Presentation: EMU under pressure (pdf)

Hans-Werner Sinn is Professor of Economics and Public Finance and President of the Ifo Institute for Economic Research at the University of Munich. 

What Euro crisis? : Despite huge rescue packages, interest-rate spreads in Europe refuse to budge. Markets have not yet found their equilibrium, and the governments on Europe’s south-western rim are nervously watching how events unfold. What is going on? The rescue packages were put together on the weekend of May 8-9 in Brussels. In addition to the €80bn program already agreed for Greece, the European Union countries agreed on a €500bn credit line for other distressed countries. The International Monetary Fund added a further €280bn.

The driving force behind all this was French President Nicolas Sarkozy, who colluded with the heads of Europe’s southern countries. French banks, which were overly exposed to southern European government bonds, were key beneficiaries of the rescue packages. Since rescue measures beyond the pre-arranged Greek package had not been on the agenda for the Brussels meeting, German Chancellor Angela Merkel thought she could safely go to Moscow to commemorate the end of World War II - - unlike Sarkozy, who declined Russian Prime Minister Vladimir Putin’s invitation. Worse, the leader of the German delegation to the EU meeting fell ill and was taken to hospital upon arrival in Brussels. This left the German delegation headless.

Proclaiming a systemic crisis of the euro, Sarkozy seized the opportunity and took Germany by surprise. He asked for huge sums of money and, as Spanish Prime Minister José Luis Zapatero reported, threatened to pull France out of the euro and break up the Franco-German axis unless Germany opened its purse. After just two days of negotiations, the Maastricht Treaty’s no-bailout clause, which Germany once had made a condition for giving up the Deutsche Mark, was defunct. The “Club Med,” as Germans call the southern countries, had taken over Europe.

Even the European Central Bank chipped in, buying government bonds of over-indebted countries, using a loophole in the Maastricht Treaty and overruling the Bank’s German representatives. The European house creaked mightily. Germany’s president stepped down soon after the decisions - - some say because of them. Germany’s political elite are in an uproar, and serious voices advocate splitting the Eurozone into northern and southern tiers, with France relegated to the latter.

I do not share this view. The euro has successfully protected Europe against exchange-rate risks, and it is a useful step towards further European integration. Moreover, the stability provided by the Franco-German axis is indispensable for Europe.

Nevertheless, the tensions created by Sarkozy’s recklessness threaten Europe’s political stability, heightening market uncertainty relative to what a more prudent, coordinated rescue program would have implied. The programs that have been agreed will not suffice to reassure creditors, and Germany will most likely be unwilling to bow once again to Sarkozy in the coming negotiations to prolong the rescue measures  - - at least as they are constructed now - - beyond the initially stipulated three years.

The arguments used to justify the coup are dubious. In order to overcome the no-bailout clause, Sarkozy and other European leaders dramatized the decline of southern European governments’ bonds and the corresponding increase in interest-rate spreads. By formally proclaiming a systemic euro crisis - - when in fact there was only nervous market reaction concerning a few European countries’ government bonds – they could invoke Article 122 of the Union Treaty, which was intended to help member countries in the event of natural disasters beyond their control.

If anything, the proclamation of a systemic crisis poured fuel on the fire. Investors took Europe’s leaders at their word, because politicians usually downplay rather than overstate a crisis.

The average interest-rate spread relative to Germany of the countries protected by the new rescue package was 1.08 percentage points on May 7, when the world was claimed to be going under. Then it seemed that the rescue packages were pushing the spreads to much lower values, but optimism faded as European leaders’ interpretation of the crisis sunk in with more and more market participants. In the week ending June 18, the spread had climbed to 1.1 points on average.

Obviously, the market is now as nervous as it was before that May weekend. But that is a far cry from spelling doom for the euro. In 1995, shortly before the euro was announced, the corresponding interest-rate spread was 2.6 percentage points, more than twice today’s level. The euro was simply in no danger when European leaders decided to rescue it, and it is not in danger now. Markets are just moving towards a new equilibrium with higher interest-rate spreads, which reflect the higher default risk of some European countries - - a bit like in pre-euro times, though much less extreme.

There is nothing wrong with this. The market adjustment will end when appropriate spreads are found. Any political attempt to stop this process any sooner is bound to fail. There is no reason for panic, and every reason to stay calm and wait for the new equilibrium to emerge.

Interest-rate spreads between safe and risky assets are natural to functioning credit markets. They signal potential risks and enforce debt discipline on borrowers. This is exactly what Europe needs. The Stability and Growth Pact, aimed at punishing countries that breach the 3%-of-GDP deficit limit, was a joke: not a single wayward country was ever punished. Fortunately, capital markets finally stepped in to impose the necessary hard budget constraints on governments.

This discipline will stem the gigantic capital imports by the countries at Europe’s periphery and end the overheating ushered in by the interest-rate convergence that the euro brought about. These countries will go through a slump that will reduce their inflation (perhaps bringing them close to deflation) improve their competitiveness, and reduce their current-account deficits.

Conversely, Germany, which has suffered from relative deflation and a long slump under the euro, will experience an inflationary boom that will reduce its competitiveness and current-account surplus. French Finance Minister Christine Lagarde, who often complained about trade imbalances in Europe, should applaud these market reactions, which were unintentionally strengthened by her president.