As members of a monetary union, stronger economies have an interest in keeping the problems in the weaker economies from spreading and affecting the rest of the union. Therefore, there is a common stake at making sure each country is meeting its obligations and doing the best it can to support its economy. A common currency is strong enough to ensure this common stake in success is strong, but is proving to be not enough to make sure the union is strongly held together, with all economies converging to a comparable and robust level of economic performance.
The euro area sovereign debt crisis clearly shows how fiscal problems and the inability to use independent monetary policy (due to the monetary union) can create serious economic problems that can threaten the credibility of the union as a whole and its common currency. (See A Vicious Cycle in the Euro Area for more explanation).
On the one hand, if a country in the union defaults on its debt and other member countries allow this to happen, there could be a flight away from the euro currency, making it very difficult or very expensive for any country in the union to raise funds in the open market. On the other hand, Germany, the core of the euro area and its strongest economy, is against a situation where it willingly bails out other members in distress and creates a situation of moral hazard or an implicit assumption that Germany will always bail out any country that has unhealthy finances. Also, Germany is understandably reluctant to become less competitive (the argument is to allow higher inflation, which would increase wages, which would make its goods more expensive and lower its dominance in exports) in order for the other members to “catch up” in terms of economic growth and performance.
As shown by the euro sovereign debt crisis, a monetary union is vulnerable to fiscal problems. Now that it is clear how one member country’s fiscal dilemmas can affect the rest of the monetary union and threaten its survival, the case for a fiscal union becomes stronger. In other words, a set of countries bound together by a common currency need also be bound together by some common fiscal union. This implies that each government would need to share some sovereignty with the union over its national budget and also its banking policies, since banks that buy government debt and lend money across borders also tie countries together. See economist Barry Eichengreen’s article Europe’s Divided Visionaries for an excellent explanation on this type of future for the euro area.
Aside from institutional reforms that will take time to build, much of the response to the crisis so far has been centered on the short term financing difficulties that the periphery countries are in. EU and euro area leaders agreed in 2010 to establish the European Financial Stability Facility (EFSF) as a short term solution to provide emergency funds to countries that are having trouble meeting their short term obligations. The EFSF, launched with 440bn euros committed from member states, is designed to eventually become a more permanent institution to be known as the European Stability Mechanism (ESM). The EFSF so far has provided bailout funds to Greece, Ireland, and Portugal. Separate from the EFSF, is the European Financial Stability Mechanism (EFSM), not to be confused with the soon-to-be ESM, which is an EU wide source of bailout funds. It is important to note that Germany is the largest contributor to these joint funds. In addition to bailout funding coming from these institutions, Germany has also provided bilateral support, especially to Greece, and has played a leading role. The Financial Times has a helpful interactive that breaks down all the bailouts to date in the euro area.
The European Central Bank, as with many central banks, has a mandate of price stability. Its role, and the traditional role of a central bank, is to ensure that price levels in an economy are stable. Faced with a sovereign debt (and banking) crisis, it has been forced to step up as a lender of last resort. The ECB has entered the market and has lent money to troubled banks and in exchange the banks gave the ECB their holdings of government debt which the ECB recognized as good quality debt. In many cases (most notably in Italy), this has helped ease pressure off perceived risk of some sovereign debt, while helping out the banks that had initially held that debt. Some analysts of the euro area crisis suggest that the ECB should go into the secondary market (where bond are traded after they are issued) and purchase sovereign bonds in order to bring down yields.
The IMF has also contributed to bailout packages as an additional source of funds meant to be a somewhat of a “buffer” to show markets and investors that the bailout is large enough. However, a direct request of a bailout from the IMF is not necessarily a desirable situation for either the euro area or the IMF. A request for an IMF bailout would signal that the euro area itself is unable to handle the situation and raise further concerns on the stability of the union. Also, it would need to be extremely large, larger than what Europe could provide on its own, meaning that the IMF would be in it for the long haul and be deeply entrenched in the crisis.
Ultimately, the issues at hand for the euro area as a union boils to down to further integration or an exit, because it is clear that the current situation is unsustainable – the vicious cycle between high debt, low income, and fear must be broken. The bailouts and various methods of providing funding to distressed banks are short term measures that are meant to serve as a stop-gap until the real issues are addressed: low economic growth and government budgets that need drastic adjustments.
Time is of the essence for European leaders to come to agreements on actual euro area reforms around the strength of the monetary union and the future of what a more integrated euro area would look like on all fronts. Bailout funds cannot continue forever, and perceived riskiness will remain high until credible signs are shown and significant steps are taken to address the root concerns of low economic growth and bad government budgets.
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