Despite recently experiencing an overall economic uptick, the eurozone remains fragile and uninsured against the risk of another crisis. And a major reason is that it is still vulnerable to asymmetric boom-and-bust cycles.
Simply put, while all eurozone members can benefit during good times, some suffer far more than others during busts. This means that whenever the next crisis hits, safety-conscious investors will flee from fiscally weak countries toward fiscally strong ones that have a proven track record of generating economic growth.
When the economic calculus reverses, we can expect to experience a sense of déjà vu. Each country’s gain will entail another country’s loss, which will undermine inter-eurozone cooperation and fuel political tensions. The effects will likely reverberate through each country’s domestic politics, strengthening forces that favor disintegration.
To be sure, reforms that were implemented in response to the last crisis have improved the situation at the aggregate level; but they have not resolved the eurozone’s fundamental asymmetry. Underlying fiscal positions still vary from one country to another, despite all the efforts to achieve fiscal convergence through top-down rules.
Likewise, Europe’s financial-sector reforms in recent years, while significant, have not provided an adequate solution to the problem. The European banking union has now partly muted one of the primary channels – domestic banks – through which public debt piled up during the last crisis. Financial supervision has been placed at the EU level, rather than being delegated to national authorities. And government bailouts have been replaced with creditor bail-ins, at least when the latter does not threaten financial stability. But none of this will avert the need for public bailouts when the next crisis hits, out of fear that financial contagion will amplify the initial market reaction.
At the same time, Europe’s new crisis-management tools have obvious limitations. With a lending capacity of only €500 billion ($535 billion), the European Stability Mechanism (ESM) will likely not make much of a difference in the next crisis. An alternative option would be to activate the European Central Bank’s “outright monetary transactions” program, in which the ECB would purchase eurozone member states’ bonds in secondary markets. But the OMT, announced in September 2012 but never applied, would be politically difficult to implement. And because, like the ESM, it is conditional, it would do nothing to alleviate the tension between creditors and debtors.
In fact, even a second round of the ECB’s Public Sector Purchase Program would not solve Europe’s asymmetry problem. Because the ECB, together with national central banks, buys government bonds in proportion to each country’s share of ECB capital, the PSPP cannot privilege the countries that are under stress.
High-debt countries are limited in their ability to pursue proactive fiscal-stimulus policies. During the peak of the last crisis, some countries had to spend over 5% of their GDP just paying interest on their outstanding debt. And even after the market turmoil ended, and the PSPP brought interest rates down, high-debt countries last year still spent an average of around 3-4% of their GDP on interest payments. Most of these countries are far from being insolvent. But their debt is like a straightjacket, limiting their capacity to deliver economic growth in good times, and posing a liability in times of crisis.
A formal debt restructuring is often offered as an alternative to ineffective supranational and national fiscal frameworks. In this scenario, market supervision would replace political supervision. But, because some countries are still clearly more vulnerable than others, introducing a debt-restructuring program now would scare investors away from those countries, thereby doing more harm than good.
In the short term, policymakers should explore other avenues for solving the public-debt overhang. The PSPP, as it is currently constructed, allows repatriation of interest on bonds purchased by the ECB and national central banks. But interest savings are modest, because the ECB is formally limited from buying more than a certain amount of each country’s government debt. Lifting this limit would permit the existing framework to be used in the future to alleviate some countries’ fiscal burdens.
Meanwhile, the ECB would need to play a different and more distant role than it has. And independent authorities – such as the European Commission or even an entirely new institution – would need to ensure that savings were put to productive use in each country.