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Tough Love for Eurozone

Interviewee: Daniel Gros, Director, Centre for European Policy Studies
Interviewer: Roya Wolverson, Staff Writer for Economics, CFR.org
May 12, 2010

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The European Union's nearly $1 trillion bailout plan--prompted by a spreading sovereign debt crisis--bought the region time to rectify the finances of heavily indebted member countries, but concern is growing that the austerity measures these countries face may prove politically and economically untenable.

The Centre for European Policy Studies' Daniel Gros says the impact of austerity measures will vary from country to country. While Greek citizens will have to cut back on consumer durables such as cars, washing machines, and televisions, in Spain "you could just cut wasteful housing investment and keep consumption more or less constant," says Gros. The eurozone framework also requires longer-term adjustments that could infringe on member countries' national sovereignty, though Gros doubts there can be a greater EU role in national-level economic policymaking. Instead, he says, the more important reform is a mechanism that allows eurozone countries to fail, which would reduce uncertainty and contagion. This would involve disciplining profligate countries though "a sort of Chapter 11 bankruptcy for member countries that cannot avoid default or restructuring."

How will austerity measures needed in heavily indebted European countries affect Europe's quality of life and perceptions of its global power?

Europe will be even more inward looking than before, but it will not be really fatally weakened. There has to be a very harsh, significant impact in Greece and Portugal, because these countries are living above their means. So you need to cut consumption by 10 percent at least. That means pensions, social security, and wages all have to be cut, which is already going on in Greece. Greek workers, for instance, used to get fourteen salaries per year [explained further in this CNN Article], and basically of these fourteen, two are being cut away. Let's say you have monthly salary of two thousand euros, and you get it per year fourteen times. Over the summer you get two salaries, and for Christmas you get two salaries. So you are to cut by one-seventh, around 14 percent. Greek citizens will have to cut back on consumer durables--things like cars, washing machines, and large television screens. But those aren't so critical, compared to necessities like food or rent. In Spain, you don't need to cut consumption, you could just cut wasteful housing investment and keep consumption more or less constant. Healthcare [in these countries] has not been so much a focus of attention. It is a smaller share of expenditure in Europe than in the United States, so that is not really the focus of the cuts. Spending on defense is the last priority all over Europe, with one exception: Greece. So military budgets will be cut even more.

How will the quality of life in these countries compare five or ten years down the road to the United States or other developed economies?

Europeans have always had less monetary income, but more government services. Their monetary income will be somewhat reduced, but also they will get less government services than before. On the whole, they will still get more of the government services than in the United States, but less than before.

Financial markets have focused less on sovereign debt in Germany, France, and Britain. To what extent will these countries also need to accept a lower living standard going forward?

Economic policy is about making a thousand little choices every day, and that cannot really be controlled from Brussels.

They don't need the same lifestyle changes, because their overall economic resources are balanced. In the case of these countries, not a lot will change, with the possible exception of France, where there will be fewer employed in the government, and somewhat fewer services provided by the government. The difference here is that the French have now a rather substantial deficit as well as a current account deficit, or external deficit, which means that the resource balance for the country is weaker on the whole. Germany, by contrast, has a huge trade surplus. So even if production falls in Germany, people can consume. And for Britain, [the current account deficit] is about balanced.

Many analysts stress the need for permanent structural reforms to the European Union to ensure its survival. Will these reduce national sovereignty for member states?

The poor countries, or the indebted countries, lose their sovereignty. Greece has already given it up. Portugal and Spain are not far behind. The loss will be less severe going forward, but it will last for quite some time. Whether there will be a permanent reduction is still being decided. The goal is to somehow get a greater European role in national economic policymaking overall. I'm skeptical about that, but we'll have proposals about it from the European Commission on May 12. In my view, a greater role in national-level policy doesn't work, since economic policy is about making a thousand little choices every day, and that cannot really be controlled from Brussels.

What we need is something which allows us to let governments fail. But we need a system which is constructed so that even if Greece were to fail, we wouldn't have a big problem everywhere else, and then we can actually apply discipline. We at the Centre for European Policy Studies outline a concrete proposal for the European Monetary Fund, together with Thomas Mayer, which has attracted quite some attention in Europe. It involves splitting up the fund, and saying this fund can be used to help countries in distress, just like the fund that was set up by the European Union, announced May 10. But additionally, we propose allowing the fund to also organize a sort of Chapter 11 bankruptcy for member countries that cannot avoid default or restructuring.

What does Chapter 11 bankruptcy at the country level look like?

If one makes countries' failure possible, then we have a very strong incentive for countries to behave.

We would say, if a country goes bankrupt, then the European Monetary Fund would buy up the old debt of the country with a very substantial haircut. The other creditors would therefore have a loss, but the loss would be limited and clear from the beginning. And then the European Monetary Fund would hold all the claims on the country concerned, and would then negotiate a new tough adjustment program, of course with lower debt levels, but it would then have very large leverage. The difference between what we propose and the European Stability Mechanism [which the EU announced on May 10] is that the European Stability mechanism does not contemplate the failure of any member country. It only seeks to prevent failure by any and all member countries. But we must prevent failure at all costs, and that's what our approach would hope to do. It's like with the banks. You can have a policy where you say, "No big bank can be allowed to fail."† Or you can say, "I will prepare the banking system in a way that allows big banks to fail."

If individual countries cannot be controlled, as you say, is the eurozone sustainable?

On balance, yes, because as I said there are other mechanisms one could think of. If one makes countries' failure possible, then we have a very strong incentive for countries to behave. And even if they don't--if we lose, say Greece--that's OK. The eurozone can still survive.

What is the incentive for more economically stable countries like Germany and France to stay in, if they are paying for other countries to fail?

Because they still have a stable framework, no messy exchange rates within Europe, and an indicated financial area. And if the union loses 2 or 3 percent of that area at the margin, that's not a big deal. They're still gaining a lot of stability by eliminating exchange rate changes within Europe, and outside periods of crisis, a very integrated financial system.

What about political stability?

Without the European Union, the risk of political instability would likely rise. If you had wide exchange rates between Italy and Germany, that would create tensions between the countries, just like it did in the 1990s. Then, there were very large swings [in exchange rates]; the euro depreciated a lot; Germany lost a lot of market share; and there were many countries between the two countries to blame for these wild swings. But we were on the way to Europe's Economic and Monetary Union, and as a result of its creation, the swings died down, and the problem went away.

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