By Fernando Fernandez, professor at IE Business School
Forget about short cuts and soft measures: Europe’s problem is that it has lost the market’s confidence, and in order to get it back it will have to take some hard measures.It’s a well worn phrase which is why I have permitted myself a certain amount of poetic license, because it seems to go perfectly with the confusion that is rife among markets and analysts following recent events. The feeling of insecurity is such that we are desperately seeking a lifeline to cling to. Someone is always up for the job of throwing said lifeline and public opinion seems to have honed in on two specific groups: governments comprised of technocrats and the European Central Bank (ECB). The former are expected to bring the required level of sanity and the ECB is supposed to start buying up debt with no thought for expenses. But once again it’s the wrong diagnosis.
The European Commission, according to its vice president Olli Rehn, has decided that the key lies in restoring confidence in fiscal sustainability and the financial system, and in speeding up reforms that stimulate growth potential. Hence we have to change our tune or we have to take notice of the Commission, but either way we should not be looking for short cuts.
The European problem is a simple one. Investors have lost confidence in the Euro, not just in Italy. Let’s not confuse the symptoms of this particular illness. They have done it for a series of institutional reasons – the well-known design faults of the Monetary Union – and mistakes made in the way the crisis has been managed. In my opinion they include two particularly big mistakes. The first was to declare that European sovereign debt is restructurable – albeit only Greek debt, but who on earth believes that at this stage – without having the necessary financial resources or legal instruments to effect an immediate exchange, and the second was to punish banks for their sovereign debt holdings without having the necessary resources to fill the hole created. Both decisions have had consequences that were impossible to recover from in the short-term: they have made sovereign debt a credit asset, a financial instrument that competes with emerging debt, and have eroded the credibility of the European banking system, which has been forced to divest its sovereign debt. The response of investors has been to see the sustainability of European debt as being much the same as that of emerging economies, demanding fiscal tightening, devaluation and structural reforms. With the added detail that one of the policies of this trilogy was unthinkable until the Greek referendum made it possible. It’s not that they have taken a dislike to us but rather that they are giving us a dose of our own medicine. Looking to the ECB as the savior in these circumstances is a naïve thing to do.
Does anybody seriously believe that it was the liquidity of the Bank of Brazil that saved its country from default during the Argentinian crisis and Lula’s arrival? Until the exchange crises crossed the Atlantic, we economists had always thought that the secret lay in a rigorous fiscal and monetary policy ratified by the incoming president while removing internal barriers to growth and opening the economy to the world, changing the attitude of Brazilian society and overcoming decades of protectionism and an ideology of self-sufficiency. Reading the reports by the European Commission like the one we have seen this week inspires a certain optimism that Europe has understood the message at last, but then you only have to take a look at the statements made by the Eurogroup and the minutes of the summits to abandon all hope again.
The direction to take is clear, but painful. The countries that have had investors withdraw have to regain their confidence. This will not be achieved by massive interventions by the ECB in the secondary debt market, or in the primary for that matter, even if we did change its statutes to allow it. Regaining confidence means having to change the dynamics of sovereign debt and preventing it from growing exponentially. This could be achieved by sharing the risk of non-payment, leeching off the credibility of the German treasury through the famous eurobonds, but this would be a blatant breach of the terms of the treaty and it is not going to happen now, unless we also want to destroy the security of the European legal system.
The alternative is to hope that this is just a passing bout of speculation and that interest rates will go back to normal with the new, more competent (at least technically speaking) governments, more skilled in the mysterious arts of finance. But that isn’t going to happen either, at least not on a big enough scale, because investors will still be reluctant and skeptical, and funding needs are not going to disappear just because Papandreu, Berlusconi and Zapatero have retired. There is no alternative but to work on reducing the volume of finance needed, i.e., fixing the public account and external accounts, and increasing growth potential.
Europe has insisted on behaving like an emerging economy. It cannot now act surprised because the markets have noticed and are treating it as it really were. It was probably inevitable, a consequence of globalization. Without the Greek crisis it would probably have happened a few years later and it will not be long before the same happens to the US. But it is also true that it has an additional exposed flank, something that it still has to address. It is the duty of the European authorities to complete the monetary union project to achieve optimum positioning. This will require advancing on four fronts: labor mobility, trade integration, flexible prices and salaries and a common stabilization fund. Meanwhile, there is a fifth front which is also the most difficult to address, namely a European governance that has hitherto proved itself incompatible with the demands of the real world. But the solution to this crisis is not going to come from Europe, unless periphery countries accept life in a protectorate regime. The only way to avoid this would be for the government to take decisive action to tackle the reforms needed to regain its credibility.