The EU End Game: Decision Time

Here’s another important article in the run-up to EU’s top leader meeting next weekend. The author is Marco Annunziata, chief economist of GE capital.  In this post Mr. Annunziata calls for solidarity within the euro zone and makes a powerful attack on the proposed French-German “Pact for Competitiveness”. He warns of political instability and a break-up of the single currency system. GE’s chief economist defends Brussels actions so far, because there has been no other alternatives. However, now the time has come for the big and difficult decisions.

“We’re all in it together – this is what EU policymakers must be thinking as they near the crucial summit of 24 and 25 March.”

Marco Annunziata

The global financial crisis, which many of them at first brushed off as a US problem, has turned into an existential crisis for the euro zone. Markets are pricing in a significant risk of sovereign default for its weakest members, two of which have had to be rescued with the help of the IMF, and the idea that the single currency area might break apart suddenly seems less far-fetched. Yet the clearest lesson of the turmoil in Europe’s sovereign debt markets is that the currency union is irreversible,” Mr. Annunziata writes.

The unprecedented measures and sacrifices of the last twelve months are tangible proof: EU policymakers have committed hundreds of billions of euros to a mutual support mechanism, swallowed the bitter pill of calling on the IMF, and seen the ECB break taboo after taboo, culminating in its direct purchases of government bonds.

These have been accompanied by heated debates and bitter disputes every step of the way, most recently resulting in Mr. Weber’s decision to relinquish the presidency of the Bundesbank and with it the prospect of succeeding Mr. Trichet at the helm of the ECB.

“There is no doubt that European policymakers’ actions have been tremendously controversial and painful. They have been taken because there is no alternative.”

With the establishment of a single currency, economic and financial integration have leapfrogged policy coordination to an extent that has only recently become fully apparent.

This is especially true in the financial sector: not only have cross-border financial institutions become an important reality, but cross-border asset holdings have greatly increased the degree of interdependence—and of mutual vulnerability.

A euro zone break-up—even the limited spin-off of a few countries—would have a tremendously disruptive impact on banking systems, credit growth and economic activity across the area.

“The fact that investors nonetheless still fear a breakup tells us how serious the challenges are.”

They stem from the anomalous nature of the euro zone: less than a full-fledged union, but more than a loose federation.

ECB President Trichet is fond of pointing out that the Euro zone’s aggregate fiscal position is sounder than that of the US or the UK; but the weakest euro zone countries have come to resemble shaky emerging markets of decades past.

Investors are not yet persuaded that they should be looking at the sum rather than at the individual parts.

The solidarity which had been ruled out ex ante with the no-bailout clause (Article 125 of the EU Treaty) has come back ex post in the form of the European Financial Stability Facility.

Euro zone members have realized the need to stand by each other. They are still reluctant to draw the consequences, however, and they continue to send mixed and confusing messages. They should stop hesitating.

“This is the time to cut the Gordian knot of the euro zone’s conflicted identity.”

The most immediate issue to resolve is who should pay the price of unsustainable fiscal policies.

There is broad agreement that sovereign bonds issued after 2013 should incorporate collective action clauses, and be subject to the risk of restructuring. This is a positive step.

Investors should face the risk of losing money if they finance reckless policies. This is not only fair, but efficient: investors will perform their due diligence and demand a higher risk premium as soon as they see policies going off track, which in turn will give governments an incentive to take corrective measures at an early stage.

But debt issued after 2013 is tomorrow’s problem.

What unsettles markets now is that in 2013 some Euro zone countries will have public debt ratios well in excess in 100%, which they might be unable to service.

“If euro zone leaders believe a sovereign default by a member country might eventually be the best way to share the pain, they should prepare for it, and quickly.”

The first priority is to bolster the financial sector. The bank stress tests currently underway represent a rare second chance after last year’s flop—it should not be wasted.

Credible and transparent results quickly followed by concrete steps to recapitalize or resolve the weaker institutions would be the best way to bolster confidence in the banking sector.

The second priority is to provide a credible firewall against contagion risk. The agreement reached last weekend to raise the EFSF’s effectcive lending ability to 440 billion euros is a positive step in this regard—while allowing the fund to buy government bonds on the primary markets makes no substantial difference from the existing set-up.

“If euro zone leaders instead truly believe that a sovereign default on currently outstanding debt is unthinkable, they should say so once and for all. Investors could then be persuaded to look at the aggregate fiscal numbers rather than the individual countries’.”

There is no free lunch though—the funding costs of the stronger members would rise as they openly shoulder the responsibility for their weaker partners. Solidarity, however, must go hand in hand with accountability.

“If euro zone countries stand shoulder to shoulder with each other, they have to play by the same rules. This means burying the Stability and Growth Pact as we know it. It has failed so spectacularly that tinkering with it would be a waste of time.”

Barring as politically implausible the idea of a stronger fiscal union, the best way forward is for each country to adopt similar fiscal rules in its own legislation—ideally in its Constitution.

Balanced budget rules would bolster credibility, and would no more limit the scope for fiscal stimulus than the collapse in market confidence which has already forced consolidation throughout the single currency area.

Political support for such hard budget constraints is hard to muster—but that is no surprise: Fiscal rules need to be strong enough to truly replace a fiscal union; otherwise it is political support for solidarity that will sooner or later disappear.

We need a clearer signal of how the costs of past recklessness will be shared, and we need to see the more fragile banking sectors put on a stronger footing—this is essential to restore a durable stability in financial markets.

We need credible rules that will force countries to live within their means—both to reassure investors and to make solidarity within the euro zone politically sustainable.

And we need to do this quickly, so that Euro zone member countries can then focus on the most important challenge: generating faster growth and holding their own in an increasingly competitive global economy.

“Germany and France have proposed a “pact for competitiveness” that calls for harmonizing pension systems, tax bases, and to some extent wage policies. This is implausibly ambitious, unnecessary and misguided.”

Once subject to hard budget constraints, countries should realize by themselves that pension systems must be made sustainable and wage indexation mechanisms abandoned.

Competition among states will then bring greater benefits than common standards which would most likely be set at the minimum common political denominator.

The euro zone’s recovery has so far surpassed expectations, showing the old continent still has wind in its sails.

Germany has proved that Europe can benefit from the boom in emerging markets—and it has done so not just through wage moderation, but with innovation and greater productivity, generating impressive gains in competitiveness. Success breeds confidence, and German consumer confidence is back at pre-crisis record levels.

“The rest of Europe can—and must—follow Germany’s lead.”

Globalization is not a zero-sum game. But the game has gotten tougher, and Europe now needs to switch gears. Bolstering its financial and institutional set-up is a necessary pre-condition, but the focus must then quickly switch to improving productivity and competitiveness through innovation.

The relative calm now prevailing in euro zone financial markets should not deceive us.

Investors have given them the benefit of the doubt, but if EU leaders fail to deliver, tensions will surge again,  jeopardizing the recovery.

Policymakers in the US and elsewhere are watching nervously.

It’s time for EU leaders to step up their game, to switch their sights from survival to success.

By Marco Annunziata

Chief economist of GE capital

Original post at:

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Filed under International Econnomic Politics, Laws and Regulations, National Economic Politics, Philosophy

55 responses to “The EU End Game: Decision Time

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