Since its development in late 2009, the European sovereign debt crisis has presented the greatest challenge to the economic and political governance of the single-currency “eurozone” since its inception in 1999. While Greece has been at the epicentre of the crisis, Portugal, Ireland, Spain and now Italy have also been affected as European politicians, bankers and investors have so far been unable to stop the contagion from spreading. With the entire monetary union now being called into question, we talk to European economics expert and CIGI Senior Fellow Pierre Siklos about righting the eurozone’s sinking ship.
CIGI: Many analysts of the sovereign debt crisis have said that, fundamentally, it is a political issue, created when countries with varying fiscal policies entered into a monetary and political union. With those differences now coming into view, and voters in the core eurozone economies increasingly unwilling to aid the periphery, is the EU political project now in serious jeopardy?
Pierre Siklos: The simple answer is yes, because of a failure in leadership. The two main players, France and Germany, have not been acting in a bold fashion and have made statements that contradict each other. The quality of leadership was what allowed the eurozone to be created in the first place. Now there’s a leadership vacuum. You have a chancellor of Germany who seems unwilling to accept the choices put in front of her, and a president of France off in election mode.
Another failure has been the lack of emphasis on the upside of having a single currency — all we hear now are the costs. Germany has been much better off, and its economic revival can arguably be traced to the creation of the eurozone. From time to time you hear central bankers and leaders talk about the benefits of the euro, but the policies put in place to protect it are contradictory and unconvincing to markets. If that continues long enough, the political project and the eurozone itself are in very serious trouble.
CIGI: Throughout the crisis, we have seen tension between the eurozone’s leaders, who are protecting themselves from politically damaging bailouts, and its central bankers, who are trying to limit market-damaging losses to private creditors and bondholders. Is there a middle ground that can satisfy European taxpayers and investors alike?
Siklos: The problem is that there is a middle ground, but it’s not clear to me that European politicians are interested in seeking it, or that they even know the consequences of their actions. When you have such a conflict between the well-being of the eurozone as a whole, and the health of individual members, I don’t think there’s a middle ground that will satisfy everyone.
There’s a failure on the part of politicians to realize that by having a single currency, if something goes wrong, the eurozone is going to have to bail that country out. They just don’t want to accept that. But slowly, like Chinese water torture, they seem to be backing down. At first, there wouldn’t be bailouts, then there were bailouts. Then it was no default, and now there may be partial default. At first, it was no haircut to private creditors and bondholders, and now they have to share the burden.
It’s difficult for me to believe that Greece will not default in one way or another. If there is a middle ground, that’s the first thing that needs to be realized. Then there has to be a very serious reform of the economic governance of the euro area. You can have sovereign governments, but it’s hard to see how each can have its own sovereign debt, as if one country’s misbehaviour doesn’t matter to the rest. It’s irrelevant that Greece is a tiny fraction of the eurozone, because once contagion sets in, size doesn’t matter and investors begin to panic.
CIGI: Recently, the sovereign debt contagion spread to Italy, the EU’s third-largest economy, which carries more sovereign debt than Greece, Portugal and Ireland combined. Though Italy is not yet close to default, does this show the inability to restructure debt in other EU countries is hurting investor confidence across the eurozone? If so, what country may be next?
Siklos: The way an economist understands contagion is that it refers to an effect that can’t be explained by economic fundamentals. Outwardly, Italy doesn’t look like it’s in trouble, but it has a high debt-to-GDP ratio and a slow-growing, low-productivity economy that shows no signs of improving. An investor looks at that as a bad bet because if there’s a negative shock and Italy has to borrow more, they’ll move towards debt-to-GDP ratios that Greece has, and never be able to pay it all off.
Spain’s been in trouble, of course, despite a very good debt-to-GDP ratio. Its problem is the shock it took to the housing sector, combined with high unemployment and low productivity. Along with Portugal and Ireland, the most likely eurozone candidates have already been hit. The next question is what happens if other EU countries outside the eurozone get into trouble. The easy answer is that they let their currency depreciate, but that could impact their eventual entry into the monetary union, which is looking very far away these days.
The bottom line is that if Spain and Italy go, then it’s almost game over because they represent such a large fraction of the eurozone. It doesn’t really matter if other economies are affected after that.