ECONOMICS:Better co-ordination of economic policy and a €750 billion bailout should be enough to rescue the euro zone, writes BRENDAN LYNCH
EUROPEAN MONETARY Union (EMU) has had its first full-blown crisis. A major ingredient of the crisis was the fundamental weakness of EMU, which is the absence of political union and a federal European government.
The crisis began in late April with a sudden deterioration in Greece’s public finances and resultant difficulties in funding the Greek deficit in the international bond market. But the crisis quickly broadened and on May 7th, the international bond market had a sudden market failure that could be described as a market heart attack.
Major risks suddenly appeared for all sovereign bond market funding and especially euro zone states. It became imperative that the EU introduce a new initiative over the following weekend or EMU might have collapsed.
Opportunistic speculation may well have been an ingredient in the EMU debt crisis but shaky fundamentals were a big part of the problem. Cash rich investors are justifiably nervous. They can’t trust banks, except as far as they are guaranteed by governments. But government borrowing is very high; the US is 11 per cent of GDP, Germany is 5.6 per cent, France 8.4 per cent. Investors have major doubts over the sustainability of the current economic policy framework in the developed world, especially whether the largest budget deficits since the second World War can be reduced over the next four years to the 2 per cent range.
There are real investment issues concerning some euro zone states; for instance, justifiable doubts about Greece’s capability to service its national debt in the medium term. There were also doubts about Spain’s ability to reduce its budget deficit to 3 per cent of GDP relatively quickly.
The EU (27 states) and the euro zone within it (16 states) is a unique constitutional and economic entity. While it is definitely not a federal state, sovereignty is shared between the states and there is a single economic market. There are strong supra-national institutions like the EU Commission and the European Central Bank (ECB). EU law has “supremacy” over national law in all member states.
There is a legal agreement between the member states (the Growth and Stability Pact),which is also enshrined in EU law, to limit the budget deficits of member states to 3 per cent of GDP and if they rise above that to bring deficits back below 3 per cent in a short time in agreement with the other member states.
The political, legal and economic construct of Economic and Monetary Union in the EU resulted in the government bond yields of the member states coming quite close together, despite the absence of a federal state. This resulted in large savings in government debt interest for countries like Italy, Greece and Ireland.
The question was always going to arise at some point as to what would happen if a significant default risk emerged for a euro zone state. Now we know most of the answer. After the bond market collapse of May 7th, a special meeting of EU finance ministers reached agreement for support, over and above the specific Greek bailout.
Firstly, a bailout fund was created for euro zone state bonds that could amount to the very high level of €750 billion, which would be funded by all euro zone states. Secondly, the European Commission published proposals called “Reinforcing economic policy co-ordination”, which represented a good compromise for reinforcing the stability pact and enhancing economic co-ordination.
In addition, the ECB independently decided to directly buy euro zone sovereign bonds.
EU economic law already includes quite a degree of consultation and collective review of the member states’ economic policies. The stability pact forces member states with budget deficits above 3 per cent of GDP to get EU Council of Ministers’ approval for their annual state budgets.
The new proposals will force all member states, including those with deficits below 3 per cent, to subject themselves to a high degree of economic and fiscal policy surveillance and collective review by other member states and the EU Commission with regard to possible changes in economic policy and their annual budgets.
Following recent announcements of fiscal austerity measures in Greece, Spain and Portugal, those countries are now targeting budget deficits of 7.6 per cent, 6 per cent and 4.6 per cent of GDP in 2011. Ireland’s current target for 2011 is 10 per cent, following a likely 15 per cent plus in 2010. Furthermore, the tax revenue projection for 2011 is based on an optimistic 3.3 per cent economic growth rate in 2011. The political and economic reality is that it is not feasible for Ireland to have a budget deficit target in 2011 that is considerably higher than any other euro zone state and especially Greece, Spain and Portugal. There is no doubt the Government will have to propose tough austerity measures to achieve a budget deficit that is probably no higher than 8.5 per cent of GDP in 2011 and possibly below 8 per cent of GDP. This will mean spending cuts and tax increases that are much more than the proposed €3 billion the Government has indicated to the media.
EMU has been bloodied in a major crisis, but has survived. If the stability pact measures are enacted into EU law along with the €750 billion bailout fund, there is a good chance that EMU will emerge stronger and more likely to survive for a long time than before it was tested in the recent crisis. These additional supports for EMU also represent another step towards greater economic and political integration in the EU.
Brendan Lynch is an economist and author of EMU: Ireland's Dream Start, published by the Institute of International and European Affairs. He was an economic adviser to the Rainbow Government in the 1990s
