Don’t Blame The Euro, Says EEAG Report 2011 – Analysis


The U.S. financial crisis infected Europe with an economic malaise so severe that it brought some countries to breaking point in 2010. The reaction was to bail out the banks, implement Keynesian recovery programs and formulate loose monetary policies. This approach has aggravated already huge public debts, which, in some cases, were already unmanageable.

The 10th EEAG Report on the European Economy, prepared by the research group CESifo, in association with economic experts including IESE Prof. Xavier Vives, considers the origins of the European sovereign debt crisis, assesses the current situation and makes practical suggestions for restoring Europe’s financial health.

Macroeconomic Outlook

In 2009, there was considerable speculation about the global economic recovery: Would it be V, L or W shaped?

Today, it seems, the recovery has taken a V shape, as world trade grew throughout four consecutive quarters in 2010.

Although this may seem positive, it’s important to remember that this growth has not happened across the board. In the emerging and developing markets, industrial growth has overtaken its pre-crisis expansion rate, but this is not so in most advanced economies.


European austerity measures, and the steady reduction of fiscal stimulus packages in the United States, put the brakes on the general recovery in 2010. As a consequence, the report anticipates similarly subdued growth in 2011, with Asia contributing the most to global GDP.

New Crisis Mechanism

The Stability and Growth Pact could have contained the debt within the euro zone had it been properly implemented, says the report. Up until 2010, there were 97 cases of deficits that rose above 3 percent of GDP – a rate forbidden by the pact.

The report proposes an economic control system that uses market forces as a safety valve against dangerous levels of public debt.

A three-stage crisis mechanism, based on the E.U.’s suggested European Stability Mechanism (ESM), could be used to protect against financial collapse without resorting to full-coverage insurance.

1. If a country is unable to pay off the money it has borrowed, a temporary liquidity crisis will be assumed, giving the state enough time to raise taxes or cut expenditure, and restore the faith of potential lenders.

2. If the country is still in crisis after 24 months, impending solvency should be assumed, while Collective Action Clauses (CACs) can be used to help governments find other ways out of their problems.

3. If the state has no option other than to draw on the ESM guarantees, then it will need to declare full insolvency until all of its debt has been paid off.

Greece: A Choice Between Evils

The report examines the rescue package that was provided for Greece by the European Commission, the ECB and the IMF after its crash in early 2010. It looks at the peculiarities of the Greek economy, and whether or not Greece will need further support when the current package runs out.

Several factors must be considered when looking at how Greece can solve its sovereign debt crisis. These include Greece’s high level of self-employment, the consequent risk of tax evasion, low levels of competitiveness and net exports of services.

There are three possible ways that Greece could deal with its unsustainable current account deficit: leave the euro and revert to a devalued drachma, extreme depreciation within the country, or further E.U. transfers to finance the deficit.

The possibilities of internal or external depreciation are costly and lengthy processes, and risk the well-being of firms and financial institutions. Yet they are far preferable to the option of endless transfers, given that these are unlikely to help Greece gain international competitiveness.

Spain: End of Line for Gravy Train

Spain’s economic “success story” has undergone a radical revision. During the 10 years prior to the current crisis, the country experienced impressive growth, a surge in employment and an improved fiscal outlook.

However, rather than continuing its upward climb, this growth has come to a screeching halt. Unemployment has surpassed 20 percent, and GDP shrank significantly, causing a large budget deficit.

This has amplified the need for urgent reform in Spain, both in implementing structural changes and in calming the markets so as to avoid insolvency.

The report recommends that the state restructure both the system of collective bargaining and the legal mechanisms for protection of employment.

These changes should be accompanied by measures to improve the higher education system and the quality of R&D.

Taxation and Regulation

Finally, the report takes a look at what caused the crisis, and how these problematic factors can be avoided in the future through the use of taxation or regulatory measures.

Taxes could be used within the financial sector to increase revenue, for example, as a form of insurance premium: The rate of tax a company would pay would reflect the risks it took and the support it would need in case of any emergency.

Alternatively, the Financial Activities Tax (FAT) could be used, using either a simple, narrow-base system, or a type of VAT.

Another way to protect against a recurrence of a future crisis is to use tax to encourage behavioral change. This could be done by requiring banks and financial institutions to invest in more reliable assets or reduce their leverage.

Above all, rather than calling the euro into question for its role in contributing to these imbalances, the report believes that the answer lies in “more prudent investment behavior, based on the principles of liability and responsibility.”

“Europe also needs a system of generally accepted supervision and codes of practice in the financial industry, as well as tight public debt constraints, so as to tame the excessive and unhealthy capital flows that caused the crisis. Once such a system has been established, the current difficulties of the euro may turn out to be mere teething problems in what ultimately will become a success story in the process of European integration,” the report concludes.

IESE Insight

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