August 23, 2011
by Kai A. Konrad and Holger Zschäpitz
Original Article in: CESifo Forum 2/2011
Country leaders reacted. Within two days they constructed what is known as the 750 billion euro rescue device. It consisted of the EFSF, the EFSM and additional guarantees provided through the International Monetary Fund. In hindsight, some policy makers admit that the initial idea was that a European promise of support of this size would be sufficient to re-establish confidence among market participants. The hope may have been that market participants return to their prior expectations about government bonds of members of the eurozone: holding these bonds are perfectly safe assets, with bonds of different countries being almost perfect substitutes for each other.
Now, one year later, it is evident: their policy went completely wrong. In addition to the 110 billion euro rescue package for Greece, the governments of Portugal and Ireland had to be rescued. They received considerable financial aid from the rescue device, and other countries like Spain or Italy are candidates that may follow. And the insurance premiums for many of the relevant countries – including the ones rescued – are higher in May 2011 than they were in May 2010.
Officially, Greece was supposed to return to the private capital market after a period of no more than three years. But rather than an improvement in credit worthiness, during the last 12 months we have seen a process of deterioration. Rather than preparing for a return to the private capital markets, Greece entered into debt renegotiations about prolonging the help and easing the debt burden further. There is seemingly almost a consensus that Greece cannot reach a financially healthy situation without either a partial devaluation of its debt in the process of a default followed by a debt restructuring, or massive foreign transfers.
It is difficult to admit a mistake, in particular a mistake of this size. Not surprisingly the policy reaction to the failure is not a change of direction, but rather: ‘what we did was right, but it was not enough’. Projecting this behaviour into the future, a likely direction of European policy is a speedy integration of fiscal policy inside the eurozone. First steps in this direction took place. We see the modifications of the Stability and Growth Pact that include a view on macroeconomic imbalances in member countries, the intensified reporting and benchmarking in the context of the ‘European Semester’ and of the ‘Euro Plus’ agreements as part of this process. These instruments clearly strengthen the position of the European Commission inside the European Union, expand on existing tasks and allocate new tasks to the bureaucracy of the European Commission.
We are doubtful whether these steps will cure the European government debt crisis. It is very likely that, given these steps, the problems will persist and may even grow further. At some point in the near future policy makers in the eurozone will have to take further steps.