in the North and deficit countries in the South. In the North, unemployment remains low and social safety nets virtually intact. In the South, social systems are crumbling and large segments of the population are becoming marginalized. One out of two young Greeks

or Spaniards are unemployed with the overall unemployment rate  climbing to 30%.

 More than 400.000 families with children in Greece try to make ends meet with no single employed adult in the family. Sharp declines in personal after-tax disposable income or pensions have made middle class families in Portugal, Spain and Greece unable to pay debts and mortgages. They  are becoming rapidly over indebted if not impoverished. A growing number of productive-age adults and professionals are seeking employment abroad, in Germany, the UK and other European countries.

Confidence in the capacity of national governments, traditional political parties and European institutions to pursue credible policies so as to improve standards of living has been seriously eroded. Xenophobia and Euroscepticism are on the rise throughout Europe. In the South, austerity policies are perceived as unjust, ineffective or as having been imposed to serve creditors at the expense of the most vulnerable groups in society. In the North, most notably in Hungary, the Netherlands, Finland, Austria, France and Denmark, domestic residents are made to believe that they are paying a high bill to bail-out their profligate European Southern co-members, while they themselves have to cope with worsening economic conditions. According to the May IPSOS/CGI opinion, three out of four Europeans believe that the economic crisis will worsen in their own country; they view European institutions as incapable of reversing the trend and narrowing the growing divide between North and South.

Can the EU exit from this economic, political and social crisis? The answer is positive provided that the source of the European crisis is correctly diagnosed and appropriate measures and initiatives are taken to provide the appropriate cures.

The Diagnosis

The origins of the European crisis have been extensively analyzed by many authors. The subprime mortgage bond debacle that exploded in the United States in 2007 rapidly spread to Europe’s financial and banking sectors. Like their US counterparts, big international European banks, virtually unregulated and convinced that they would be bailed out by national governments if needed,  had proceeded to extend  cheap credit to  sovereigns, local governments and the private sector, covering their potential risks via derivatives and/or the securitization of loans. As documented by Lewis (2011) and others, hedge fund managers and speculators soon detected that  European sovereigns , namely Greece , Ireland, Italy, Portugal and Spain would be unable to avoid default or rescue their banks through new borrowing  if attacked;  amassed debts exceeded by large margins their projected tax revenues. A potential sovereign bond crisis would also rock the euro and the Eurozone .By the end of 2008, the market for government default insurance and credit default swaps started booming and speculation against the euro intensified.

 Greece was the first to be attacked at the end of 2009. Its downgrading by rating agencies in November and December 2009, brought about an unprecedented rise in spreads which eventually shut the country off from international markets and forced it to seek its first rescue package  in May 2010.In the meantime, between 2008 and 2011, Greek credit default swaps were up from 11basis points to 2300! Every 1,100 dollar bet made in 2008 returned 700,000 dollars in a few years (Lewis, 2011, p xiv) bringing about huge profits to market participants.

The unprecedented fiscal consolidation and austerity package agreed upon between Greece and its creditors in three successive Memoranda of Understandings in exchange for 240 billion euros in loans, plunged the economy into a deep recession.  The financial crisis produced a domestic liquidity crisis making households and firms  unable to obtain credit. The credit crunch in conjunction with the dramatic fall in disposable incomes made them unable to pay back their obligations.  The unsustainable Greek sovereign debt crisis was thus converted into a domestic banking crisis.

In Ireland, it was the Irish banks that were the culprits. They had proceeded to lend astronomical sums of money – approximately   106 billion euros according to some estimates (Lewis, 2011, p.85) - to property developers. The ensuing real estate bubble burst in 2008. The government’s decision to guarantee all debts of the affected banks brought about huge increases in the budget deficit and the collapse of an entire economy. The Irish bank debt was converted into Irish government debt. The domestic liquidity crisis that ensued, exacerbated by imposed austerity policies, brought about a severe recession and aggravated the overall debt problem.

Similar processes have characterized developments in Spain, Portugal, Italy, Cyprus and other European member states. Over-indebtedness, public or private in nature, spurred by an unregulated financial sector and the illusion of “implicit guarantees” and a risk-free Eurozone,  triggered  confidence crises in asset markets and speculative attacks in sovereign bond markets ; in view of the no- bailout clauses of the ECB Charter and the Lisbon Treaty, these led to large bail-out programs of European sovereigns through the newly created European Stability Facility Fund ( EFSF) and subsequently through the permanent European Stability Mechanism ( ESM) in exchange for severe austerity  and budget consolidation programs . The results have been devastating for large segments of European society.

The Outcome

Tables 1 and 2 present the salient features of the main countries at risk between 2008 and 2012.

Table 1: Main economic features: Italy, Portugal, Spain, Ireland, Greece, EU (2008)

	GDP*	General Government Gross Debt**	Current-Account Balance**	Annual Real Effective Exchange Rates vs Euroarea***	General Government balance**	Gross Fixed Capital Formation as (%) of GDP*	Unemployment Rate*
PORTUGAL	0.0	71.6	-12.6	101.94	-3.6	22.5	8.5
SPAIN	0.9	40.1	-9.6	102.84	-4.5	28.7	11.3
IRELAND	-3.0	44.3	-5.6	94.48	-7.3	21.8	6.3
GREECE	-0.2	113.0	-17.9	103.84	-9.8	22.6	7.7
ITALY	-1.2	106.1	-2.9	101.35	-2.7	21.0	6.7
EU17	0.4	70.2	-1.5	100.00	-2.1	21.5	11.4
EU27	0.4	62.3	-2.1	-	-2.4	21.0	10.5
* Annual percentage change
** As a percentage of GDP
*** 2005=100 (Price deflator, exports of goods and services)
Source: EUROPEAN ECONOMY 6|2011

Table 2: Main economic features: Italy, Portugal, Spain, Ireland, Greece, EU (2012)

	GDP*	General Government Gross Debt**	Current-Account Balance**	Annual Real Effective Exchange Rates vs Euro area***	General Government Balance**	Gross Fixed Capital Formation as (%) of GDP	Unemployment Rate*
PORTUGAL	-3.2	123.6	-1.9	102.61	-6.4	16	15.9
SPAIN	-1.4	84.2	-0.9	103.51	-10.6	19,2	25.0
IRELAND	0.9	117.6	5.0	96.35	-7.6	10,0	14.7
GREECE	-6.4	156.9	-5.3	111.02	-10.0	13,1	24.3
ITALY	-2.5	127	-0.7	100.88	-3.0	17,9	10.7
EU17	-0.7	90.6	1.2	100	-3.7	18.3	11.4
EU27	-0.4	85.3	0.3	-	-4.0	17.9	10.5
* Annual percentage change ** As a percentage of GDP *** 2005=100 (Price deflator, exports of goods and services), only for year 2012 2013 forecasts in parentheses Source: European Economic Forecast, EUROPEAN ECONOMY 2|2013, Spring 2013

  

Official debt to GDP ratios have increased  in all countries overshooting projections by a large margin ; despite the severe fiscal consolidation programs , public deficit to GDP ratios have either remained unchanged ( Ireland, Greece) or have sharply increased (Portugal, Spain). Financial sectors have become increasingly vulnerable as a consequence of  sovereign debt distress, liquidity shortages, capital flight and rising non-performing loans. Gross fixed capital formation has dropped by more than ten percentage points in almost all countries, with the exception of Portugal where the drop has been in the order of 8 percentage points. Growth rates are negative in all countries, except Ireland, and unemployment rates have soared. 

The massive decline in domestic demand, including investment demand, has resulted in temporary improvements in current account balances which, however, will not be sustainable if and when growth resumes. Overall price competitiveness has in fact deteriorated. Despite massive cuts in wages,   energy cost hikes, combined with tax increases and productivity declines have contributed to appreciating real effective exchange rates.  Last but not least, large segments of European society cannot make ends meet with poverty and inequality rising at unprecedented rates. In summary, the effects of the imposed programs have been disastrous.

The Cure

The realization that policy failures have crumbled economies and societies alike and the diagnosis provided above points to the appropriate cure for exiting the crisis.

What is required is an overhaul of policies and the pursuit of institutional changes that would jointly address the debt overhang problem, the investment slump, the liquidity squeeze and the social crisis. Unless the extreme austerity policies are reversed the soonest possible, there is a great risk that the Eurozone will crumble, the European project will be discredited and stalled and Europe will be severely weakened as a global power.

The Eurozone must cease to behave as a club of creditors. A testimony to that assertion is the Greek program. Between 2010 and 2013, Greece has borrowed from the Troika 219,2   billion euros . More than 97 % of this funding has been used to pay back creditors and to cover recapitalization needs.  The imposition of non-concessionary interest rates on official debt have exacerbated the debt dynamics. Less than 8 billion euros over four years have been used to support pressing domestic budget needs or channel liquidity to a starving market. More importantly, all funds from a primary budget surplus or privatizations need to be deposited in an escrow deposit account at the Bank of Greece to service future debt payments while legal provisions embedded in the loan agreements stipulate that, in case of inability to pay , creditors can seize national public assets.

The Eurozone needs instead to become a steward of decent livelihoods,  growth, jobs and enhanced opportunities for the younger generation.

What should be the elements of a progressive agenda for Europe and the Eurozone to exit the crisis?  A three-pronged strategy is urgently needed:

a)    Strengthening   Mutual Adjustment , Banking Supervision and Solidarity

Exiting the crisis requires the pursuit of more symmetric macro-economic adjustment rules across surplus and deficit countries to correct major imbalances in the context of an enhanced stability pact. It also requires   new financial instruments to mutualize risks and promote needed investments including a European Guarantee Facility, a Eurobond, or EIB- guaranteed development bonds . Timely action and institutional initiatives are needed   so that markets are convinced that the ECB or the ESM will intervene effectively in times of speculative attacks  to safeguard financial stability without  lengthy political processes or politically-motivated  delays. It took the combined statement by the Governor of the ECB that he “will do whatever it takes to save the euro” and the announcement that the ECB was ready to undertake Outright Monetary Transactions (OMT) - namely that it would   intervene without any limit in sovereign debt markets subject to  conditionalities imposed to a country under stress - to calm the markets.  Had the European Central Bank sent a similar signal to investors and speculators who were shorting Greek bonds in 2010, access to the markets could have been maintained and the costs of the crisis would have been mitigated.

 Moreover, decoupling is necessary between the need for funds of national banking systems  and domestic public finance. Banks that face a significant deterioration in their financial positions have to cease transferring the burden onto taxpayers. The June 2013 directive establishing a range of instruments to tackle potential bank crises, including bail-in clauses, was a step in the right direction. It might prove inadequate however, if a bank is “ too large to fail” and contagion  risks are involved. In such a  case, turning a Bank directly over to  the ESM so that the ESM itself and not the  national government would  proceed with full recapitalization and prompt resolution would “break the deadly embrace between insolvent national banking systems and insolvent member-states” ( Varoufakis et al. 2013) . Such a measure should not await the completion of a banking union which will take time to be implemented. 

Finally, effective oversight of the European banking system is urgently needed so as to safeguard transparency, competition and ethical banking practices. The massive concentration of resources and power in the hands of large international banks which operate with minimal regulation has become fertile ground for toxic financial products, inappropriate lending, extractive practices, corruption and successive crises . Tax audits for bank managers, regular reporting of bonuses and monitoring of lending practices for consumer protection are important components of a more effective regulatory framework. This was the central message of the 1998 CDP  report ( UN, 1998) which advocated the creation of a Word Financial Organization to set uniform rules of conduct for financial transactions.

b)Addressing the Debt Overhang and Securing Financing for Sustainable Development

Exiting the crisis in a sustainable manner requires addressing effectively the debt overhang, the domestic liquidity shortage and the investment slump.

Debt sustainability is a precondition for investment and growth. A large debt overhang dissuades potential investors , perpetuates financial instability and stalls growth.  When debt is judged  to no longer be serviceable, as is the case in Greece and maybe Portugal today, debt restructuring is urgently needed. Postponing the decision only exacerbates the debt dynamics and deepens the recession as proven by recent experience. By refusing to engage in timely  debt restructuring  in either 2010 or most of 2011, European leaders    sheltered   European banks against  potential losses from their large exposures in  Southern European sovereign debt which they then rapidly proceeded to divest; in so doing they transferred  large costs to European wage earners , pensioners , individual bond holders and taxpayers. The same costly inertia is present today, as official creditors refuse to admit the need for official debt restructuring, despite the IMF announcements to the contrary.    

Apart from debt restructuring, access to adequate and reasonably priced credit by viable firms, especially SMEs, needs to be urgently restored. Under present conditions, it will take a long time before liquidity is channeled to households and SMEs through the stressed national banking systems. Public action involving the creation of independent recyclable-loan vehicles, funded by a combination of official and private resources and/ or supported with guarantees issued by European institutions ( e.g. KFW or the European Investment Fund) would mitigate the recessionary impact of the liquidity shortage. The presence   of strong cooperative or public development banks can be similarly proven valuable in promoting competition, the channeling of liquidity to the real economy and adequate project and development financing .

Finally effective   resource management to attain realistic primary surpluses would facilitate the resumption of investment and growth. This is not only a national but also a European priority: the existence of unregulated tax havens and offshore platforms, the lack of European –wide agreements on disclosure and tax treatment vis- a –vis non- European member states such as Switzerland,  the systematic overpricing and underpricing of intra-  company transactions for tax advantages,  all promote capital flight and tax evasion . These problems require European collective action to complement much needed domestic structural reforms in taxation, public administration , governance and regulatory systems.

c)  Reversing Austerity , Providing Social Safety Nets  and  Promoting Policy Coherence  for Competitiveness and Jobs

In the presence of globalized markets, European competitiveness cannot be enhanced on the basis of drastic wage and asset-price reductions, rising unemployment and sharp declines in purchasing power. On the one hand,  developing countries and even many emerging economies are in a better position to reap low labor- cost competitive advantages than European countries. On the other hand, severe austerity measures and internal devaluations end up producing opposite results: the drastic reduction of disposable incomes and the massive closure of firms result in growing inability by households and firms to pay taxes, social security contributions or bank debts and mortgages with negative effects on budgets, debt and productivity.

In the long-run therefore, Europe’s competitiveness  can   be enhanced only through productivity-enhancing investments , R&D and  continuous innovation. These are the drivers that  would  make Europe a preferred destination for global enterprises,   an exporter of high value-added products and services and a provider of high-quality jobs. The implementation of such a progressive vision requires the pursuit of far-sighted and carefully planned structural reforms to open up markets, reduce the administrative cost of doing business as well as public-sector, educational and/or labor market reforms depending on country needs. It also requires a fair tax system, a growing public investment budget and accountable, transparent governance systems.  Finally, in the presence of fiscal consolidation programs, such reforms need to be complemented by coherent policies to secure decent livelihoods through active employment policies, the orderly restructuring of outstanding  loans, low-cost access to health systems and  the extension of carefully designed social benefits.

In summary, for the EU to exit the crisis, current austerity policies need to be reversed. They end up undermining not only the fiscal consolidation process and competitiveness but also social cohesion and democracy. 

A progressive alternative agenda for a competitive and cohesive Europe that places decent livelihoods, jobs and  democracy  as top priorities  does exist . What does not exist as yet is a collective determination to mobilize social and political progressive forces across countries and stakeholders to build a European Progressive Front for Decent Jobs and Livelihoods. This is the present day challenge for all progressive Europeans .

References

Lewis, Michael (2011), Boomerang: The Meltdown Room, Allen Lane

United Nations, Committee for Development Planning, (1998), “Asia’s Financial Crises: Lessons for Policy” Economic and Social Council, Official Records, Supplement, No. 14, pp.1-11.

Varoufakis, Yanis, Stuart Holland and James K. Galbraith , (2013), “A Modest Proposal for Resolving the Eurozone Crisis, Version 4.0”, (varoufakis.files.worldpress.com/2013/07/a-modest-proposal-for-resolving-the-eurozone-crisis-version-4.0-final1.pdf)