The never ending story

The fall-out from the Lehman default in 2008 should remind everybody that a negative feedback mechanism into other parts of the financial system and the real economy can create a negative-sum game for all parties involved.

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After another couple of weeks full of rumours, denials and suspense, it has become clear that European policy makers are once again exposed and that the policy transparency and coordination that is indispensible for solving the sovereign solvency puzzle in Europe is still not present. Actually, it seems that ‘political’ incentives for a number crucially important players involved have caused opinions to diverge again in recent weeks. Populism amongst voters all across Europe is on the rise and the willingness of policy makers to risk a significant political ‘cost’ for the common European ‘good’ seems to be fading.

In this respect it is crucially important to acknowledge that the sovereign solvency problems in the peripheral countries are the result of a combination of factors. Not all of these factors are (or have been) within the span of control of the governments of these countries. Obviously, some of them are, such as the irresponsible fiscal behaviour of countries like Greece and Portugal. However, design errors in the set-up of the Eurozone (monetary union without fiscal redistribution mechanism), excess credit growth and (the resulting) housing market bubbles have played a significant role as well.

In the case of Spain and Ireland the latter factors were significantly more important than pre-crisis management of public finances. Meanwhile, Germany and France have not ‘led’ by example on the fiscal side. They have ignored the rules of stability and growth for nearly 50% of the time since the introduction of the Euro and even pushed for an adjustment to the rules when their failure to adhere became too obvious.

Also, monetary policy makers have not signalled the need to differentiate creditworthiness assessments of sovereign borrowers in the Eurozone. The ECB never discriminated in lending conditions for banks that offered sovereign debt as collateral for their borrowing needs. Greek treasuries were treated equally as German treasuries in this respect. Nor did the ECB warn aggressively for the risks to financial stability that resulted from excess borrowing by either the public or the private sector in peripheral countries.

One can argue how much policy makers in either ‘core’ or peripheral Europe should be blamed for this. In some areas it seems absolutely fair to say they should have known better. At this juncture, however, it might be more important that European policy makers understand that the acknowledgement of shared responsibility for the problems has at least three large benefits. First of all, it would help to make a more accurate diagnosis of the origins of the crisis. A better diagnosis would obviously help in finding the right medicine to cure the Eurozone from its life-threatening illness.

Secondly, this would mean that the chances of reaching a cooperative solution between core and peripheral policy makers would increase. By accepting shared responsibility for the problem (rather than making suggestions about solving someone else’s problem) the willingness by all involved to execute the steps needed to come to the most optimal outcome would increases enormously – in part because it would create higher levels of trust between core and peripheral countries with regard to each keeping its part of the bargain (financial burden sharing by the former, austerity and reform by the latter).

Thirdly, the risk of contagion of sovereign problems between one country of the Eurozone and other peripheral countries will increase significantly if financial markets sense that Eurozone members are unable to close the ranks. The fall-out from the Lehman default in 2008 should remind everybody that a negative feedback mechanism into other parts of the financial system and the real economy can create a negative-sum game for all parties involved. The fact that such a risk exists already creates a strong incentive to prevent it from becoming reality.

However, a sense of shared responsibility lowers the probability that some countries try to take ‘free ride’ with regard to the solution that others are willing to provide. Rising tension might at some point create an environment in which European policy makers will finally realise that they all need each other in order to reach the best possible outcome. This has already happened several times in recent years — both during the credit crisis (at a global level) and the sovereign crisis (at the European level). In true European spirit, common responsibility and burden-sharing might therefore win the day in the end. However, everyone must realise that even this is only likely to happen if all European policy leaders take responsibility for their individual parts in a common problem that can only be solved by mutual cooperation.

Will we get the true leadership needed to achieve this? Leadership that is willing to ignore the short-term political costs of such an approach? It is certainly not too late for hope, but the chances of a credible long-term solution are fading more rapidly than seemed likely just a few moths ago. The can will probably be kicked down the road once more, but will come back to haunt us within months, rather than years. Policy makers better be ready to act decisively by then or Europe will look much more fragmented in the not too distant future.

Valentijn van Nieuwenhuijzen , June 2011

Article also available in : English EN | français FR

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