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Europe's Debt Crisis: Five Ways It's Been Put to Good Use

by Jacob Funk Kirkegaard, Peterson Institute for International Economics

Op-ed in the Christian Science Monitor
September 6, 2011

© Christian Science Monitor

Europe's debt crisis often seems like a giant snowball accelerating down a hill. With each rotation, it picks up more destructive power.

Squabbling officials are tossed to the side, unable to agree on robust responses. Citizens feel crushed. Financial markets speculate on which country will be flattened next, and how that will affect the American economy.

And yet, Europe is not facing political or economic collapse. The euro remains a resilient currency. In fact, stepping back from the crisis provides quite a different view: lasting transformation that will—in the long run—strengthen the 27-member European Union as a whole, and the 17 nations that share the euro currency.

Reforms in the weaker euro economies on Europe's periphery—Greece, Portugal, Italy, and Spain for instance—are so dramatic, it's as if the Margaret Thatcher of the 1980s has hopped the English Channel.

These changes may not be sufficient to avert short-term problems, such as a further restructuring of Greek government debt or more instability reverberating from Italy's notoriously dysfunctional political system. But in five critical ways, they will make the European Union far better equipped to face long-term political and economic challenges:

1. A 'Real' Central Bank for Europe

For starters, the European Central Bank (ECB) is now behaving much more like a real, activist central bank, making financial stability a priority in the entire euro area.

In the past, it acted more like an enlarged version of the German Bundesbank, devoted exclusively to price stability through inflation control. Like the Federal Reserve, it is now willing to "do whatever it takes" to overcome the effects of chaotic financial markets as it supplies banks with liquidity and purchases government bonds from fiscally troubled countries in the euro area.

This willingness to act and the ECB's unique position as a supranational central bank—not beholden to any individual government—gives it unprecedented leverage over reform in individual euro-area capitals.

Like the International Monetary Fund (IMF)—a knight that rescues economies but only if they carry out needed reforms—the ECB in July demanded additional fiscal austerity and labor market reforms from Italy in return for bond purchases of Italian government debt.

That the ECB has made its crisis decisions despite the dissent of Germany, i.e., overruling the euro area's most powerful nation, shows it can act in a truly Pan-European fashion—even while politicians argue on behalf of their national interests. Europe will need such a strong, independent bank if it is to finally exit from the debt crisis.

2. More Fiscal Unity by Forming a Crisis Fund

Nearly two years old, the sovereign debt debacle is the first serious home-grown financial crisis in Europe since the introduction of the euro in 2001. It has exposed weakness in European institutions and the totally inadequate economic and political preparation in many of the European countries that gave up their national currencies to join the euro.

The most integrated region in the world, the "European house" is obviously only half-built—well short of functioning as one seamless economic union.

But the creation of a new financial crisis-fighting tool will help to reinforce the European Union and the euro as a lasting, relevant body and currency. Out of the debt crisis has come the European Financial Stability Facility, which can provide conditional emergency loans to stricken euro members—another IMF-like function. It can also shore up undercapitalized banks (just as the US government's Troubled Asset Relief Program did in 2008-09).

The new stability fund—in its current form—will not suffice to stem the confidence crisis gripping Europe's institutions. Yet its creation marks the clear realization that Europe needs a fiscal compliment to its monetary union. Fiscal togetherness ultimately depends on voters' readiness to accept ideas such as joint taxation. Although a fiscal union is the urgent message of the financial markets and European Central Bank, it won't happen overnight. Only a lengthy process in close consultation with affected populations can make that happen. The new stability fund, however, is a crucial first step toward fiscal integration.

3. Thatcherism on the Mediterranean

Greece may not be able to repay its enormous current debts—leaving debt holders to take their lumps—but it is undertaking reforms that decisively break with its past as perhaps the most mismanaged economy in Europe.

Standard market-oriented structural reforms are now being unleashed across the weak periphery of the euro. Previously politically toxic increases in the retirement age are now happening in Greece, Portugal, Spain, and France; labor markets are being liberalized; closed-shop industries are opening up to competition; and state-owned assets are up for privatization.

Tough structural reforms rarely deliver improved economic performance in the short term. But already the euro area's aggregate government deficit is less than half that of the US federal government, a significant improvement from when the European crisis started. When combined with the aggressive austerity measures adopted in Europe since the beginning of the crisis, these structural reforms will raise growth rates over time.

Today's crisis will thus provide crucial impetus for addressing Europe's long-term demographic and economic challenges.

4. Leftist Parties Move to Center

The debt crisis has also dramatically shifted the political orientation of center-left parties across the European periphery. This mirrors the "New Labour" shift to the center, steered by Tony Blair in Britain in the mid-1990s, and before that in the social-democratic parties in Germany, the Netherlands, and Scandinavia.

Traditional socialist parties in Southern Europe—the Panhellenic Socialist Movement (PASOK) in Greece or the Socialists in Spain and Portugal—are today espousing a far more limited and sustainable vision of the welfare state than before the crisis.

Political differences will of course remain, but the earlier experience from Northern Europe suggests that the centrist shift is a lasting political realignment that facilitates broad national consensus for sustainable fiscal and economic policies.

5. Populism is Less Popular

Importantly, voters in crisis countries are emphatically rejecting domestic economic populism at the ballot box, and instead are accepting welfare reforms and cutbacks on a scale previously considered likely to trigger revolutions.

Certainly, Europe has seen its share of violent street protests in recent years. Smaller populist parties have emerged in several countries, such as Finland and the Netherlands. Yet these have proved unrepresentative of general public opinion in Europe.

For instance, when Ireland and Portugal went to the polls in 2011, pro-reform parties supportive of IMF austerity programs won and formed new national majority governments.

And in every national election in the European Union since 2008, the most fiscally conservative platform has carried the day. This is certainly no coincidence, as Europe's crisis has been severe enough to convince even risk-averse electorates to choose market-oriented orthodoxy over simplistic firebrands.

Certainly, Europe still has far to go, but it has put its crisis to good use.


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Book: Managing the Euro Area Debt Crisis June 2014

Book: Inside the Euro Crisis: An Eyewitness Account June 2014

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Book: Responding to Financial Crisis: Lessons from Asia Then, the United States and Europe Now October 2013

Policy Brief 13-17: A Realistic Bridge Towards European Banking Union June 2013

Op-ed: Five Myths about the Euro Crisis September 7, 2012

Article: Why the Euro Will Survive: Completing the Continent's Half-Built House August 22, 2012

Testimony: Challenges of Europe's Fourfold Union August 1, 2012

Policy Brief 12-18: The Coming Resolution of the European Crisis: An Update June 2012

Book: Transatlantic Economic Challenges in an Era of Growing Multipolarity July 2012

Book: Resolving the European Debt Crisis March 2012

Policy Brief 12-20: Why a Breakup of the Euro Area Must Be Avoided: Lessons from Previous Breakups August 2012

Policy Brief 12-5: Interest Rate Shock and Sustainability of Italy's Sovereign Debt February 2012

Policy Brief 12-4: The European Crisis Deepens January 2012

Policy Brief 11-13: Europe on the Brink July 2011

Working Paper 11-2: Too Big to Fail: The Transatlantic Debate January 2011

Book: Transforming the European Economy September 2004