Today’s sovereign debt crisis in the euro area has been building up for more than a decade. Within the monetary union, the “one size fits all” interest rate could not stabilise the very different individual economies. Some countries were enjoying fast catch-up growth—in some cases at spectacular rates—and opening up their financial markets. Other economies were growing only slowly. Germany, which represents around a quarter of euro area GDP, was digesting the ending of the post-unification construction boom and undertaking major reforms. It exported and invested abroad, and built up savings at home. This dichotomy between slow and fast growing countries, and between savers and borrowers, led to large economic imbalances: the average current account from 2002 to 2007 was more than 5% of GDP in absolute terms, a huge number by the norms of previous decades.
The scale of the pre-crisis imbalances was the result of much more than just the “one size fits all” monetary policy. One problem was that national governments too often failed to keep their side of the bargain in joining the monetary union. Yet, without domestic monetary policy—handled by the European Central Bank—it is much more important for other policies to be set right at the national level. Instead, some countries ran budget deficits during years when the economy was overheating—so-called procyclical fiscal policies—and did not provide enough budget room for manoeuvre for the downturn. More importantly, a country in a monetary union needs to be flexible and to make sure that wages keep in line with productivity. Necessary reforms to market regulation and labour institutions, which the OECD and others repeatedly called for, were simply not made in too many cases.
Excessive risk-taking, lax lending conditions and weakness in financial regulation added to a credit binge and a build-up of debt as capital flowed to fast-growing countries. Without monetary union, exchange rates or interest rates could have adjusted, but not under a single currency. With real interest rates too low in countries like Ireland and Spain, there was a run up in private debt and huge housing booms. Bank lending from countries with high savings, such as Germany and France, was channelled into what quickly became overheating economies. At the same time, in the euphoria, financial markets mispriced sovereign debt, lending to Greece at an interest rate not much higher than that on German government debt. But despite the apparent success of convergence, monetary union concealed structural fault lines, which became starkly apparent after the financial crisis struck in 2008.
Euro area countries are now paying a high price for these mistakes through the sovereign debt crisis. Growth stalled and the euro area is now likely to underperform other major economies. Debtor countries have been the hardest hit. Greece, Ireland, Portugal and Spain, though each with quite different characteristics, have experienced sharp falls in activity and unemployment is at very high levels—as high as 50% for young Spanish people for instance. Excessive lending and borrowing in the private sector has provoked financial crises and made a large hole in the public finances. In the case of Ireland, the government debt-to-GDP ratio rose from very low levels to well above 100% of GDP in just a few years as the deficit widened and the government stepped into support the financial sector, the government itself requiring financial assistance from the EU and IMF. Rebalancing euro area economies and restoring growth will be a difficult task that will last for many years.
To get out of this crisis, Europe needs to act in the short term so that the underlying excessive build-up of imbalances and debt can be resolved. That means putting in place a credible “firewall” against the sovereign debt crisis and supporting demand as much as possible. At the same time, the public finances need to be put back on track and banks’ balance sheets need to be cleaned up and strengthened. More importantly, ambitious structural reforms are needed to boost growth prospects, improve debt sustainability and strengthen the cohesion of the whole euro area. The clear lesson from the first decade of monetary union is that major changes are needed to make monetary union work as it was intended. Economic and financial policies need to be much more effective than they were over the past decade in creating sustainable growth and financial stability.
The crisis has spurred European and other international policymakers into action. Substantial changes are being made to learn the lessons of the crisis, both at European level and in individual countries. Many of these changes would have seemed unimaginable before the crisis. A good example is the euro area’s European Stability Mechanism (ESM) coming into operation from July 2012 as a permanent crisis management fund. With a capacity to lend up to €500 billion (around 5% of euro area GDP), it is a firewall needed to help make sure that solvent countries can finance themselves even if markets turn against them.
Rules governing the euro area are stronger as the result of a wide-ranging legislative package, the so-called “six pack” covering fiscal and macroeconomic issues, and a new Treaty around the “fiscal compact” designed to keep national budgets in good shape. These initiatives should make sure that there is more surveillance of the build-up of imbalances in the future, including in private debt, and put pressure on countries to respond. But the main focus is on strengthening fiscal institutions both at EU and at national level. This is needed to make sure that fiscal management improves, as well as to ensure that the new rescue funds do not weaken budgetary discipline. With major new measures in place, the key challenge now is implementation. The past cycle of failure of countries—and that includes France and Germany—fully to apply the rules has to be broken.
The weak financial oversight that fuelled the imbalances is being tackled too. Europe is taking part in the international overhaul of its regulatory architecture. It has taken steps to improve cross-border oversight, creating upgraded authorities to co-ordinate supervision of banking, insurance and securities markets across the EU. There is a now a European Systemic Risk Board to look at macro-prudential risks. However, little progress has been made in some crucial areas. The close relationship between domestic banks and their governments has proven risky during the crisis. The lack of effective resolution mechanisms for banks, particularly across borders, if they get into trouble, needs to be addressed as a priority.
Ultimately, the best protection against any recurrence of the current crisis is to make Europe’s economies and financial system fundamentally more sound. Better surveillance and supervision can only do so much against an economy that is prone to instability. To become more stable within the euro area, national economies need to become more adaptable. Labour institutions have to ensure that wages stay in line with productivity. Tax incentives that encourage property bubbles need to be removed and planning laws reviewed. The banking system needs to become more integrated and diversified.
The euro area can be made to work economically. European policymakers have taken some important steps, but more time and effort will be needed to weather the sovereign debt crisis and ensure that excessive imbalances do not build up again in the future. Monetary union can work but more bold political decisions will have to be taken.
OECD (2012), Economic Survey of the Euro Area, Paris
©OECD Observer No 290-291, Q1-Q2 2012