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Need for clarification: the often forgotten strengths of the euro area
Some countries in the euro area face a combination of high levels of indebtedness, budget deficits and weak or absent growth. Amid growing market turmoil and the risk of contagion, an increasing number of economists call for debt restructuring in the affected countries. These proposals often share an anti-euro sentiment and seem to be in accordance with the naysayers who were taking potshots at the euro even before its inception in 1999.
However, many critics ignore the euro area’s strengths. There is a need for clarification. Let me start by stressing some facts:
Still, there is no room for complacency. The sovereign debt crisis in several Member States of the euro area and financial markets turmoil indicate that we are facing very challenging times.
Currency without a state
There can be the case for moral hazard in so far as fiscal profligacy of one single Member State could be averaged out by the virtuous behaviour of the majority of the other countries. The incentive structure is flawed because it can lead to unsustainable fiscal policies of individual Member States, which in turn would generate negative spillover effects to the monetary union as a whole. With hindsight, we have to acknowledge that some countries allowed fiscal profligacy, weaknesses in the banking sector and deteriorating competitiveness. The institutional set-up could neither prevent nor resolve a severe crisis of the magnitude that we are currently experiencing. Although the instruments and procedures were available, they were either not implemented, ignored, or watered down.
In a nutshell: the euro area suffered from serious weaknesses in the fields of financial, fiscal and economic governance on the preventive side and had lacked a crisis resolution mechanism.
The epicentre of the global financial crisis has shifted from the US to the euro area. The rapid spreading of the crisis is reducing the options at hand to tackle the crisis. Europe has already taken important decisions to improve its crisis resolution mechanism and to strengthen preventive measures to avoid macro-economic imbalances and unsustainable fiscal policies. It is important to implement these rules now and make the institutions operational, as markets tend to lose patience. There is a strong appetite for a comprehensive solution. The banking sector must increase its resilience against sudden, external shock. This is particularly important in times of high market volatility and elevated uncertainty. Quick action is needed to clean up banks’ balance sheets and recapitalise them, where it is deemed necessary.
On top, countries with elevated debt levels and augmented budget deficits have to put public finances on a more sustainable path and spur growth by structural reform. Sovereign defaults should be avoided, as the cost most likely would outbalance the benefits by far. The ECB has repeatedly objected to all concepts of debt restructuring that are not purely voluntary or that have elements of compulsion; any credit events and selective default or default should be avoided. A strong and transparent commitment to sound public finances is the best weapon to combat market attacks.