Greece and Spain have just had their credit ratings downgraded, while Ireland and Italy have been put on a negative credit watch. Sovereign debt spreads, which were extremely (abnormally?) low following their adoption at the euro, were evidence of the lack of discrimination concerning risk. Spreads have widened considerably, especially in the last few months, just as governments are rushing to set up economic stimulation packages that will force them to call on more market funds in the future.
The countries that have been hit hardest have high public debt ratios (Italy, Greece). The others are just coming out of a period of strong growth largely fuelled by an upsurge in private debt, which has helped keep down the amount of public debt. This period is now over. While the recession has reduced fiscal revenues, the consequences of excessive debt loads on the financial sector have led governments to buy up “toxic” debt and to extend guarantees. The deterioration of public finances is now inevitable.
The lack of discrimination towards risk in recent years has resulted in low interest rates that have stimulated private debt. The results were not only strong growth, but also the rise of imbalances (such as the Spanish current account balance) and the erosion of competitiveness. Between Q1 2000 and Q2 2008, unit labour costs rose only 0.6% in Germany, but soared by more than 28% in Italy and Spain.
Unsurprisingly, this has rekindled debate over the future of the euro. Facing default, one or more countries could be tempted to exit EMU, even though others outside of the euro zone are clamouring to join. This is notably the case for countries hit by massive capital outflows and sharp drops in exchange rates, which hurt economic players with foreign-denominated debt (notably in euros) and worsens the situation in the banking sector.
If one eurozone country were to default (or worse, several at once), no mechanisms have been provided to run to their defence. The absence of fiscal federalism is clearly one of the fragilities of monetary union (and one of the reasons it cannot be qualified as an optimum currency area). California’s budget problems and the premiums it has to pay on bond issues have not triggered a debate on withdrawing from the United States! The measures in the Stability Pact, which were designed, among other, to keep public debt to sustainable levels and to build manoeuvring room to weather hard times, were supposed to create an elastic force. Today, the Pact has naturally been put on hold.
Yet it is hard to imagine a country quitting the euro. The country would be hit by extremely high interest rates, renewed foreign exchange risk and an upsurge in inflation triggered by higher import prices. A lower exchange rate would trigger a sharp increase in euro-denominated debt servicing charges, investors would be mainly worried about how to keep their savings in euros; and then there are all the legal complications associated with switching currencies.
Of course, other member countries would come to the rescue of the defaulting party, while naturally demanding IMF-type conditions to ensure public finance reform and to contain the risks of moral hazard. This rescue would not necessarily take the form of budget support, which would require the approval of national parliaments. On the other hand, nothing would prevent, the ECB from taking action. Although Europe’s central bank cannot legally underwrite public debt at the time of issue, it can purchase Treasury securities on the secondary market. The worsening of the crisis actually increases the chances that progress finally will be made towards fiscal federalism.
A few fundamental lessons can be drawn from current tensions. First, the eurozone’s transition to an optimum currency area, which some hoped would be an endogenous process, has not occurred. With hindsight, this justifies Germany’s position in the 1990s: the creation of the euro should be the crowning achievement of a process of more in-depth integration. In the end, the loss of a foreign exchange policy did not encourage member countries to undertake sufficient reforms to avoid the appreciation of their currency in real terms: the purchasing power of the euro in Spain, for example, has regularly eroded compared to the euro in Germany. To the contrary, the benefits of low interest rates have fuelled buoyant economic growth, resulting in a kind of “benign neglect” of competitiveness. Boosting competitiveness without resorting to exchange rate adjustments implies a more flexible economy, which in turn means sacrifices, at least initially, that could come at a high political cost (i.e. the Irish treaty referendum).
What peer pressure has been unable to accomplish from this point of view (implementation of the Lisbon agenda has been disappointing), might become reality because of market pressures.
What is important, in the end, is that member countries are bound to lend their support in case of default by another member country. But we are not there yet. Although paying a spread of 100bp to 150bp certainly has major drawbacks, it does not signal default. Moreover, less risk aversion could narrow these spreads. ECB President Jean-Claude Trichet was right to dismiss all the talk about the break-up of the euro zone as pure fantasy.