Lessons to Learn (and Not to Learn) from the Greek Crisis

Europe’s heads of state and government held an emergency summit on Greece at roughly the same time that European Commission President Jean-Claude Juncker unveiled a report he drew up with support from the Presidents of the European Parliament, European Council, European Central Bank, and Eurogroup for ‘Completing Europe’s Economic and Monetary Union.’ This juxtaposition is only partly coincidental. The ‘five presidents’ have been working on their report because the ongoing crisis in Greece makes it clear to all that there are still important gaps in the architecture of the single currency. Greece is not, however, the only reason many regard further reform of European institutions for macroeconomic governance as inevitable.

Reconsideration of the institutional requirements for a stable monetary union (re-)started in October with concern expressed by the European Council about the need for action across multiple fronts to promote growth and employment. It gained momentum with recognition among members of the euro group that ‘closer coordination of economic policies is essential to ensure the smooth function of the Economic and Monetary Union.’ It became a formal part of the European policy agenda when the European Council called for the report last December. It began to take shape in the form of an analytical note diagnosing the origins of the European crisis and presented to the European Council in February. And it has evolved into a two-stage process for the completion of interlocking economic, financial, fiscal, and political unions.

The crisis in Greece is at best only an illustration of the problems resulting from an incomplete monetary union. Nevertheless, Greece is the lens through which many European policymakers perceive and understand the European crisis. Therefore it is important to pay attention to what we should learn and what we should not learn from the Greek crisis as European policymaker prepare to undertake a comprehensive institutional reform agenda.

The first – and most important – lesson from Greece is that banks should not rely excessively on capital and collateral that is backed by their national governments. The systemically important Greek banks all survived the ‘comprehensive assessment’ administered by the European Central Bank in 2014. In other words, they were sufficiently capitalized to remain solvent even under adverse circumstances. They also had sufficient collateral to gain access to liquidity. Unfortunately, however, those factors held only so long as the Greek government remained creditworthy and stayed within its bailout program.

Once it became clear that the Greek government would leave the program in February, the European Central Bank lifted the waiver that made Greek-government-backed assets eligible as collateral for routing liquidity operations. That decision is what pushed the Greek banks into their dependence upon emergency liquidity assistance from the Bank of Greece. Fast forward to the present, that same decision is what has brought the crisis to a head. For a variety of reasons, the banks are likely to run out of access to emergency liquidity assistance before the Greek government actually defaults. The Greek banks would be safe if they had different capital and different collateral. As things stand, they are the canaries in the coalmine. The single currency is the mine itself.

Europe’s economic and monetary union needs a new financial architecture. The five president’s report gets that part right. The proposal for a credible backstop for resolution funding and a European deposit insurance scheme would be particularly useful in restoring confidence for the Greek banks. Nevertheless, those proposals would not eliminate the exposure of Greek banks to capital and collateral backed by the Greek government. Hence the report should go further – and it does. As part of this architecture, the single currency needs a centralized system for sovereign debt management to create sound assets that banks can use to collateralize their treasury operations. The creation of a European Treasury as proposed by the five presidents would be an important step in the right direction.

Unfortunately, five presidents identify the right instrument for the wrong reasons. The five presidents report argues that Europe needs ‘more joint decision-making on fiscal policy’.  A European Treasury would provide a focal point for the exercise of policy discretion through collective decision-making. The second lesson from the Greek crisis, however, is that Europeans do not want collective decision-making on fiscal policy.  Instead, they want to have autonomy over who to tax and how to spend. They also want autonomy over entitlements and incentives. Most of all, they will preserve that autonomy even at great risk. For example, German politicians refuse to be ‘blackmailed’ into bailing out the Greek state (supporting Greek pensions or subsidizing Greek public sector employment) even at the risk that a Greek default would spark a humanitarian crisis followed by a Greek exit from the single currency; Greek politicians refuse to concede on pensions, privatizations, or other fiscal targets even though they may ultimately run out of cash.

Such disagreements over fiscal discretionary matters are not uncommon. You can find wide divergences in fiscal practices across U.S. state governments like Massachusetts and New Hampshire. You can also find numerous examples of secessionist movements rooted in demands for greater fiscal autonomy – as in Beligum, Italy, Spain and the United Kingdom. Collective decision-making over fiscal matters requires a high degree of solidarity. What Greece reveals is that such solidarity is largely absent at the European level. This does not preclude the possibility that future generations will be able to make more decisions in common but it does suggest that future is not now.

Discretionary policy is not only about who pays and who benefits. It is also about the goals of macroeconomic governance – including aggregate demand management. The five presidents seem to believe that Greece and other peripheral countries would be better off if there were some fiscal mechanism for aggregate demand management at the European level. That is why the five presidents call for a European Treasury. The passage is worth quoting at length: ‘There are many ways for a currency union to progress towards a Fiscal Union. Yet, while the degree to which currency unions have common budgetary instruments differs, all mature Monetary Unions have put in place a common macroeconomic stabilization function to better deal with shocks that cannot be managed at the national level alone.

There are at least three things wrong with this statement. First, there is no reason to believe that a European Treasury would have done much to support economic activity on the European periphery or in Greece in particular. Hence the need for fiscal stabilization is one of those lessons that we should not learn. If you look at long-depressed regions within countries – like the Mezzogiorno in Italy or Andalusia in Spain – it is easy to understand my pessimism. As I have argued elsewhere, the use of fiscal instruments for macroeconomic stabilization works best over time and not across geographic space. The only exceptions are those systems like Finanzausgleich in Germany which target inter-regional differences directly. But such systems depend upon a huge degree of inter-regional solidarity that does not exist in most places – even large federal arrangements like the United States. As a result, the putative benefits of federal fiscal systems are wildly overrated even as the political costs of common fiscal institutions threaten the unity of countries as mentioned above. The ongoing debate in the United States about ‘defunding’ the federal government is an added example.

A second problem is figuring out which ‘mature Monetary Unions’ the five presidents have in their data set. The Belgian-Luxembourg economic and monetary union did not have a common treasury for macroeconomic stabilization policy. Moreover, efforts by Belgium to engage in aggregate demand stabilization in the 1980s played a large role in generating enthusiasm among the Luxembourgers to build their own central bank and join a different ‘common currency’ – meaning one in which Belgium was no longer primus inter pares. As for big financial areas like the United Kingdom, the United States, and Canada, they developed unified treasury operations long before economists even understood notions of aggregate demand management. Their goal was to create stable instruments for the management of government finances. In this goal, they were aided and abetted by banks who sought to profit from providing finance to sovereign authorities. Over time, banks and sovereigns developed a symbiotic relationship with sovereign debt instruments evolving into a universally recognized ‘risk free’ asset to use in treasury operations.

This common ‘risk free’ asset is what the euro area currently lacks and the five presidents should seek to replace. Otherwise domestic banking systems will continue to remain bound to local sovereign authorities much as the Greek banks are bound to the Greek state. This bank-sovereign linkage highlights the third problem with the statement in the five presidents report. They say that ‘the degree to which currency unions have common budgetary instruments differs.’ That is undeniable given the wide variety of instruments that are available for government financing. Nevertheless, there is a point of commonality as well. That shared attribute is the preference that financial market participants have for one instrument within each monetary union over all the rest when they engage in a flight to liquidity or a flight to safety.

That order of preferences is true in the euro area as well. The problem is that the instrument most preferred by financial actors in times of duress are bunds which are issued by a single participating country – Germany. This is a third lesson from the Greek crisis. It is hard to think of any other ‘mature Monetary Union’ that has a similar arrangement. And it is easy to see how such an arrangement could be unstable, particularly if there is less supply of that instrument within the monetary union than there is demand for liquidity and safety. If Greek banks held ‘eurobonds’ or some other shared ‘risk free’ asset there would be no banking crisis in Greece today and there would be no risk that a default by the Greek government would force Greece to exit the euro as a common currency – any more than Detroit (or California, etc.) was forced to exit the dollar.

[Mere mention of the word ‘eurobonds’ is likely to turn off most readers, who will roll their eyes at the political impossibility of creating mutualized sovereign debt instruments. Those same readers all have Visa or Mastercard in their wallets, and have access to mutualized consumer credit instruments issued by banks shared by people across the globe. They probably also work for firms that take both Visa and Mastercard in payment for at least some of their operations. And they continue to use credit cards despite the fact they know – or have at least heard of – people who have gotten into trouble by running up too much credit card debt. Somehow the existence of this technology offers nothing to convince them that sovereigns could operate within a similar network that combined both limits on borrowing as a share of disposable income with ongoing assessments of creditworthiness and within which the default of a single participant need not bring down the system as a whole. It is easier to pretend that the fault lies elsewhere than to imagine that familiar financial instruments could solve complex public policy problems. The tragedy is that many Greeks may lose access to the Visa and Mastercard networks as a consequence.]

Another way of looking at the Greek crisis is through the twin lenses of ‘competitiveness’ and fiscal responsibility. These are long and complex arguments for which the five presidents have two institutional solutions. One is to create national competitiveness authorities like they have in Belgium and the Netherlands to keep an eye on relative wage costs and market-structural reforms. The other is to create an ‘advisory European Fiscal Board’ to provide additional oversight on national processes of fiscal consolidation.

There is something ironic about both proposals. The Belgian and Dutch competitiveness authorities emerged out of beggar-thy-neighbour macroeconomic strategies designed to shift unemployment from the Low Countries onto Germany and France. They worked but only because Belgium and the Netherlands are relatively small countries. Such measures also created labour market distortions. Perhaps that is a small price to pay to help prevent small countries from crashing out of the Europe; nevertheless it is no panacea. A close look at the data suggests that Greece did not suffer because of a lack of competitiveness – and neither did Ireland or Italy. Spain and Portugal fit the competitiveness argument more closely. Even there, however, it is unclear that more ‘competitive’ labour markets would have been sufficient to prevent the problems that emerged around the cajas in Spain or government finances in Portugal.

As for the advisory European Fiscal Board, the analysis confuses cause and effect. Here the fourth and final lesson from Greece is important. The problem is not that the Greek government lost control over its finances; the problem is that the rest of Europe cannot allow the Greek government to default. Moreover, financial market participants have long recognized that fact. That explains why the spreads between Greek and German assets were so narrow for much of the history of the single currency. Again the explanation points back to the link between Greek government finances and the stability of the Greek banks. If this link were severed, then Greek policymakers would face market discipline.

Market discipline on sovereign borrowing is hardly perfect and the Greeks might have gotten into trouble nonetheless. The difference in a world with eurobonds or some other common risk free asset would be that Greek policymakers would not be holding Greek banks hostage and they would also have no reason to exit the euro. The two worst case scenarios – capital controls and a Greek exit from the single currency – would be eliminated not because of the advice of a European Fiscal Board but by the circulation of a shared risk free asset for use across the monetary union.


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