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POLICY INSIGHT No.61 MARCH 2012

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POLICY INSIGHT No.61 MARCH 2012 abcd a POLICY INSIGHT No.61 MARCH 2012 From vicious to virtuous: A five-point plan for Eurozone restoration Marco Buti and Pier Carlo Padoan European Commission; OECD he economic and financial crisis in the • Despite the downturn towards the end of Eurozone is in its fourth year. In late 2011, 2011, there are signs of stabilisation and an Tit had evolved dangerously into a vicious increasingly likely recovery in the second half circle of sluggish growth, tensions in sovereign of 2012. Sovereign debt markets have improved, debt markets, and banking sector fragility. Investor as reflected in successful bond auctions and confidence in the Eurozone seemed on the verge declining yields. of collapse, many sovereigns and banks struggled to access market funding, and the future of the These favourable trends are in no way a reason Eurozone was widely questioned in financial for European policymakers to relax. Rather, they markets and the policy debate. offer the opportunity to focus on a more strategic response. It is essential that this opportunity is not While tensions have eased recently, the Eurozone squandered. is still in a situation in which multiple equilibria can materialise. Further measures are required to address unfinished business and to avoid the establishment of a bad • In a vicious circle, confidence falls and equilibrium. deteriorating financial market conditions jeopardise debt sustainability, more so in an environment of low growth.1 A five-point strategy to ensure the good equilibrium prevails • In a virtuous circle, things work in reverse – rising confidence strengthens market sentiments and A strategic response that will bring the Eurozone growth, thereby improving debt sustainability towards a good equilibrium is based on five and strengthening market confidence and mutually reinforcing points (see European growth further. Commission 2011):2 The horns of the dilemma are that shifting • Remove uncertainty about a second programme from a vicious to a virtuous circle requires time, for Greece and undertake credible economic but markets are impatient. What is needed is a adjustment in other vulnerable members. ‘confidence bridge’ – a set of decisive and credible policies that can turn the economy around, thus • Establish an adequate firewall against contagion realigning expectations that the good equilibrium in sovereign debt markets. (sustainable growth and debt burdens) will ultimately emerge. Securing a good equilibrium • Ensure that EU banks are sufficiently capitalised. for the Eurozone is possible. Developments since the beginning of this year have surprised on the • Reform the framework for economic governance upside. in the Eurozone. • The ECB’s provision of longer-term bank • Implement policies to boost growth and address funding (the famous Long Term Refinancing imbalances. Operation, LTRO) has had a powerful effect in boosting confidence; fear of an imminent bank failure and a credit crunch have receded. 1 A formal analysis is provided in Padoan, Sila and van den 2 Leaders of Eurozone Member States have committed to CEPR POLICY INSIGHT No. 61 CEPR POLICY INSIGHT No. Noord (2012). these last October (European Council 2011). To download this and other Policy Insights, visit www.cepr.org MARCH 2012 2 Progress is being made on all five elements. However, • Eurozone nations have accelerated the the pace of implementation is not uniform and establishment of the ESM by one year to July failure to make sufficient progress on any single 2012. element – possibly motivated by complacency over recent developments – will undermine the overall • There is an agreement to review the adequacy strategy. The possibility of falling back towards a of the combined EFSF and ESM resources by the bad equilibrium is still uncomfortably high. end of March. Importantly, these policies need to be implemented A higher ceiling would also help to unlock a further as a coherent package – because of the systemic contribution to the firewall from a substantial nature of the problem, a partial solution is bound increase in IMF resources. to be ineffective and lack credibility. Primarily relying on the EFSF/ESM (or the IMF) to support vulnerable members or intervene in markets Reasons for optimism in vulnerable has tangible advantages over an overstretched role members for monetary policy in providing such support. It would allow for conditionality to be imposed and Eurozone finance ministers agreed a second would assign costs explicitly and transparently to programme for Greece, while Greece's creditors the fiscal authorities. have agreed to a historic debt restructuring. The programme implies a very substantial adjustment in the Greek economy in the coming years, Progress on bank recapitalisation and restoring public-debt sustainability, safeguarding funding financial stability, and boosting competitiveness. Recapitalisation of Eurozone banks is progressing In the months ahead, Greece, the troika, successfully. Despite widespread initial fears, banks and Eurozone members must ensure its full will easily reach the 9% Core-Tier-1 capital ratio implementation under a regime of strict monitoring target set for them by end of June 2012 (European and effective technical assistance. The agreement Banking Authority 2012). The bulk of the required of private bond holders to accept the terms of deleveraging will be achieved through capital debt forgiveness and exchange gives Greece much increases rather than through asset shrinkage. It needed further fiscal breathing space. is important to ensure that banks increase their capital levels to avoid a process of credit curtailment There is also reason for optimism with respect to and generalised bank deleveraging. other vulnerable members. The banks' liquidity situation has markedly • The programmes for Ireland and Portugal are on improved over recent months. Against a track and growth is returning in Ireland, even if background of still ill-functioning interbank a further substantial economic adjustment will markets, the ECB's recent three-year LTRO moves be required in coming years. and relaxed collateral requirements have defused an imminent liquidity squeeze that threatened • New governments in Italy and Spain have some vulnerable members. As such a squeeze could announced their own strategies for economic have reignited the negative feedback loop between adjustment, and implementation is underway. balance sheets of the sovereigns and banks in these countries, the LTRO walled off an important source The threat of a sovereign default in these member of negative shocks. states has receded, thereby quelling market speculation of an imminent break-up of the Eurozone. Available evidence, such as the OECD New Eurozone governance framework responsiveness to reform indicator, shows that The framework for economic governance in the structural reforms are particularly strong in the Eurozone is being radically overhauled. vulnerable Eurozone nations (see below). • The so-called six-pack of legislative measures to reinforce economic and budgetary surveillance Adequate sovereign firewall was adopted in December 2011 and is already The ‘firewall’ for sovereign debt must be of operational. sufficient size and quality to dispel investor concerns that economic or financial problems in • As an important milestone and part of its new any one Eurozone state could undermine financial macroeconomic imbalances procedure, the stability in the Eurozone as a whole. There has Commission adopted last February its first Alert been substantial progress in this respect. Mechanism Review (European Commission 2012). CEPR POLICY INSIGHT No. 61 CEPR POLICY INSIGHT No. To download this and other Policy Insights, visit www.cepr.org MARCH 2012 3 (Figure 2), while short-term costs can be vastly • The additional two pieces of legislation to overstated (OECD 2012). complete the reinforcement of surveillance are in the final stages of agreement between the Figure 2. Short-term effects of structural reforms European Council and Parliament. A. Unemployment rate B. GDP %points Per cent 0 9 Meanwhile, the new fiscal compact is in the process -0.5 8 of ratification by the members. -1 7 -1.5 6 -2 5 -2.5 4 -3 3 A decisive push on structural reforms -3.5 2 -4 -4.5 1 Low economic growth and rising unemployment -5 0 0 5 10 15 20 0 5 10 15 20 remain major weak spots in the crisis management Quarters after reform Quarters after reform strategy. Economic activity and employment must C. Real wage D. CPI inflation be strengthened by appropriate policy actions and Per cent Per cent reforms at both national and EU levels. The EU 4.50 1.60 4.00 1.40 3.50 can contribute significantly to this task by further 1.20 3.00 deepening and strengthening the single market, 1.00 2.50 0.80 in particular for services. Members should address 2.00 0.60 decisively rigidities and other weaknesses in their 1.50 1.00 0.40 product and factor markets. 0.50 0.20 0.00 0.00 0 5 10 15 20 5 10 15 20 Weak economic growth remains the Quarters after reform Quarters after reform key challenge Note: The size of the simulated reform corresponds to a reduction in the value of each policy parameter from a hypothetical “rigid” economy to a hypothetical “flexible” economy (calculated as The unsatisfactory growth performance of, an average of “flexible” OECD countries). The composition of and imbalances in, the Eurozone over the past the basket of benchmark OECD countries is slightly different decade originated in poor structural settings that across policy parameters. See Cacciatore
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