Why have we not (yet?) solved the Financial Crisis?


For several months we have been bombarded with new EU and ECB proposals and decisions on reforming one or the other fragment of the EU and Eurozone economy. But still, growth is anaemic, unemployment rising, the double-dip recession deepening, the Greek crisis spinning out of control, social cohesion in Spain, Portugal, Italy and other EU countries disintegrating.

Why, ask many EU policymakers, are our efforts not successful? Have we not done some very innovative and radical things, have we not thrown many of the self-imposed rules and regulations overboard, in order to overcome the crisis? EU citizens also want an answer to these questions, urgently.

I see three major flaws in the EU/Eurozone crisis strategy: one is process-related, two are substantial.

Process: We need a Grand Bargain!

The never-ending flow of summit meetings, with ever new announcements and decisions has left both businesses, consumers, media and the financial markets at a loss where this trip will take us. I agree with Dennis Snower, the President of the Kiel Institute for the World Economy (see Financial Times October 16), that a Grand Bargain should have been, or needs to be struck, instead of the stepwise individual partial solutions. I have pleaded repeatedly – at a world scale – for a new Bretton Woods-type conference, where world leaders, aided by experts, would meet for a prolonged period of time (“open-ended”) and negotiate one unified package, dealing with all aspects of the financial and sovereign crises. For Europe, a similar Grand Bargain Summit could tie up all the loose ends in one large sweep.

The advantage of such a Bargain would be that it could deal with the short-run legacy problems of the debtor countries and the long-term sustainability problems jointly, and thus give creditor countries – being assured that sovereign solvency problems would not re-occur – the incentive to provide more help to the debtors, knowing that they will be repaid. In the present situation, creditors will not be willing to cover outstanding debts, because this would reduce the dectors’ incentive to repay.

Snower lists four lines along which such a Grand Bargain should be structured: a) a “stabilising fiscal rule” for each Eurozone country, with a 25-year horizon, basically specifying a structural deficit path which would allow countercyclical policies both in the down- and the upswing; the European Commission would have budgetary power if the targets were missed; b) transparent solvency criteria, so that countries violating their agreed debt ratios could be declared insolvent and subjugated to an orderly restructuring process; c) a full banking union, including joint financial regulation, deposit insurance, bank resolution, catastrophic loss insurance; d) EU structural funds should be singularly directed towards growth-enhancing activities.

These are far-reaching, but important proposals, but – in my opinion – lack at least two crucial issues of substance.

Substance 1: Restructure the Financial Sector!

So far, banks are engaged in heavy de-leveraging to reduce their balance sheets in order to meet higher equity ratio criteria. Each bank does this separately, there is no “European” plan and criteria which banks are sustainable and which are not. In addition, there is still no decision on how to deal with banks too large to fail and whether to separate commercial from investment banking. Thus, most banks retrench, but otherwise follow the same business models as before the crisis. This will result in high costs and a recurrence of the crisis. Thus, joint regulation is one thing, but the content of regulation still needs to be agreed upon at the EU/Eurozone levels. Strong banking sector lobbying has so far prevented these important steps.

Substance 2: Develop a Growth Strategy!

Snower advocates – rightly – the re-direction of EU structural funds towards growth-enhancing measures. This, however, does not go far enough to provide impetus towards growth. It is not only the crisis countries which need growth, but the whole of the EU/Eurozone – if to various degrees and with different measures. The overall EU economic policy orientation is towards budget consolidation and debt reduction, important in these times, but broadly insufficient. Even the sensible indicators and measures circumscribed in the Agenda 2020 (similar to the ones in the Lisbon Agenda of yesteryear) do not go far enough – and institutionally and instrumentally are subjugated to budget consolidation. The best proof of that is the institutional underpinning and sanctions provided by budget consolidation.

Both the EU and the Eurozone must adopt a more complete economic strategy portfolio, where employment creation, economic growth with environmental safeguards, external balance and budget balance are the main, and evenly weighted, pillars. This requires a European framework, under which country-specific innovation and growth policies, industrial policy, employment and training schemes and education policies supporting higher value-added production and services supply in addition to repairing the environment and finding ways to combine the avoidance of environmental degradation with welfare enhancement. In the short run, the creditor countries should use their fiscal space to support relevant measures, but in the medium to long-term run such a balanced economic policy agenda must be developed for the EU/Eurozone as a whole. So far, the relevant measures have mainly been supply-side driven, important but insufficient again. More innovative policies are necessary to reduce the competitiveness gaps between EU/EZ countries and narrow the large current and balance of payments discrepancies between the member states.

Fazit

The incremental approach chosen by EZ and ECB policymakers is self-defeating, since it is unable to combine solutions to the legacy questions with longer-term viability problems, in this way preventing assurance that short-term help can be paid back.

Thus, a “radical” process innovation of a Grand Bargain, or Bretton Woods II, or Eurozone Future is required in order to tie these loose ends together.

Much more radical need to be the issues of substance, i.e. how the EU/EZ will restructure its financial sector in order to restore its functionality in the future, and how to balance and design its future economic policy, away from single-minded budget consolidation direction towards a welfare-enhancing growth, environment and employment oriented strategy. Budget consolidation and debt reduction are only instruments, but not objectives of a sustainable socio-economic policy.

 

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Filed under Crisis Response, European Union, Financial Market Regulation, Fiscal Policy, Global Governance, Socio-Economic Development

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