In Defense Of Europe’s Grand Bargain

This guest post is by Jacob Funk Kirkegaard, a research fellow at the Peterson Institute for International Economics.  He is more positive than the current consensus on recent economic and political developments in the eurozone.

The frantic spectacle of European leaders struggling to avert a financial crisis caused by Greece has seemed unsettling and at times amateurish. It is certainly easy to point fingers at policy makers patching solutions together solutions that immediately unravel under pressure from the markets, and to do so again and again over the last several weeks.

But if you look less at the sausage-making process and more at the final result, you have to be impressed. There are of course many painful steps that still need to be undertaken by all sides – the Greeks, the weaker European economies, the European banks and the European governments. But the derision of some commentators and the uneasiness of the markets seems overstated.

Recall the disdain, for example, when the TARP was introduced in late 2008 or the bank stress-tests were carried out last year.  Today most would argue that they ultimately played a large and constructive role in containing the immediate crisis contagion. In time, Europe’s response to the Greek crisis will be viewed in a similar positive light.

Though numerous and poorly timed, Europe’s policy reversals during this crisis have at least been in the right direction. European leaders went from a “small number with no IMF involvement” to the required “BIG number with 100% International Monetary Fund (IMF) conditionality” for all the money involved. It is difficult to imagine a stronger endorsement of the much-maligned multilateral organizations than the willingness of large euro-zone governments to commit hundreds of billions of taxpayer’s money exclusively under conditions imposed by the IMF.

Second, and more important, European leaders have produced a constructive political “grand bargain” between member states and the European Central Bank (ECB) concerning the future of European monetary union.

 For its part, the ECB agreed to move beyond its minimalist obsession with price stability, a legacy of the Bundesbank mentality and in defiance of Germans on the central bank’s Council. It has effectively agreed to become a credible “lender of last resort” and crisis manager for the entire euro-zone by granting its own Governing Board the ability to buy essentially whatever asset – public or private – they want through their new “Securities Market Program.” With the new powers it essentially granted itself, the ECB now has the ability to counter most of the contagion risk from a future Greek default.

The crucial and politically more important question, however, is what the EU member states are now prepared to contribute to this “grand bargain.” It would seem logical that the next step involve a European fiscal as well as monetary union permitting massive intra-European fiscal transfers from the richest to the neediest countries. But that prospect does not exactly lie around the corner. No revision of the Lisbon Treaty (which would be required for this scenario) institutionalizing regular budget transfers will be passed by the EU or the key euro-zone members any time soon.

Instead, member states have agreed to put on a “fiscal straight jacket” and accept “legislated deflation,” following the path of Latvia, Ireland, Greece (too late of course), Spain, Portugal and now Italy. In these cases, governments have cut public wages (wages in Europe have proved far less sticky in this crisis than economic theory would predict) and taken a host of other fiscal austerity measures. The negative short-term effects on European growth prospects are obvious.

The volte face of the leftwing Spanish government after the “grand bargain” was announced to risk political suicide by cutting public wages and freezing pensions means that the resolve of euro-zone governments to act in the face of crisis must be taken seriously. Europe really does seem prepared to embark on “coordinated fiscal austerity” and move back to Maastricht Treaty basics.

Will this new political commitment to a “new Stability and Growth Pact” (SGP) be more credible than it was in 1997 (when the 60% debt stock criteria was abandoned) or in 2004 (when the big euro-zone countries undermined the 3% deficit criteria)? It is early days, but the signs from Madrid and elsewhere are good. A likely Greek default will illustrate the devastating result of non-compliance, and the political cost of running unsustainable fiscal policies. Seeing what will happen to fiscally wayward countries is certain to shock European electorates and alter what kind of fiscal policies are politically sustainable in Europe.

One lesson of this crisis is that the days of a phony euro-zone government bond yield convergence are gone for good. Financial markets now happily and rapidly apply very significant default premia on irresponsible euro-zone countries. The “new SGP” will not have to be pressed by politically reticent European governments. Instead it will be enforced real time by financial markets. The chimera of “political peer pressure” is gone, replaced by the iron law of the marketplace. This is a positive step.

Without a unified fiscal or political authority, the European house does remain “half-built.” But now the world gets to find out whether the European project is based on a fundamentally flawed design or whether it works when member countries actually stick to the rules.

Finally, the European actions, while painful, have accomplished what is necessary to prevent a contagion from a medium-term Greek default – for example, in the form of a debt restructuring next year. In that sense, it – could well serve as an important stress test for the “grand bargain” negotiated this month.  Any new SGP cannot hope to function in the long-term without a willingness by the EU to let insolvent countries go, while protecting the solvent members from the associated contagion. A Greek default might therefore be politically necessary to mark the limits of moral hazard for the rest of Europe.

37 thoughts on “In Defense Of Europe’s Grand Bargain

  1. Debit restructuring really means default in some circles. Observers also want the U.S. more involved (though, financially?).

  2. “caused by Greece” ?

    Are you sure this global financial collapse is caused by old, small Greece?

    The Ponzi orgy of banks too big to fail have nothing to do with it?

    Give us a break

  3. If the bond markets have effectively negated the existence of the Eurozone vis-a-vis borrowing costs – then what exactly is the benefit of being in the EU? Greece, Spain, Portugal, etc. basically are left with all the “risk” of having a sovereign currency with none of the benefits. In the short-term of course the North is bailing them out of their current debt problem so it makes sense, but in the long-term what are the positives? If Europe had a unified tax and benefit system and freedom of immigration between countries then the unification of the currency would make sense – but it doesn’t.

  4. This post is politically naive. It assumes that Europeans will accept a big drop in their standard of living at the behest of the financial “markets.” This is unlikely, or at least very far from certain. I also believe, contrary to the poster, that it’s undesirable, but that’s a philosophical, not an analytical point. I also find it interesting that Simon Johnson and others who post here apply one standard to the U.S. (bank bailouts bad because reinforce political power of bankers) and another to Europe (bank bailouts good because reinforce political discipline on big-spending Euro democracies). Why are you in favor of bankers’ enforcing of financial orthodoxy in Europe, but not in the U.S.? I’m probably missing something here, but there seems to be a glaring contradiction.

  5. He’s not referring to the entire global crisis, just to the debt the Greeks accumulated through their own mistakes, and the crisis that is causing in Europe.

  6. This post is respectable stupidity amplified by atavistic yearning for pre-electronic days, when IMF bureaucrats could resolve global imbalances by dispensing chickenfeed and cramming down draconian austerity.

    In today’s world of fantasy finance, the risk created by soverign debt is enhanced exponentially by credit default swaps. Trillions in bets create permanent turmoil, and nothing can be done but to kick the can down the road. All players know this. The Fed buys worthless mortgages and now the ECB buys worthless soverign bonds. None of this matters because all of the money is itself worthless, except in exchange for assets themselves lacking utterly in value. This is called trading. Want to sell a dog for $100,000? Just exchange it for two $50,000 cats. Book the profit. Collect the bonus. Keep the game going. The monetary technocrats have made suckers of every prudent saver and investor, and nothing any of them has done or said, or will do or say, can repair the damage. The best we can hope for is temporary respite from chaos.

  7. “wages in Europe have proved far less sticky in this crisis than economic theory would predict”

    What is this economic theory of which you speak? Wouldn’t it be more accurate to say “far less sticky in this crisis than most economists routinely assume”?

    Seriously, isn’t the extent of wage stickiness a concept that often gets turned into a number for the convenience of model-builders, like so many ‘elasticities’, unsupported by much in the way of either a theoretical or a credibly empirical basis?

    It’s funny to see how the raw observation that European wages have been sticky in the past gets so easily transmuted into something that some economic theory somehow predicted. Alchemy finally triumphs in economics!

  8. The ultimate question is whether or not European governments are emerging from denial only to double down on a system that doesn’t work, or whether they are committing to a system that does work. Clearly the current system doesn’t work – and the markets see this. Any system that encourages overconsumption by artificially holding down default premia through a risk guarantee, then requires massive austerity measures without allowing governments to devalue currencies, is broken. Pundits have been saying this, now markets are saying this, and the ECB still is living in its own little world (either that, or the ECB wants the system to fail and is maneuvering to achieve a goal that’s inconsistent with its stated goals).

    All of this leaves us with a fundamental problem – how does the entire world run a trade surplus, and where will the demand come from? When everyone has a savings rate of 30%, and investment returns are below par, how does the world respond? When the source of demand can offer no service that those with monetary wealth demand sufficiently to pay their cost of survival, what happens? What happens when globalized hypercompetition prevents states from legislating to limit competition in labor markets under the mantra of freedom?

    The general equillibrium model doesn’t model survival costs for households. It also doesn’t model bankruptcy.

    Anti-statists are celebrating the destruction of state power wrought by globalization… Like Vandals sacking Rome.

    The current regime – Team Obama – is still committed to open globalization, however. He should spend an afternoon with Dani Rodrik.

    Then again, that would mean listening someone other than Larry the Fable Guy.

  9. This bed wetting about “might default” and the nature of debt restructuring shows the elites are incapable of decisions consistent with the required timing and welcoming the consequences . To solve the problem as can be best done under the circumstances. To decide unilaterally. All great turning decisions arise from some component element of the decision process deciding to, well, decide. To force the issue for others.

    A default needs to occur. A default deliberately sought by a state from defiance. It is interesting that the elites are almost totally in thrall to their intellectual training. Aristotle taught Alexander. Aristotle knew he was not Alexander and Alexander knew he was not Aristotle.

    Might the real leadership problem of the West really be the intellectual thralldom of it’s elites? What better a question about President Obama? Too thinky… never endingly thinky until too late for the main chance?

  10. Indeed, the crisis has mostly to do with the fractional reserve banking system, publicly financed, privately managed and milked.

    Well, it does not have to do with the PRINCIPLE of the unique currency, but, tangentially, with some details of its application, its minimalist theme. Fortunately, and out of necessity, this is now out of the window. The new dispositions go so far beyond the Lisbon Treaty, that they clearly violate it, in my opinion. An excellent idea, I reckon. Since national assemblies can approve emergency laws, Lisbon is irrelevant, anyway.

    Part of the essence of the crisis is the same as in the USA though: TBTF banks lent carelessly, knowing full well that they would win whatever happened, since they are the financial arms of government (not officially, but practically).

  11. Overall, public opinion favors much stronger limitations on free trade than the current (or previous) administration.

    There are obvious question wording effects, (“Is trade with other countries a good thing in general?”), but when you ask a detailed question about “free trade” or free trade agreements like NAFTA, the response is overwhelmingly consistent:

    “Which of the following statements comes closer to your opinion? Trade restrictions are necessary to protect domestic industries. OR, Free trade must be allowed, even if domestic industries are hurt by foreign competition.”

    Restrictions Necessary 60%
    Free Trade Must Be Allowed 28%
    Unsure 12%

    “Generally speaking, do you believe that free international trade has helped or hurt the economy, or hasn’t it made a difference to the economy one way or the other?”

    Helped 26%
    Hurt 50%
    No Diffrence 10%
    Unsure 14%

    In spite of this, Team Obama remains almost unrelentingly committed to keeping access to US markets open, has signalled a refusal to apply compensating taxes on imports that fail to meet US environmental/labor standards, etc.

    And as you note, there’s no lack of eagerness on the part of foreign economies to lend us money to support trade/fiscal deficits. Whenever one points out the huge deficits and argues “it’s unsustainable”, the response has been “it’s been going on for 20 years? why can’t it go another 50?”. That response is suddenly seeming shaky.

  12. We will all have a resounding answer to this question by Wednesday, June 5, 2010. The day after Super Tuesday when there are ten state primaries.

    By now the realist incumbents must have a real understanding about their chances of staying in office. That said, these incumbents would seemingly absolutely need to counter anti incumbency pressures with some real populist actions. Might they be so divided they cannot craft even a sham consensus to save their incumbency. Then, they might not beieve that they have a problem.

    If these incumbents really have a primary election level problem they act now. Right now. It is only 16 days to the election. They need only present something to Obama. That requires both houses to act. Certainly, the House must pass some real hormonally populist measures.

    My own view is that these incumbents suffer from inability to craft consensus even to saving their incumbency. In short, they may be paralyzed by the surprise hurtling at their persons.

    Party voters must toss these people. That is not necessarily the same as the cacaphonic angst of the non voting populist.

    We will know this anwser in seventeen days.

  13. Greece is responsible for this because it has shown the hole in the European Union: they have a unified currency, but they don’t have any way of forcing countries to adopt economic reforms when local budgets get out of control. It’s not that they didn’t know this when Greece was admitted to the EU. Opponents of Greece’s admission argued the country’s finances were out of control and the books fudged. Now, since the EU and IMF have come up with a bailout package, the crisis goes on because no one believes it is politically sustainable for Greece’s electorate to accept drastic cutbacks in social programs. They are right to say this. The Greek crisis has also undermined support for the EU crucially in Germany, where the electorate is saying they don’t want their money going to this scheme, especially after the costs of German reunification. I would not be surprised now to see both Germany and France withdraw from the EU currency scheme.

  14. There is endless comment on the need for the weaker EU countries to adjust. Is there not also a need for virtuous Germany to also adjust it’s tax and trade policies so that it does not continue to run huge trade surpluses against other EU members?

  15. @ edward:
    France and Germany ARE the EU, and the Eurozone, and Schengen, etc. Between France and Germany, there is half French, half lower German (lower in the sense of low on the Rhine: Dutch)Benelux, with 30 million people (= California). Moreover, Northern Italy is also mostly part French (it was colonized by Gauls), part German, and integrated with northern countries more than, say, Sicily.

    The point: France, Germany, together, and a fortiori with their immediate satellites, are a superpower. Europe is built by France and Germany (and mostly France, because the Germans would not want to oppose the French for another 1,000 years… Merkel went to relax in Moscow, as she let Sarkozy work on the rescue package, which made the Lisbon Treaty instantaneously obsolete). Others, including Britain, can’t beat them, so they have to join.

  16. @ SteveK9

    That is what Lagarde, the French finance minister, said loud and clear, several months ago. Without PIIGS to sell stuff to, Germany would sink. France has strong internal demand, due to a younger, more hedonist population.

    For example Spain has bought Extremely high Speed trains from Siemens (which reach 250 mph, 400 km/h on the Madrid Barcelona line). Spain could have bought the trains from Alstom, the French company which is the competitor of Siemens (the Chinese was deconstructed and rebuilt Siemens trains, in an apparent violation of intellectual property… and now they propose to sell said stolen property to the USA).

  17. “Recall the disdain, for example, when the TARP was introduced in late 2008 or the bank stress-tests were carried out last year. Today most would argue that they ultimately played a large and constructive role in containing the immediate crisis contagion. In time, Europe’s response to the Greek crisis will be viewed in a similar positive light.”

    I find it amusing at this point…the number of somersaults those from the old, dying, and mucho corrupt-o system are doing in an attempt to cover their tracks one last time.

    (They know it’s coming down, but what else is a charlatan to do?!)

  18. On the other hand, Germans like to spend their vacations (and a fair amount of money) in sunny Greece, Spain, Italy, Portugal…

  19. If it’s such a grand Bargain for Europe, let Europ pay for it. No longer should American tax dollars go to the IMF for such ventures.

  20. I do agree. My first question was “If throwing money at people who can’t manage money is a bad idea here, why isn’t it a bad idea everywhere?”

  21. Let’s see,…the “TARP” cost the US Taxpayer ~ $900bn (just shy of a trillon dollars), but no one talks about the $16tn US Backstop! Yep,…no one, but former SEC.Chairman Cox’s recent (late april/2010)hearing too prevent TBTF Bank Failures ever mentions it? This was plowed into the recovery by the Fed Reserve (someone say tiny Tim?) as an insurance policy. Amazing,…simply amazing.

  22. Jack Chase writes: The Fed buys worthless mortgages and now the ECB buys worthless soverign bonds. None of this matters because all of the money is itself worthless, except in exchange for assets themselves lacking utterly in value.”

    According to Michael Hudson: This is the road to Debt Serfdom. The nationalization of billions and trillions of bad debt manufactured by casino banking. The money to service and repay this debt is going to be squeezed out of public goods and higher taxes on “ordinary” people.

    From what I understand, Hudson says “classical economics” and taxing economic rents and the rentier class will restore balance and proportion to the economic system. :)

  23. This is definitely a Peter G. Peterson paper.

    Surprised to see it on Baseline.

  24. TARP is not going to cost the US taxpayer 900bn. Because of repayments it is estimated now to cost $117bn. And the Fed is making money despite it’s bailout work. In 2009, income earned by the Reserve Banks totaled $52.1 billion, of which $46.1 billion was transferred to the Treasury. That’s up from the $35.5 billion the Fed earned in 2008.

  25. TARP isn’t the bailout. It just looks like the bailout for the reasons you articulated.

    See the federal reserve for the actual bailout.

    Ask Pete Peterson, of Blackstone, how that non-bailout of Blackstone’s loans via Lehman’s Freedom CLO felt when that particular life-raft drifted over to the NYFRB right before the hull tipped and sank.

  26. Then ask yourself, was it fraudulent for the NYFRB and/or Lehman to assume the pretense (or allow the pretense), to the market, that the Lehman CLO was a public sale being purchased by a private market participant?

    In March-April 2008.

  27. I note that you compare this to the TARP, on the basis that it is now thought to have been a good idea which has largely worked out. Sadly, I fully disagree. Yes, it is now called the European “TARP”, however the fact that it is a bailout, notably backed by almost unlimited guarantees, but with strict terms to be applied along the way. We did not attach any conditions to the TARP, except that it was to be repaid with interest. And now, about 70% has, many lauding that fact, and largely forgetting, perhaps conveniently, how and why it was sold to Congress by Paulson. It was sold as the Toxic Asset Relief Program, to be used to purchase toxic assets to take the pressure off of institutions which were in freefall on their balance sheets and destined to follow Baer and Lehman in a domino fall of failures. It was truly a horrow show.

    We must remember just what occurred and how it transpired (and continues to transpire):

    Among many other things, the government has (largely through the FED) extended essentially unlimited guarantees to the TBTF’s (at least this is what the markets believe, and it is substantially true). Also, shortly after the crisis came under “management” the major mark to market rule was changed, largely allowing the toxic assets to be reported any way in which each bank wanted to, based upon the theory that maybe they would have a real value in the future, some day. Also, the FED has bought substantial amounts of those assets, and has an ongoing program for the biggest banks to print endless supplies of capital for them at virtually no real cost (one might argue for less than the cost of inflation, egads!!).

    Is the ECB willing to become the FED of Europe? Does this result in an even greater bubble (based on the fictional perceived value of currency) in the future?

    I see this as economic pacifism shown to economic terrorists, and is, as in the US, just a bail out of the vested financial elite of Europe. This is just one more sign that the entire world’s economies are run by oligarchs, pure and simple. Someday we all will pay. Can anyone understand that the Mayan calendar may be playing out. Prufrock comes on December 12, 2012. We can just be spectators as we watch out fellow man destroy the world.

  28. The poor banks are innocent, they were deceived by governments right? There’s always two sides in a loan. Even if we assume that the main problem is the accumulation of debt by Greece (it wasn’t) didn’t the market fail to correctly price Greek risk? It’s as much a mistake of the lender as of the borrower. And up to now only the borrower is suffering the consequences.

  29. I had exactly the same thought when I read this:

    “For its part, the ECB agreed to move beyond its minimalist obsession with price stability, a legacy of the Bundesbank mentality and in defiance of Germans on the central bank’s Council. It has effectively agreed to become a credible “lender of last resort” and crisis manager for the entire euro-zone by granting its own Governing Board the ability to buy essentially whatever asset – public or private – they want through their new “Securities Market Program.”

    Wow. OK, that power can block contagion. It can also be captured like every other government power… so now the EU – like the US Treasury – can, without the genuine consent of its taxpayers, pony up for whatever crappy assets the bankers who own the politicians don’t wish to hold.

    How’s that going to work out? In fact in what fantasy does that ever represent a “win” for the taxpayer? How many banks are selling off their good investments?

    I’ve seen laudable moves on the part of Euro governments which leave me the impression that they are trying… to a greater extent than ours. For example, Germany’s ban on naked short selling, their desire to keep GS the hell out, etc.

    This doesn’t seem like one of them.

    Sticky nominal wages need not prevent rapid reductions in the effective real wage rate in Southern European nations while they remain in the Euro Zone. Here’s how.

    Allow the Euro to depreciate. This improves Europe’s overall competitiveness and imposes some of the adjustment burden on holders of Euro denominated debt.

    When out-migration is insufficient, the insolvent government must lower public sector employment, wages and transfer payments. Greece has been forced to reduce public sector wages by 20% and reduce pensions significantly. The second step is for the Greek government (with help possibly from the EU) to work to attract more tourists and create tax incentives to induce companies to expand private sector employment.

    National governments in the EU periphery can lower their real wages still further by increasing their value added tax rate (rebating it on exports) and by offering marginal employment subsidies to companies that increase employment during FY2011 and FY2012 above 2009/10 levels. The migrants who came to the EU illegally or on temporary visas should be sent home to create opportunities for EU citizens. The better off Northern Europeans should be encouraged to spend vacations in Southern Europe and to eventually retire there (eg. by subsidizing package vacation tours looking at vacation property in the South).


    The precedent of EU bailouts of Greek sovereign debt has worsened moral hazard incentives for both EU member governments and the banks that lend them money. The banks that foolishly lent money to EU nations headed for insolvency (probably in part because they anticipated a rescue despite the constitutional prohibition) should be forced to take a haircut. The bank managers who colluded in the violation of EU rules about sovereign debt should be fired. This will make it much more difficult for financially weak governments to borrow in the future.

    The EU plans to use Peer Review to prevent governments from overextending themselves. This may work for a while. But, once the crisis is past and memories recede, peer review is will lose its backbone. Member governments (and the regional governments within member countries) will need find a way to convince banks to lend to them without an implicit EU guarantee. I agree with Martin Feldstein that banks should require governments with high Debt to GDP ratios to pledge collateral (tax increases dedicated to servicing the debt or real assets such as airports, railroads, port facilities, toll highways and government owned corporations). This is how state governments in the U.S. handle their debt.

    The long run solution for Southern Europe is improved education. PISA test scores (at age 15) and upper-secondary school graduation rates are substantially lower in Greece, Southern Italy, Spain and Portugal than in Northern Europe. Vocational training programs are also of low quality. Assistance for Southern Europe should focus on reforming education systems and making learning more relevant to worker productivity.

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