Institute for New Economic Thinking (INET) and INET Council on the Euro Zone Crisis (ICEC): Europe is Sleepwalking Towards Disaster of Incalculable Proportions

The alternative to fixing the euro is a catastrophic crisis with the euro zone socially unsustainable.

The dilemma is how to unwind the high debt levels and losses in competitiveness accumulated and do this in the middle of recessions that are beginning to strain some societies to the breaking point, and in light of the overwhelming size, power, and scepticism of financial markets.

ICEC suggest the answer must involve a combination of extraordinary measures, which include institutional and fiscal-structural reforms aimed at minimising the immediate output cost of real exchange rate and fiscal adjustment, support from existing funds (the EFSF and ESM), additional support from surplus countries, voluntary debt restructuring, an exceptional role for the ECB, and exceptional emergency macroeconomic and monetary policy measures.

A recent report “Breaking the Deadlock: A Path Out of the Crisis” summarizes:

It is still possible – economically and politically – to find a way out of the euro zone crisis if policy makers separately address two problems: dealing with the legacy costs of the initially flawed design of the euro zone, and fixing the design itself. The former requires significant burden sharing and an economic strategy that focuses on stabilising the countries that are suffering from recession and capital flight. In contrast, fixing the design requires a financial (banking) union with strong euro-­area institutions and a minimal fiscal backstop.

The key findings by ICEC (from NR):

  1. This dramatic situation is the result of a euro zone system that is thoroughly broken. This systemic failure exacerbated a boom in capital flows and credit, and complicated its aftermath after the boom turned to bust.
  2. It is the responsibility of all European nations that were parties to the euro’s flawed design, construction, and implementation to contribute to a solution.
  3. Absent a collective effort the euro zone will disintegrate quickly. The stresses have been building for a long time and conditions in several countries are not socially or politically sustainable much longer.
  4. In formulating recommendations, the ICEC report makes a clear distinction between the legacy problems that were created by the dysfunctional design of the euro zone over the past 10 years and the challenges of re-design that would restore the soundness of the Euro zone system.
  5. One cannot deal with the legacy overhangs as long there is no clear commitment to long-term re-design.
  6. At the same time it is impossible to build long-term mechanisms such as a banking union as long as the legacy overhang of debt imbalances debt, competitiveness, and capital inadequacy of financial institutions impede the path toward a healthy Europe.

The report begins:

We (ICEC) believe that as of July 2012 Europe is sleepwalking toward a disaster of incalculable proportions. Over the last few weeks, the situation in the debtor countries has deteriorated dramatically. The sense of a never-ending crisis, with one domino falling after another, must be reversed. The last domino, Spain, is days away from a liquidity crisis, according to its own finance minister. This dramatic situation is the result of a euro zone system, which as it is currently constructed, is thoroughly broken. The cause is a systemic failure that exacerbated a boom in capital flows and credit and complicated its aftermath after the boom turned to bust. It is the responsibility of all European nations that were parties to its flawed design, construction, and implementation to contribute to a solution.

Deepening recessions and high unemployment are tearing at the social fabric in the deficit countries and causing enormous and avoidable human suffering

– INET/ICEC

ICEC goes on:

Deepening recessions and high unemployment are tearing at the social fabric in the deficit countries and causing enormous and avoidable human suffering. Alleviating this suffering should be the first priority of euro zone policymakers.

ICEC identifies a downward economic spiral in the deficit countries also to be labelled as “deficit countries”, “debtor countries”, “crisis countries” or “south” to refer primarily to Italy and Spain. Ireland, Portugal, Greece, and Cyprus could also be considered to be in this group, but their situation is somewhat different because they are in IMF-­EU supported adjustment programmes. ICEC avoid the “centre” versus “periphery” terminology that has become engrained in the last year because a country such as Italy is too central to Europe – geographically, economically, and historically – to be considered part of the “periphery”.

The deficit countries are experiencing a self fulfilling fiscal crisis as the deficiency of aggregate demand at present leaves many resources unnecessarily idle, and narrows the tax base at a time of fiscal stress.

Stabilising output and employment in the recession-struck deficit countries is impossible without delaying some of the on-­going fiscal adjustment and channelling more support to the deficit countries.

Policy makers in the surplus countries (“Surplus countries”, “creditor countries”, or “north” interchangeably refer to countries such as Austria, Finland, Germany, Netherlands, and the Slovak Republic) must make an effort to convince their voters that significant burden-sharing is necessary to stop the crisis, because deficit countries will otherwise remain stuck in a spiral where fiscal adjustment depresses output in the short run, making it harder for the private sector to repay its debts, putting pressure on asset prices and asset quality of banks, constraining credit, and further depressing output and revenue, which undermines fiscal adjustment. This leads to a breakup of the euro zone, which imposes largely avoidable but very high economic and other costs on both surplus and deficit countries.

ICEC have many specific recommendations for fixing the euro even without further political integration, without full fiscal union, without euro zone bonds and only limited mutualisation (Really? Is that possible? Wauw!). The recommendations have no common liability in any of the long-­term proposals beyond those necessary to establish and backstop the banking union and the ESM, and both are subject to strict safeguards.

The diabolical loop between banks and sovereigns is dragging both down as each rescues the other.

– INET/ICEC

Some of these interrelated recommendations to structurally fix the euro and to put the euro zone on a firm footing include:

  • Financial union, particularly reform of the institutions governing the integrated EMU banking sector.
  • Financial Reform to fix the malfunctioning of the financial sector.
  • Banking union. Financial integration is critical to a stable union. The diabolical loop between banks and sovereigns is dragging both down as each rescues the other, most notably in Spain and Ireland, and could do the same elsewhere. As confidence disappears and investors run away, only the states finance the banks and only the banks fund the state. Breaking this nexus requires making the stability of the banks the concern of the entire union.
  • An EU or euro zone-­level financial supervision and resolution agency must be established, either in the ECB or both in the ECB and in the form of a new agency with authority over national supervisors.
  • Raising monetary policy to a supranational level.
  • Stronger centralised control over both fiscal policy and banking supervision.
  • Fiscal controls to discourage fiscal free riding.
  • A euro zone-­level lender of last resort
  • A debt-­restructuring regime
  • A common risk-­free asset not tied to or issued by a specific country to counter the impact of pure panics, i.e. sudden drops in risk appetite of investors. This safe asset could represent a significant source of new income and be created without joint and several liabilities across countries

Some of the urgent short run measures include:

  • Partial and temporary mutualisation of legacy debt by a new “redemption fund” with the power to issue bills under a joint and several guarantee.
  • Voluntary debt restructuring could take the form of offering to exchange existing bonds for new bonds with the same face value and coupons but longer maturities (say, the original payment dates plus 5 years).
  • Fiscal-­structural reforms, which could include raising the pension age, staff reductions in bloated public administrations, and labour market reform.
  • “Fiscal devaluations” e.g. by substituting payroll taxes with indirect taxes.
  • Outright transfers from the E.U. budget.
  • Low interest loans from the EFSF/ESM.
  • A temporary role for the ECB in the crisis, which could and should be committing to much larger interventions in the market for debt of sovereigns, who are meeting their obligations.
  • Emergency macroeconomic and monetary policy measures.
  • ESM to undertake direct capital injections into the national banking system as a commitment to “catastrophic loss insurance” at the euro zone-­level.

A minority of Council members believe that avoiding future crises requires changing the statute of the ECB toward a dual mandate that includes output and employment objectives, and that the price stability objective should be revised to also target nominal GDP growth.

Source: The Institute for New Economic Thinking (INET)

About ICEC and INET: This article is from a new report “Breaking the Deadlock: A Path Out of the Crisis” from July 23, 2012. The Institute for New Economic Thinking (INET) has sponsored the formation of the INET Council on the Euro Zone Crisis (ICEC) that is comprised of 17 leading European economists. The group held its first meeting on June 26-27 in Brussels (which included George Soros and Adam Posen) and a nonstop virtual meeting has taken place since then. As the pressures toward disintegration of the euro increase and the deep social unrest in Spain, Italy, and other countries erupts, the INET Council of the Euro zone members felt compelled to issue a brief report that creates a vision of how the euro zone could be repaired and redesigned at this desperate juncture. The signatures include:

Patrick Artus
Global Chief Economist , NATIXIS – Banque de Financement et d’Investissement

Erik Berglof
Chief Economist and Special Adviser to the President, European Bank for Reconstruction and Development

Peter Bofinger
Professor, Universität Würzburg

Giancarlo Corsetti
Professor, University of Cambridge

Luis Garicano
Professor of Economics and Strategy, London School of Economics

Paul De Grauwe
Professor, London School of Economics and Political Science

Guillermo de la Dehesa
Chairman, Centre for Economic Policy Research (CEPR)

Lars Feld
Professor for Economic Policy, University of Freiburg

Jean-Paul Fitoussi
Professor Emeritus, Institut d’Etudes Politiques de Paris

Daniel Gros
Director, Centre for European Policy Studies (CEPS)

Kevin O’Rourke
Professor of Economic History, University of Oxford

Lucrezia Reichlin
Professor of Economics, London Business School

Hélène Rey
Professor of Economics, London Business School

Andre Sapir
Senior Fellow, Bruegel

Dennis Snower
President, Kiel Institute for the World Economy

Hans-Joachim Voth
ICREA Research Professor, Universitat Pompeu Fabra

Beatrice Weder di Mauro
Professor of Economics, Johannes Gutenberg University of Mainz


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