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No Great Firewall Will Save Europe

Author: Steven Dunaway
February 27, 2012

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With a tentative agreement on a new EU-IMF lending program for Greece, talk in Europe and major capitals once again has shifted back to increasing available financial resources to aid countries affected by the euro crisis. The idea still in favor is to use European and international sources to build what could be perceived as a "great financial firewall." The large size of this firewall is expected to reassure financial markets and help aid contain the sovereign debt conflagration in Europe.

Euro area governments are locked again in discussions on boosting the resources of the new permanent mechanism for providing financial assistance to member countries, the Economic Stability Mechanism (ESM), beyond the 500 billion euros originally allocated. The favored approach is to top up the ESM with around 250 billion euros in uncommitted funds from the European Financial Stability Fund (the euro area's temporary assistance facility). The ESM would then have a war chest of 750 billion euros, equivalent to roughly $1 trillion.

To supplement their own resources, the Europeans have asked countries outside the zone for assistance. Because of the significant adverse consequences for the world economy from possible sovereign debt defaults in Europe and/or a break-up of the euro, many countries have expressed sympathy but have been reluctant to pledge support directly.

A Bigger IMF Fire Hose?

Instead, the IMF is considered to be the preferred vehicle for international support. The IMF's available resources, however, are not sufficient (amounting to only roughly $250 billion) since the fund has already committed substantial funding for the programs in Greece and Portugal. Therefore, some G20 members are proposing a $500 billion increase in IMF resources.

With $1 trillion in financing from an enhanced ESM and potentially up to $500 billion in new financing available from the IMF (if the ratio of two-thirds euro area to one-third IMF financing used in the Greek and Portuguese programs were continued), it is argued that the euro area would have a substantial financial firewall to defend itself and calm financial market fears. But there remain significant stumbling blocks.

An agreement on raising the lending capacity of the IMF was supposed to be a hot topic at the G20 finance ministers meetings in Mexico City February 25-26. But that discussion was derailed before it started. G20 countries have linked an increase in IMF resources to an increase in euro area funding for the ESM, but euro area countries cannot agree on such an increase because of German opposition. Thus, any decision on increasing IMF resources was pushed back pending euro area agreement on greater ESM funding. However, that may not be sufficient to trigger an increase in IMF resources because U.S. officials continue to resist, insisting that Europe has enough resources to finance itself.

A Financial Maginot Line

Discussions over building a great firewall for Europe are likely to drag on. But lost in the doomsday rhetoric used to justify this firewall is a fundamental point: A new, bigger, better financial firewall will not solve the euro area's problems. It may serve only to create a false sense of security and turn out to be a financial Maginot Line, providing no real defense for Europe and the euro.

No matter how much additional financing is made available, it will never be enough unless the euro area's southern members forcefully deal with their fiscal and competitiveness problems--the root causes of Europe's sovereign debt crisis.

The lack of an adequate firewall is not the source of the difficulties that Italy and Spain face in financing their budget deficits and rolling over maturing government debt. Inadequate economic policy responses in these countries have adversely affected their access to private funding. Firm implementation of needed policy changes is the only thing that will address market concerns and provide private funding on more reasonable terms.

Both Italy and Spain have signaled their intentions to rein in fiscal deficits and reduce government debt in line with targets agreed to with the European Commission through a combination of tax increases, asset sales, and spending reductions. They have also announced detailed plans to restructure their economies to enhance growth prospects by reforming labor and product markets to increase flexibility and competition and to lower production costs.

Tightening the Reins in Spain

However, there are lingering doubts among private investors as to the strength of these countries' commitments and their ability to implement policy plans. Spain, for example, is already suggesting that its budget deficit target for 2012 should be increased, and while the recently enacted labor market reforms are an improvement, they do not do much to improve competitiveness since Spain's labor market will remain less flexible than competitors in northern and eastern Europe. Building a better financial firewall will do nothing to allay market concerns.

Advocates of establishing a great firewall suggest that it would take some of the financial pressure off of these countries. But this effect would only be temporary unless Italy and Spain establish a strong track record on policy implementation to reassure private markets.

The firewall's existence would provide private investors with assurance that European governments and international institutions would effectively bail them out by intervening in government bond markets. The intent would be to maintain orderly conditions if those markets decided to dump their holdings of Italian and Spanish government bonds in response to inadequate economic policy reforms. Ironically, a great firewall could encourage such poor policy responses by taking some of the pressure off country authorities to act quickly, especially since many of needed changes to the structure of these economies will be politically difficult to implement.

Economic policies, not great financial firewalls, matter most in resolving the eurozone sovereign debt crisis. Renewed emphasis has to be placed on pressing for adjustments in fiscal policies and the structural reforms needed to enhance growth prospects. If Italy and Spain deliver on these policy changes, there will be little need for any great financial firewall.

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