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FOR weeks, Europe’s policymakers have stood accused of doing too little, too late as the sovereign-debt crisis that engulfed Greece threatened to spread to Portugal, Spain, Ireland and perhaps elsewhere. By May 7th, as yields on vulnerable euro-area countries’ government bonds rose sharply, there seemed to be a real threat that foreign financing for these countries would stop. That in turn raised fears about the exposure of banks to European governments and private borrowers. Europe’s Lehman moment, it seemed, might be at hand.
The European Union’s policymakers were forced to act with unaccustomed speed and unprecedented force. In the early hours of May 10th finance ministers, meeting in Brussels, agreed on an extensive scheme of repairs for the euro zone. The biggest stack of financial scaffolding is a “stabilisation fund”, worth up to €500 billion
The stabilisation fund would be supplemented by up to €250 billion more from the IMF.
In addition, the European Central Bank (ECB) said it would purchase government bonds to restore calm to “dysfunctional” markets.
Some of these are easier to assuage than others. By buying government bonds, the ECB is pumping money into the economy. This is potentially inflationary. However, the central bank says it will soak up the cash, for instance by selling instruments of its own, so that monetary policy will not in fact be loosened.
Already, countries that have been dilatory in cutting their deficits have pledged to be more resolute. Portugal’s government, which clocked up a deficit of 9.4% of GDP last year, has said it will delay plans to build a new airport, to follow a recent promise of cuts in unemployment insurance.
It is hoped that this and other measures, including a €6 billion reduction in public investment, will cut Spain’s budget deficit from 11.2% of GDP last year to just over 6% in 2011. “The situation is difficult and it would be nonsense to hide it,” said Mr Zapatero.
However, keeping up the pressure on countries with big deficits may prove difficult with a safety net in place. After all, the rescue package is, in effect, an attempt by policymakers to convince investors that euro-zone sovereign debts are collectively insured: the debts of one are guaranteed by all. The idea that the €440 billion scheme will be retired after three years is hard to believe: it is difficult to withdraw a guarantee once it has been given. All governments, even that of reluctant Germany, understand that they have taken a step towards a kind of fiscal federalism. Indeed euro-zone policymakers are now scrambling to claim the plan as their own so that they can set the terms for the economic co-ordination and surveillance that it entails.
For many, the fallout from the Greek crisis has proved what they had suspected all along: that the euro zone needs more fiscal co-ordination in order to work. If its members are to underwrite each other’s debts, they will demand more say in each other’s budget plans. The stability and growth pact, the scheme that was meant to limit euro-area countries’ budget deficits to 3% of GDP and public debt to 60% of GDP, has clearly failed.
Budgetary discipline will be only one part of euro-zone surveillance—and perhaps not the most important part. The commission also wants to monitor trade imbalances and the build-up of foreign debts. Greece, Ireland, Portugal and Spain have become heavily reliant on foreign capital, racking up big current-account deficits year after year (see chart 2) and hence accumulating ever larger foreign debts. Portugal is deepest in hock: its net international debt (what it owes, less its foreign assets) rose to 112% of GDP last year. Roughly half of that total was public debt. Spain, Greece and Ireland are also heavily in debt.
What makes this problem so acute is that very little of the foreign capital in these countries is greenfield direct investments, like new factories, or purchases of shares in big firms listed on stockmarkets—the kind of money that tends to stick around and can bear losses. The bulk of it is either government bonds or short-term money that has been funnelled through the banking system to fund mortgages and loans to small firms, and is more likely to disappear in a crisis. Portuguese banks’ net foreign debts were around 46% of GDP last year. These credit lines need to be rolled over regularly and their price and availability depend on the creditworthiness of the government. In the fallout from the Greek crisis, the market’s confidence about Ireland, Portugal and Spain was draining away. As the yields on their government bonds rose at the end of last week, there seemed to be a real threat that foreign financing would come to a sudden halt.
Dependence on foreign capital in these countries is both symptom and cause of a deeper problem: a lack of export competitiveness. Cheap foreign credit fuelled the booms in domestic demand in Greece, Spain and Ireland in the years after the euro’s launch in 1999. That pushed up unit-wage costs relative to those in the rest of the euro area (notably super-competitive Germany) and cost competitiveness declined steadily (see chart 3). Consumer booms also skewed industrial structures away from firms that export to those that serve the domestic market and are more sheltered from foreign competition.
Policy should also be directed at shifting resources to exporters. One complaint in Portugal is that the monopolistic state of some service industries serves only to reinforce existing imbalances. The best graduates want to work for telephone and energy companies because they pay well, thanks to the profitability that comes from market power. The lack of competition imposes costs on firms, including exporters, which are forced to use their services; and weak competition reduces productivity more generally. That makes measures to boost competition in services all the more vital. A report on strengthening the single market by Mario Monti, a former EU commissioner, was issued on May 10th.
Tax policy can also help, where fiscal consolidation allows it. Increasing levies on spending, such as value-added taxes, while reducing taxes on jobs would shift economies away from domestic demand, mimicking a devaluation. Countries that habitually run a trade surplus (Germany, Belgium, the Netherlands and Finland) need to mirror the reforms in deficit changes with policies to promote stronger domestic demand and a shift away from an emphasis on exporting industries.