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A Modest Step for the Eurozone

Interviewee: Thomas Klau, Senior Policy Fellow, European Council on Foreign Relations
Interviewer: Christopher Alessi, cfr.org
April 4, 2012

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Eurozone finance ministers agreed last week to expand the capacity of the euro bailout funds to around €800 billion, or $1 trillion (NYT). The move was intended to calm global markets by creating a so-called firewall against further eurozone sovereign debt contagion, while eliciting new financing from the International Monetary Fund. Still, markets have continued to react cautiously due to concerns that the debt crisis is shifting to Spain (Reuters). The agreement to enlarge the eurozone funds is primarily a "political success," says the European Council on Foreign Relations' Thomas Klau. "This is an intermediate step on the long and difficult journey toward a sufficiently strong system of government for the eurozone," Klau argues. In order for the eurozone to have a successful future, he says "it will have to acquire sooner rather than later further federal features, such as a treasury, a bigger federal budget, and new mechanisms for financial transfers."

What is the significance of the agreement by EU finance ministers to expand the eurozone bailout fund to around $1 trillion? Does it create a sufficient "firewall" for the indebted euro area?

What it means is that Europeans have worked out a compromise between themselves, which may now be seen as sufficiently credible by non-European powers, such as Brazil and others, to make good on offering further backing for the eurozone through the International Monetary Fund. In that sense, the agreement is a political success. Though there is skepticism in some quarters, in the city of London and other financial centers, that the firewall is actually big enough or efficient enough to come up with the money in a crisis scenario.

Is it by itself enough to give the eurozone a new framework that is strong and stable enough to avert future crises and handle them if they arise? I would say not. [Like] other reforms adopted so far, this is an intermediate step on the long and difficult journey toward a sufficiently strong system of government for the eurozone. It's an important intermediate step, but it is not a sufficient one.

The Organization for Economic Cooperation and Development released a report last week forecasting an economic downturn for Europe in 2012, including contraction in the eurozone's three largest economies. Meanwhile, economic indicators show eurozone unemployment rose to 10.8 percent in February. What's does this news signal for the eurozone recovery?

There is a serious concern that those member states with the biggest debt burdens, the biggest austerity programs, and the most disadvantageous conditions in terms of refinancing themselves on the market, have actually entered into a spiral where economic activity might be depressed to the extent that the existing plans for reducing the deficits will not be implemented by the end of the year, due to depressed tax revenue and increased social transfers. This is a source of serious concern because it might lead to a situation where the divergences in economic and budgetary performance in the eurozone--if you take Germany on the one hand, and other member states on the other--increases further, which would make it politically even more difficult to manage the eurozone's joint interests and generate sufficient commonality of purpose.

If austerity is left as a standalone policy with insufficient measures both from the supply side and the investment side to mitigate its effect, then the medicine which is being administered to the patient may turn out to be too strong for the patient to take.

Are the austerity policies that have been pushed by Germany the remedy, then, for the indebted eurozone?

What you need is to produce a very difficult mix of austerity on the one hand, and growth-friendly policies on the other. There are, of course, areas where public expenditure and social transfers must be reduced, and there are countries in which wages have just risen too fast over the last decade, Greece being the most egregious example. But at the same time, if austerity is left as a standalone policy with insufficient measures both from the supply side and the investment side to mitigate its effect, then the medicine which is being administered to the patient may turn out to be too strong for the patient to take.

What exactly could eurozone leaders do to mitigate that medicine?

One thing would be to mobilize the EU budget in such a way as to to reallocate the monetary transfers so that they reach primarily those regions that do worse in economic terms at any given time. Currently, they operate within five-year programs, where the aim is to achieve political and geographical balance, rather than maximum economic impact. Another is to look at ways to leverage existing programs or institutions further, such as the European Investment Bank in Luxembourg. And finally, there is a strong case to be made for mobilizing European resources or credits to finance large-scale investments in infrastructure programs in the EU's most depressed regions. The lesson from the past, of course, is that there would have to be a much stronger degree of European control over these programs than there has been so far, so as to make sure that these programs do not materialize as bridges to nowhere.

Has the center of gravity of the debt crisis now shifted to Spain, where the debt level is expected to rise to 79.8 percent of GDP this year?

The attention has shifted to Spain, and it is the object of the greatest concerns right now. But that doesn't mean that countries like Portugal or Ireland are out of the woods. And indeed, if you look at Italy, so much depends on the political survival of Mario Monti's government, which rests on a very fragile political foundation. So even in Italy, a country which is seen now as one where ambitious and sensible reforms are [being] implemented with considerable political courage, there is a strong degree of fragility.

Taking stock of the crisis, are the indebted eurozone states--Greece, Portugal, Ireland, Spain, and Italy--on the right policy tracks, despite their often fragile political situations?

The eurozone seems to have overcome the first and most dangerous stage of the crisis. All governments, including Germany, are now solidly and demonstrably committed to do whatever it takes to make the eurozone survive.

In all the countries, there is by now a consciousness [about the policies] the country needs to undertake, but there are still open questions as to how to do it. When you look at Spain, for instance, there is currently a question of how to bring discipline not only to the national level of budgetary policy, but to the regional level--which throws up some serious political, and to some extent constitutional, issues. The awareness is there; the knowledge about what to do is well developed.

What is your long-term assessment of the eurozone crisis, and outlook for the single currency union?

The eurozone seems to have overcome the first and most dangerous stage of the crisis. All governments, including Germany, are now solidly and demonstrably committed to doing whatever it takes to make the eurozone survive. That's a decisive political fact which wasn't fully established a year ago. Establishing that fact, which gives a solid foundation for further repair work, won't be enough.

If you look at, for instance, what could happen when the ECB ends the LTRO [Long-Term Refinancing Operation] policy of providing cheap money to the banking sector, you will realize that this is going to be potentially a very difficult moment for the eurozone. The time to start thinking about what to do after the return to normal central bank practices is now.

Taken together, the mechanics of the eurozone's new governance, including the fiscal compact, will not give the eurozone a sufficiently strong joint political authority, and a sufficiently efficient joint macroeconomic and budgetary policy. The eurozone has been endowed right from the start with one federal feature--that was the European Central Bank. It will have to acquire sooner rather than later further federal features, such as a treasury, a bigger federal budget, and new mechanisms for financial transfers within the eurozone to be a successful union for the future.

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