Crisis, Contagion and Bailouts: What's Next for the European Union?Published: May 12, 2010 in Knowledge@Wharton
European financial officials finally got out in front of swift-moving market developments this week by launching a huge $960 billion (750 billion euro) financial stabilization plan -- exceeding most expectations -- to bail out Greece and ensure the viability of the European Monetary Union, at least for now. Some observers say the move prevented a potential financial meltdown in which concerns over sovereign debt defaults would have swiftly led to large-scale bank runs in some European countries. Many experts this week expected the package to continue to calm markets -- at least temporarily -- by guaranteeing most sovereign (and some private) debt in Greece, or by providing credit for other troubled member economies in the future, including Portugal, Spain and Ireland.
In reaction to the emergency measures, stock markets around the world had their strongest showing all year on May 10. By Tuesday, the mood was more tempered as some critical analyses of the emergency package began to emerge. Then, after Spain detailed a fairly draconian austerity package on Wednesday, May 12, the initial market reaction again swung to the positive. Some critics still view the overall stabilization package, which left many details vague, as a short-term fix that ultimately will fail to address deep public and private debt levels, pressing fiscal deficits and persistent internal and external trade imbalances.
The bailout -- which also includes some bilateral loan agreements, U.S. funds and dollar swap agreements through the Federal Reserve -- had the immediate effect of sweeping away fears of a possible collapse of the Eurozone's financial system. Such an outcome would have set off a new round of recession in Europe and might have dragged the world financial system back to the depths reached 12 to 18 months ago -- or worse.
One explanation for why Europe's financial authorities did not act sooner to avert potential disaster: The leading player in any stabilization measure is Germany, because of the size and strength of its economy. But Germany was caught up in regional elections in North-Rhine Westphalia that were critical to the future of Angela Merkel, the German chancellor, and her coalition. Merkel appeared to want to delay any action on the European financial crisis until after elections because much of the German electorate takes a dim view on bailouts for countries thought to have over-borrowed and overspent. The elections, held this past weekend as the bailout measures were being worked out, resulted in a serious defeat for Merkel's coalition anyway, and Merkel is now being roundly criticized for allowing financial events in Europe to skid nearly out of control. Others point out that delaying action may have made the bailout more costly to Germany and others than it would have been earlier, as borrowing costs climbed dramatically in reaction to swiftly mounting perceived risks.
In the run-up to the announcement about the European aid package, Wharton professors Mauro F. Guillén (born and educated in Spain) and Saikat Chaudhuri (born and educated in Germany), and Jean Salmona (born and educated in France), founder and chairman of the editorial board of ParisTech Review, participated in an interview with Knowledge@Wharton on the likely outcomes from the financial crisis facing Greece, some of its sister countries and the European Monetary Union more generally. How did events spin so out of control? How will the politics of the crisis affect the Eurozone's economic performance? And will there be similar crises in the future? Guillén, Chaudhuri and Salmona addressed these and other questions -- as well as many longer-term issues relevant in the wake of bailout efforts -- on May 7, just before the huge financial support package was announced.
A complete transcript of the panel discussion can downloaded in PDF here. Following are excerpts of the conversation.
Regarding how a monetary union can cripple an economy by limiting economic policy choices, including that of devaluation:
Mauro Guillén: The background to all of this is, of course, a little bit more than 10 years ago when some European countries adopted the euro as their currency. But they didn't think about situations in which maybe the adoption of a common currency would [create] stress and, in particular, the fact that even though there is a common currency in the center of Europe ... there are no mechanisms in place really to make sure that all the countries are playing by the same rules and that all the countries are essentially complying with some basic criteria, which are half economic and half political. So this is not just about economics. It is also about politics -- criteria having to do with budget deficits and having to do with the way in which you are making sure your country can remain competitive after you have essentially given away a very important policy option in your toolkit, which is to devalue your currency. In other words, you are surrendering your sovereignty in terms of your currency, which means that when you are in hard times, you cannot devalue in order to become more competitive.
But at the same time, the architects of this monetary union 10 years ago didn't think about what should be done in case one or more countries actually get into trouble. They didn't think about what kinds of institutional arrangement and decision-making procedure should be in place to tackle a crisis that unfortunately -- as always happens with these sovereign debt crises -- has built up over a very, very long period of time. But [the crises] unfold very quickly. So the roots of the situation are to be found in the last five years or 10 years and probably the last 15 years, since Greece, Portugal, Spain and so on became members of the European Union in the mid 1980s. But the unfolding of the crisis actually has taken place over just a period of two months or three months and, therefore, if you didn't plan, especially institutionally, for the situation then there is no way in real time that you can actually put in place the mechanisms to cope with the situation.
Saikat Chaudhuri: The latest economic crisis shows it's time to create the right institutions and mechanisms for dealing with the kinds of financial crises seen in Europe last week. Will we see more crises? I think that in a global economic system...we will see more crises. That's just the nature of it. I think it is a good time to start thinking about the right institutions and mechanisms at those levels, which can respond to these types of crises in an effective fashion. And that's been the lesson from the global financial crisis. I think that's the lesson from the Greece package. I think that knowledge reached a certain level in Europe [and] that we will see a strong response coming from Europe, from Germany, France and other countries. They can't let [the EU] fail. It's that "too big to fail" type of concept applied in a slightly different way.
Regarding whether the stabilization package for Greece will lead to real reform of institutions that allowed the economic and financial systems to deteriorate:
Guillén: As you know, this is a very controversial issue. That used to be the way in which the IMF [International Monetary Fund] tended to operate, especially in the beginning of the 1980s. When a country knocked on the door saying, "We can't keep going. We need a bailout. Would you help us?" the IMF typically responded ... [by] saying, "Sure. We will help you, but by the way you need to change this or that [various economic policies]." The IMF came under attack for actually going too far in terms of asking countries to do certain things that, in some instances, proved to be counter-productive. So it is tricky. There is a professor [of management] here at Wharton, Witold Henisz, in my department who has demonstrated that when you impose reforms from the outside, when a country is in dire straits, it is actually so much more likely that there will be a backlash against those reforms. It's not just about economics. We can try to figure out what is the best technique of solution. We have great economists here at Wharton who could tell us the best solution from a technical point of view. But Saikat just mentioned that you also need to take into consideration what is possible -- politically possible -- and then what are going to be the consequences of this looking down the road, depending on how you proceed now. That's why at the beginning I was saying you also have to take into consideration the political cost or the political benefits -- or both -- of doing things in a particular way.
Greece, first of all, what it needs is to tell the truth. It hasn't. Greece needs to avoid the situation in which they don't even know how much money there is in the country because their fiscal system -- it's just a problem that there is so much tax evasion in the country. They just let that problem grow in an uncontrolled way. That is also true of Italy, of course.... I don't want to single out Greece as being institutionally a disaster. But it seems to be that there are a lot of things in Greece that are not working properly.... But if you try to impose [a solution] from outside it may not be -- that's unlikely to be the best way of doing it.
Regarding attitudes that allowed the current crisis to arise and some of the political and social results:
Jean Salmona: Let me give you a sentence by former Socialist Prime Minister of France Laurent Fabius, one of the fathers of the euro idea, when he was a member of the government: "We have to be realistic. That means we should take into account the present situation. Not of course the present situation as it is, but as it should be." And that we look at the situation, not as it is but as it should be, explains a lot of our problems in Europe. The result is that the people have someone to blame. They blame the banks of course. And they blame any scapegoat. For instance, I don't know whether you have looked at the recent elections in Hungary. The far right party ... made a lot [of political gains]. And it is not only there ... In France the recent [local] elections [resulted in French conservative politician Jean-Marie] Le Pen and his very far right, almost fascist, party getting more than 15%. All of that explains that the people do not know exactly what to do. Now, coming to the euro ... I don't see how we can go ahead without more coordination -- some kind of common policy. Having common money without a common fiscal policy doesn't really make sense -- and without [having] a common social system doesn't make sense. At present, the mind of the French people is "Let's do something, but the Germans will pay." And [French President Nicolas] Sarkozy is quite good at that in convincing them to get [German Chancellor] Merkel [to pay] in spite of her political situation today.
Regarding the likelihood of a disintegration of the Eurozone:
Guillén:I would tend to think that it is not that likely that the Eurozone would unravel. I don't think it is very likely. It's not very likely because all it would take for the whole thing to be saved is for the Germans to send a very clear signal that they are not going to let that happen.
If things get bad enough in the next two or three months that there is a danger that [disintegration of the Eurozone] could happen, I think Merkel would essentially stand up and say, "Enough is enough. We are going to be supporting this and making sure that we get out of the problematic situation that we find ourselves in." Probably that would need to be done in conjunction, obviously, with France....
I don't think anybody should take pleasure in seeing the European Monetary Union or the European Union [experiencing difficulty]. Quite frankly, I am dismayed at the fact that some commentators, especially in the press, are coming very close to celebrating like saying, "We told you that this was going to happen to you," as if this wouldn't have any consequences on the economic recovery here in the United States or, for that matter, recovery around the world. It would have devastating consequences.
Chaudhuri: I strongly agree with Mauro on this because I really think that it is very unlikely that they will unravel the Eurozone or other aspects of the EU. The basic situation is now that de facto we live in a globally interdependent economic system. It is not just about Europe. It is about the global financial markets being linked. It is about exports happening. It is about markets opening up. If you look at Proctor & Gamble's [earnings] results declared very recently, or IBM's, clearly their recovery is coming from other places than their domestic market right now. That's why they are posting returns. So whether we like it or not, [the markets are connected] -- and the stock markets are certainly sending us those signals. That's the de facto situation.
The question becomes: ... How can we best align and, perhaps, address discrepancies? It is there at the social level.... It is at the economic level. It is at the political level. And really it is the institutions, like we see in the financial system, which have to get together and develop these mechanisms. I think there's no choice.
The other point I want to make is that there is a short-term consideration, a mid-term consideration, and a long-term consideration, which has been implicit, right? Yes, Merkel ['s party suffered a major defeat in regional elections last weekend], which will make it hard for her to govern from Berlin and Germany as a whole. But there are much larger implications here for the system. If it comes down to it, that notwithstanding, her focus will be on saving the German economy by saving the EU.
I think the point here is how can we achieve that integration in a meaningful way? ... It would be easy if all new entrants, or ... if the weaker economies in Europe -- including the Eastern European ones, were also faltering at this stage to make the argument that the whole EU and the euro is a failed experiment. But it's not the case. The Czech Republic, Slovakia, Romania and so forth are much better integrated. They are the lower "cost" production centers, outsourcing centers, with high expertise mind you within the EU. And it works. Greece was not integrated for the various competitive reasons or lack thereof that we were talking about.
Salmona: During the Second World War, Winston Churchill could get the British people to accept very strong measures because it was for the war.... The problem in Europe is that people do not feel it is the war, although I think it is the war -- a different type of war. Again, sorry to quote my French co-citizens but one of the heads of the Socialist party said last week when they had to vote in Parliament "for" or "against" giving $6 billion to Greece, "Eventually, okay, we are going to vote 'for,' but I must say and emphasize the fact that we are very much against the measures that Greece is taking now." ... So this is really serious. And I think that only a set of measures which would reorganize the financial system at the worldwide level would have a psychological impact on the populations and on the people who vote. Unless something like that happened -- and the U.S. has to take the lead -- nothing can happen unless [President Barack] Obama together with the IMF says, "Okay. Enough is enough. Let's start some very strong [measures]."
Regarding what a lower euro could mean for the U.S. dollar and the U.S. economy:
Guillén:What is that going to mean for the dollar? Well, I think Americans -- all of us, in other words -- are going to have to think very hard about what we are doing, and our standard of living is going to come down on average. I think this is inevitable unless we become more competitive. It is a bad thing that now when there is uncertainty in the world, the dollar suddenly becomes more valuable because that is hurting some of the incipient export activities going in and out of this economy. So it is actually, I think, bad that this is happening. But people seem to celebrate it [because] suddenly the dollar is a little bit stronger. That is actually the last thing that we would like to have right now in the U.S. -- a strong dollar. What we need is a relatively weak dollar.... We need to reduce the trade deficit and we need to become more competitive and import less. This is actually producing the wrong set of incentives. But, again, I think there are too many "ifs" and too many moving parts in the questions that were just formulated. Again, I think, right now given that the hotspot seems to be Europe -- that's the center of attention now -- what we need to do is to try to resolve the situation there and then take it from there.