The european debt debacle and the politics of an almost european union

UNIWERSYTET EKONOMICZNY W KRAKOWIE WYDZIAŁ FINANSÓW KIERUNEK: Finanse i Rachunkowość SPECJALNOŚĆ: Bankowość KATEDRA FINANSÓW

Rezart Prifti

“The European Debt Debacle and the Politics of an Almost European Union”

Praca magisterska

Promotor: Prof. dr hab. Stanisław Owsiak

KRAKÓW 2012

Table of Contents

Introduction……………………………………………………………...….................................1 Preamble (The truth everybody knew)……………………..……...……………………………3 1. A short History of Financial Crisis……………………………………………………...6 1.1.Historic background…………………………………………………………………...6 1.2.The Latin America Crises…………………………………………………………….12 1.3.The Boom that came from Asia………………………………………………………18 1.4.Conclusions (Recipes from the obvious)……………………………………………..23 2. The way to bond serving, the European way………………………………………….26 2.1.Introduction…………………………………………………………………………..26 2.2.The debt into perspective, theory approach…………………….…………………….28 2.3.The European way……………………………………………………………………32 2.3.1. Macroeconomic Realia……………………………………………………….33 2.3.2. Fiscal Rules and Fiscal costs…………………………………………………38 2.3.3. Monetary realia……………………………………………………………….43 2.3.4. Banking System implications………………………………………………...44 2.3.5. Shaping a reaction……………………………………………………………50 2.3.6. Political resistance……………………………………………………………54 3. Country Briefings……………………………………………………………………….55 3.1.Germany……………………………………………………………………………...56 3.2.Greece………………………………………………………………………………...61

3.3.Ireland………………………………………………………………………………...76 3.4.Italy…………………………………………………………………………………...81 3.5.Portugal……………………………………………………………………………….85 3.6.Spain………………………………………………………………………………….88 3.7.Reflecting Imbalances………………………………………………………………..93 3.7.1. Current account imbalances and twin deficit hypothesis……………..……….93 3.7.2. Monetary policy, the absent tool…………………………………..…………108 3.7.3. Under the shadow of definitions………………………………….………….111 3.7.4. A self-fulfilling scenario………………………………………….………….116 3.8. Conclusions…………………………………………………………………………119 4. The future of EU……………………………………………………………………….122 4.1. Introduction into a real union…………...………………………………………….122 4.2.The role of ECB……………………………………………………………………..128 4.3.The political factor…………………………………………………………………..132 4.4.Reforming the system and Further implications…………………………………….137 CONCLUSIONS……………………………………………………………………………….150

List of Figures Figure 1 Central Government Public Debts, Advanced Economies and Emerging Markets, 19002011………………………………………………………………………………………………..8 Figure 2 Current account balance as a percentage of country's GDP……………………………20 Figure 3-6 Unemployment, CPI, Debt ratios, and Annual Growth Rates for selected countries..34 Figure 7 Types of fiscal costs from financial crises ……………….………………………...….38 Figure 8 Foreign Banks' Claims on Assets of Selected European Countries, 1999-2009 (billions of dollars)……………………………………………………………………………………………46 Figure 9 House Prices in Ireland………………………………………………………………...77 Figure 10 Italy main indicators……………………………………………………...…………...82 Figure 11 Portugal Current Account Balance……………………………………………...…….86 Figure 12 Spain main indicators………………………………………...……………………….91 Figure 13 Selected Countries main indicators affecting the current account balance (as percentage of GDP)………………………………………………………………………………96 Figure 14 Relative Unit Labor Cost in Manufacturing………………………..….…………….105 Figure 15 Export Market Share for Ireland, Spain, Germany, Greece, Portugal……………….106 Figure 16 Current Account Net Balance (from 1999 in millions of euro, millions of ECU up to 1998……………………………………………………………………………………………..107 Figure 17 HICP for Euro17………………………………………………………………...…..108 Figure 18 Public and private social expenditure in percentage of GDP in 2007…………….....114 Figure 19 Average term to maturity for total outstanding debt (1997-2010).…………...……..124

List of Tables Table 1 The cost of Financial Crises …………………………………………………………….39 Table 2 Greek tax evasion and government revenue data………………………………......…...64 Table 3 Government Deficit for Greece……………………………………………...………….65 Table 4 Greece’s Revenue and Expenditure dynamics 2007-2010…………………………...…68 Table 5 Greek Bank exposure to its sovereign debt………………………………...…………...69 Table 6 Ireland Main Indicators………………………………………………………………….78 Table 7 Portugal main indicators…………………………………………...……………………85 Table 8 Pearson correlation for government budget deficit and current account balance (20002007)…………………………………………………………………………………………….103

Introduction The crisis that has plunged Europe has raised question over its own existence. Reading books of economic history and analyzing historic data in order to understand previous crises is not the same as living through one, or two of them. Especially, when it comes to data, they are cold and often used to build models that miss much of the reality; however, this statement does not undervalue the importance of data.

Nevertheless, experiencing these crises makes one understand better the multitude of issues within, and out of the system, and the multidimensional characteristics of professional interpretation of unfolding events. This paper focuses on the European economic crisis that by the time writing does not seem to end.

The main objectives of this paper are: First, to put forward the reasons of this economic crisis and analyze why European economies are at this point today. Second, modestly to give potential resolutions for this plethora of problems, which in this paper account do not seem to be strictly economic. Third, to give a contribution in future studies by documenting and giving a testimony of actual events as objectively as it is possible, thus helping with information and in the variety of interpretations of these events.

The paper partly is a synthesis of vast number of research papers, economic reports, economic theories and opinions expressed in economic media outlets. The other part expresses the author opinions and beliefs.

The paper is developed in four chapters. The first chapter describes a historic perspective of financial crises. It starts with a short historic background and continues with some of the most notorious financial crises such as the Latin America financial crisis and the Asian one. It ends with remarks on similarities that today economic hurdles have with those passed and described in history books.

The second chapter describes the way Europe went into crisis mode. It starts with a theoretic approach on debt, and then continues analyzing European economic characteristics and indicators in union level. The chapter discusses macroeconomic realia, monetary policy, fiscal rules, European banking system, and political developments.

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The third chapter is mainly an extension of the previous one, only that in this section are discussed concrete issues of a group of selected countries individually. In addition, some fundamental issues are treated in this section. Issues such as current account imbalances, the twin deficit hypothesis, monetary policy in a union, a part of public debt that is formally invisible and not shown in official data, and the idea of crisis as a self-fulfilling scenario due to circumstances in which events unfold.

The last chapter tries to give a resolution to issues raised previously by discussing the problems of a monetary union, the role of the European central bank, the political factor, an element that in this paper is evidently emphasized, and suggestions on system reform.

As previously noted, this paper is based on economic reports of institutions such as: the IMF, OECD, World Bank, ECB, The Federal Reserve and etc. As well as papers from the up mentioned institutions' staff, economic journals, economic and business newspapers and magazines. A special help that affected the perspective of the author in most parts of the paper came from the publication of a tremendous book called "This Time is Different, Eight Centuries of Financial Folly", written by C.M. Reinhart & K. Rogoff, also books and papers of Paul Krugman.

I hope that the paper will accomplish its main objectives.

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Preamble (The truth everybody new) It is not necessary to think about the origin of this debt crisis, because at least every selfrespected economist should have seen this coming. After, and during the 2007 crash, policy makers around the world rushed to find the culprits responsible for what happened and urged to take concrete steps to tackle problems that brought down the financial system. Ironically, the phrase “concrete steps” takes a strange meaning for policy makers, especially in Europe.

Most often, the bailouts were so big that it did not make any economic sense and in some countries, it surpassed even their GDP. Governments went against public opinion and bailed out financial institutions, consisting mostly of banks. Public viewed these bail outs as their way to enormous debt and they felt like they had to pay for something that was not their fault. This was their way to debt, and also was like paying for something you didn’t do Now the public is faced with another issue. The issue of who is going to bail out governments.

Most of the measures had no economic rationalization, but were carried out of necessity and for the sake of saving political face. More than ever, this argument is gaining ground and seeing everything unfold in real time one can notice the fallacy of “concrete steps”.

The financial crisis did not affect all the countries in the same way. This was mainly a crisis of the developed world, the one considered well developed. Naturally, the rest of the world felt the shock but strangely, these countries looked fairly prepared. Especially prepared were what we consider emerging market economies, which appear more secure and mature on their economic prospective. It is not clear if these countries learned their lessons from past currency, financial and debt crises or that the shock wave met the buffer of overheating economies that every paper was talking about or that it was simply good timing.

Too many fundamental questions are in the market debate now, not all of them are new but the timing of the cacophony is quite usual. Is capitalism a failed system? Is the wealth distribution discrepancy a potential reason for civil disobedience? Is the financial system wright? Does this system reward bankers for doing God’s job? Is this debt crisis a consequence of a moral hazard?

It is not possible to answer these questions with a ‘Yes’ or ‘No’, and I think that these questions are worth the debate. However, not in cacophony, and the timing is not right.

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The time is right is right for another question. Every crisis has its origins in the decision-making process and nowhere else. Thus, was the decision-making process fully grounded by economic principles and logic, or was it not? This is a question with a very general horizon, but actually, this is the case. The lack of principles is not just one of the causes of this crisis but is also the reason why the world nowadays is running near an amok state. In addition, is this just an economic problem? The question that rises here is more complicated and goes philosophically deeper. What if the debate is concentrated on the wrong issue? Therefore, we would be curing a cold with a cold beverage!

The debt crisis has more political than economic motives, especially in Europe where thinking and talking rather than acting is a good way of solving problems. The remoteness of approaching the problem seems too aristocratic. Some of the measures taken carried a dubious argumentum.

For example, asking a politician if he should vote for raising taxes in order to solve the debt problem, is almost certain he will say: �Voters will hummer us for that!�. Therefore, he does not even take in consideration the idea if it is worthy or not. The politician just chooses not to go to that other level. The argument might seem too ordinary but sometimes missing the obvious is the problem.

Another thing is that analyzing the obvious does not need data or powerful econometric models to proof anything at all. One does not need data or to run a regression model to say that white is white. Some research papers really stress the fact that "data suggest" that a decisive risk factor for a debt default scenario is the level of indebtedness of a certain country. Isn't that so? By not diminishing the importance of data, the question is why the same data and models are relevant only when a crisis strikes. If data and models had the same relevance and outcome would this mean that the decision making process is the actual problem? What is the point of calculating the probability of default of Greece when Greece de facto has bankrupted and de jure is negotiating its restructuration?

It is time to stress out the role of government. The proper role of government cannot be thrown in discussion every time a crisis hit. It looks like that policymaking is prone to procyclicality as well. The current economic crisis or debt crisis is difficult to be analyzed under the assumption that everything that went wrong was a policy problem. The above assumption would have been true if every decision taken before, during and after crisis conceivement would have been based 4

on some kind of economic principles. The problem is not the government, or it is in a certain way. However, the problem looks more human per se. Once more, ‘according to data’ another risk factor related with debt default scenario is the so called Governance Quality, or in plain words the political factor.

All of the sudden the problem just started to humanize. The crucial issue is right here, this almost global debt crisis is a political aftermath. There is a deep belief around, after what happened in 2007 and further, that ‘uncertainties’ among banks and financial institutions would be solved with public money. Therefore, the moral hazard factor that people carried less about is the decisive one, now after several years in crisis mode.

Financial institutions fought hard against regulation that was about to be enforced after 2007.

They were patient and calm while waiting for the public outrage against them to vanish through the annals of mass mediocre memory. Now almost everybody is sure that governments are going to save them again, no matter what happens and how these institutions are governed. Especially now, for the sake of the system and global economy governments cannot let another one to fail.

The fresh example is Dexia bank, the Belgian lender that was nationalized lately. That is a real shame, two bailouts in such a short time for the same financial institution.

This is the result of all measures taken in almost four years. What the amplifications of the economic crisis and media are doing to the situation, are making every financial institution believe that they are too big to fail. The 'Too Big to Fail Ones', know that are safe after what they saw what happened to Lehman Brothers, now even small institutions believe that the economy is too 'emotional' even for them to fail. This is a surreal situation; people are bailing out their money with their money and the money of their children. In this case, one does not need data or an econometric model to tell who the winner is!

This debt crisis has two main development fields, one in America and another one in Europe. The American situation tends to be more obvious when seeking reasons of indebtedness and less when looking for a way out of it. Nevertheless, America in comparison with others has many advantages, among them: elastic labor market, deep financial market, enormous banking system able to absorb shocks, but onerous politics. One cannot get everything!

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Meanwhile, Europe, the subject of this paper, appears to be more reluctant on the issue. The characteristic European reaction slowness and the lack of decisiveness is a result of the faulted structure of the European Union and the variety of political and economic vectors pointing on different directions.

To a certain extent, it feels more like a self-fulfilling scenario, with the absurdum of credit rating agencies pressuring sovereigns, market demands and the financial media hollow articles looking like means for dubious purposes. In any case seems like main actors in this developing saga have an almost clear view of what is happening and what is going to happen. As always, some exceptions are clearly to be made.

To paraphrase Freidman, there is barely anything new under economic policy1. Therefore, the problem turns out to be ‘learning’. Policy makers or market operators repeatedly do one of the following: Forget history, ignore lessons learned, or distort history for political convenience. In any way, it always turns out to be something related with history. Quoting Freidman again, maybe is because historical facts per se cannot be convincing.

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1.1.

A Short History of Financial Crisis Historic Background

History does not have to repeat itself exactly the same way. Sometimes historic actors just switch places in different points of time. History is also cold and merciless, transforming some heroes into villains and vice-versa. Once upon a time Italians were an example of a developed country, of course at that time in history represented by divided states such as Florence, Genoa, and Venice etc. Not that Italy is not developed now, but the connotation has more to do with the position being, as a lender or creditor. Florentine banks lent money to British and French kings.

At the time, those kings defaulted regularly and as a result prompting Italian banks to go bankrupt. Today, Italy is seen by 'markets' as a relentless borrower, as a country that is incapable to serve its debt and as one with rigid labor markets. At least, that is how Italy is articulated by

1

M.Friedman, "Capitalism and Freedom", The university of Chicago Press, Chicago 2002, pp. 57

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financial media, and as always the truth is somewhere between. The reason why is a subject of discussion under subsequent chapters.

Albeit, the contrary is happening now. Britain is a stable, triple A country, to be taken as an example, and Italy has the burden of a messy fiscal house, that should be put in order. Almost the same can be noticed in another aspect. Here is another example, Greece. Once the place where democracy and moral were born, today it is a country with fragile political system and torn by corruption.

The advantage of being a living witness of events is that is easy to judge, even subjectively, which part of what you observe is a perception of others, which is a misunderstanding that comes from different reasons, which is a deliberate misinterpretation of facts, and which parts seem to be true. Not all of what is happening now is how it mainly seems to be. The disadvantage is that we have to take the historical for granted.

Nevertheless, the perplexity of sovereign default comes as a result of its conceivement and not of its being per se. The default of a sovereign on its public debt is a mere result of previous events and decisions. As Galbraith noticed: First, "All crises have involved debt that, in one fashion or another, has become dangerously out of scale...2", and second that among these histories something does change but much more remains the same3. The second observation is also made later by P.Krugman. Both these observations are fundamentally important especially because they wisely emphasize the obvious.

A panoramic view of sovereign default history shows that in more than 200 years can be found five clusters or default cycles4. The first cluster starts with Napoleonic wars (1803 – 1815). This is the point in history that too many historical events have in common.. The second cluster includes the time period from 1820 to 1840. At this time, almost half of the countries were in default. The third one starts in 1870 and lasts for almost 20 years. The fourth one starts in 1930s, right along the Great Depression and lasted for a full two decades. The last default cycle was in the 1980s and 1990s. It was also known as the emerging markets crisis 2

J.K.Galbraith, “A short history of financial euphoria”, Penguin Books, New York 1994, pp.20 Ibid, pp.XII 4 C.M.Reinhart & K.S.Rogoff, “This time is different: eight centuries of financial folly”, Princeton University Press, New Jersey 2009, pp.72 3

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Being aware of these five cycles, one would instinctively think about the coming of the inevitable sixth. Considering that the period between 2003 and 2008 was characterized by tranquility regarding sovereign defaults, deductive reasoning based on history would suggest that it would be about time for another cluster of defaults or, in other words, the next cycle of defaults. If this were about to come true, in addition to the conditions being just right for the cycle, the unchecked procyclicality would cause even more aggravation. Furthermore, since the developed world was also included in the economic collapse, the potential consequences would be catastrophic. If advanced countries (who are typical providers of emergency lending to poorer countries) were also affected, who would be there to bail them out in the event of all-out economic cataclysm? It is not as if we have economic relations with the moon or other planets to rely on for aid. The closed nature of the global economy as a whole makes clear that the only exit options would be default or debt renegotiations that make creditors worse off. Including this into our statistic bundle would seem to put us in the sixth cluster.

Figure 1 Central Government Public Debts, Advanced Economies and Emerging Markets, 19002011

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The figure above illustrates debt related events for the period from 1900 to 2011. These events are not related with the five debt cycles mentioned before. Referring to figure one, we can see that emerging economy status is important in the debt cycle. Economies of these emerging markets have different characteristics compared to advanced economies. They also have different trajectories of indebtedness. The great depression debt build up was not as large when compared to other periods such as WWII or 1980s debt crises. At the same time, emerging market economies seem to act relatively immune to war economy. However, with time debt crisis became more sophisticated and do not appear to be a direct result of wars, although in case of Unites States, it might be a difficult concept to grasp. It appears as though the contagious effect clusterifies itself.

During the 1980s, the debt crisis only affected the emerging economies and the same thing happened during the Asian financial crisis, where the crisis mainly remained there, in Asia. The same thing is happening with today’s debt crisis, where the developed European countries are the ones suffering the most. Nevertheless, from the outside everything looks different with this European crisis. With certainty, some things are different, simply because the economies are in successive change and transformation, but the fundamentals remain the same and they rarely ever change.

Debt literature provides us with two important indicators of a probable debt crisis. The first indicator is the intolerance syndrome5. The debt intolerance index analyses countries’ public structure, as well as fiscal system credibility, borrowing potential, political factors, and spending habits. Normally, emerging markets economies are characterized as intolerant. More often, they are treated as a club. In the case of the European ongoing debt crisis, Greece should have been a red flag. Greece is the perfect example of the debt intolerance syndrome definition. The second indicator is the amount of buildup debt, prior to the default event. The domestic and external debt amount accumulated becomes disturbing even before a debt episode strikes or the default event takes place. Domestic debt is particularly important in this case because is usually ignored. Data shows that domestic debt ratios are particularly high prior to default. Sometimes, the debt accumulation trend is related to procyclical fiscal policies carried out by governments. Once again, Greece is the perfect modern example.

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C.M.Reinhart & K.S.Rogoff, “This time is different: eight centuries of financial folly”, Princeton University Press, New Jersey 2009, pp.21

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In the last decade, the procyclicality spending trend and government expansion can be easily empirically proven. However, when it comes to public debt buildup the trend remains vague because we take in consideration the total debt outstanding. The total debt consists of external and internal debt. Let us take a sample of five countries; Italy, Greece, Spain, Portugal, and Ireland. In 2000, the public debt taken as a percentage of their GDP, does not demonstrate a clear debt accumulation trend. Certain countries have excessive debt to GDP ratios, and Greece has other specificities. The five countries above are thought to represent the debt problem.

The lack of a clear debt accumulation trend does not lower the risk of a default for two reasons.

First, according to historical data, countries that default have a public debt to GDP ratio that varies from 35 percent to 60 percent. Second, the problem is always the debt, but in some cases, the problem is the private debt. Private debt is not related to government debt. In countries like Spain and Italy, private sector debt is the other part of the medal. This is the reason why Spain with such low levels of sovereign debt to output ratio is perceived as a hazardous deal by market and resulting in high borrowing costs. Other factors that might trigger default or a crisis episode are inflation, public policy, and domestic debt to total debt ratio. These topics will be later discussed As previously said a debt crisis is more a result of prior events. Some of the events that precede a sovereign debt crisis are banking crisis and financial crisis. It is difficult to draw a clear line between banking and financial crisis, said so, these two events would be used slightly interchangeably in this material.

Perspective is powerful. Therefore, if we put in perspective public debt crises and financial crises, it is obvious an association between these occurrences. The last crisis events had some authentic characteristics. Unfortunately, the banking and financial system losses were heavily socialized.

From a social standpoint, the taxpayers took the loss, from an economic standpoint the budget deficits swelled, and consequently the public debt increased.

There are some ways through which financial or banking crisis could prop a public debt crisis or at least set the right conditions for one. Global financial turbulence usually makes it harder for emerging markets. Such turbulences hail growth by hitting trade. When trade is affected, export volumes from emerging countries go down and commodity prices fall. During April 2008 and 10

January 2009 world export volume fell by 25 percent and commodity prices tumbled by 50 percent. As a result, exporters’ earnings declined and countries had difficulties accumulating foreign currency. This is where public debt is normally denominated. This way making it harder for the country to accumulate foreign currency, in which usually the public debt is denominated.

During market panics, emerging countries are the first to be hit by capital outflows. Financial institutions withdraw liquid funds in order to sustain their balance sheets in their origin countries, which usually are the developed countries. As a result, we are faced with a credit drain in international markets during financial crisis, therefore emerging markets governments find it difficult to obtain capital. At the same time, their domestic resources decline. Capital outflows, falling commodity prices, and falling export volumes reduces the ability of these countries to service their debt. The vulnerability of such countries is well known but this time around, they used lessons from the past. While the debt crisis has gridlock-developed countries, emerging countries find themselves safeguarded and chested with reserves full of foreign currencies.

Developed countries are not prone to financial crises and their consequences either. History shows that governments bare the hurdle to overcome the consequences or socialization. When the Scandinavian financial crises struck in the late 1980s, Swedish budget deficit was 3.35 percent of GDP. After absorbing the crisis, the surplus in 1990 lowered the deficit level in 1993 to (-11.17) percent of GDP. The central government debt kept rising, only to stabilize several years later.

Today, an example of current mix crisis is Ireland. In 2006, Irish budget deficit stood at a surplus of 2.94 percent. They experienced surplus budget in 2007 as well. However, in 2010 the budget deficit expanded to staggering levels of (-32.3) percent of GDP. It was a unfortunate and shameful for such a brilliant and rapid growing economy and for its hard working people.

Statistically, three years later, the banking crisis caused a rise of public debt to 86 percent.

Financial crisis and banking crisis go hand in hand with sovereign debt crisis.

The financial crisis domino effect does not affect only banks and financial institutions but sovereign countries as well. The Latin American and Asian experience shows that contagion effect can take down countries one by one. Once gaining momentum contagion becomes a selffulfilling scenario that puts governments under unprecedented pressure.

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The ongoing debt crisis is not an exception. The credit default swaps spread illustrates how market emotions towards a certain country can have a domino effect. In 2010, Greece was the only country that had a spread of 200 basis points. Greece counts for 5 percent of euro area sovereign debt market. In 2011 Ireland, Portugal, Spain, Italy, and Belgium were feeling the fever with spreads greater than 200 basis points.

After all, the sovereign debt crisis might be a result of all factors and circumstances mentioned before. However, when a crisis is taking shape, measures must be taken. Historically, defaults have been difficult for both sides. More often, both parts are forced to restructure as it is easier and cost effective compared to a default. Governments are difficult to deal with because of internal political problems and their tendency to opt for restructuring agreements.

One cannot accurately tell whether a country is going to default on its debt or not, but based on data and historical facts, some patterns can be extracted in order to make a clearer analysis of the events. The purpose here is not to make predictions, but to better serve the policy making process.

1.2.

Latin America crisis

Latina America is a region that inspired many to contemplate debt theory and especially public debt default. The region is always characterized by banking, currency and debt crises. Rampant inflation seems to be the norm in the region. The area appears to have a feeling toward populist and squabbly politicians, who usually promise more than they can bear. Therefore, the bad economic situation that these countries seem to never be able to eradicate, it is not so fortuitous.

Latin America countries have encountered different economic crisis throughout history. Their vulnerability to external shocks is only one part of the problem. To illustrate some of these problems, Mexico and Argentina are the best that fit the scope of this paper. They are the perfect example because of their resemblance to today’s European troubles. Current account deficits, budget deficits, private debt, currency issues, corruption, and policy deficiencies are the same issues discussed today.

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They call it “the Mexican Miracle�. During 1970s, Mexico was a country characterized by political instability and closed economy. The leviathan was made of populist politicians and corrupted civil servants and oligarchs ruled market. They lead a policy that was exclusively interested only domestically. The short sightedness of such policy demanded that domestic industries to be in hands of Mexican investors.

Foreigners were hit with high tariffs and restrictions on imports. After more than a decade of restricted policy Mexico let it go. Policy changes during 1980s, associated with oil reserve discoveries spurred an impressive growth. Foreign banks poured the country with money, thanks in a way to high returns from Mexican bonds that reached 12 percent. The high return on these bonds was a two way street. From the issuer side, they had to lure investors with high returns and on the other side investors always demand high and short-term payoffs on such occasions.

It was the typical boom story that was waiting the trigger to start the bust. During 1980s, the world was set for recession. Trade was hit hard and interest rates rose across the board. Mexico was trapped in the mix of the crisis. As interest rate increased, the debt payments became unsustainable. In other words, interest rates and other factors made Mexico not able to pay its debt, and its finance minister to declare in 1982 a 90 days moratorium on debt service. In short time, the crisis had spread through whole region.

Due to massive effort by United States and some form of mediation by Bank for International Settlements, Mexico was able to avoid a default on its debt. It rescheduled loan payments and took out loans to pay existing loans, which were in some cases, from the same financial institutions. However, de facto, the country did not default, but the result was a recession. In 1986, the income per capita in Mexico was 10 percent less than five years earlier. Inflation in the following four years reached a frantic 70 percent, and wages declined in real value by 30 percent.

Within several years, Mexico was back again. A new political class shaped new economic policy that was usually based on free market rules. Abolishing tariffs, massive privatization, and loosening foreigner’s ownership rules were some of the reforms. Beside the fact that corrupt practices were common, Mexico looked like a dancing star again. In part, this was possible due to massive capital inflows that were helped by a change in public perception of Mexican risk.

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This happened thanks to the Brady plan, which, in practice, swapped Mexican debt with "Brady bonds" which had a smaller face value. Unfortunately, the real effect was that non-substantial 'markets' responded emotionally as they usually do. Once again, this set the stage for another financial folia, which would soon be a proven déjà vu. The capital that was invested in Mexico by foreign companies during 1993 totaled a whopping $30 billion. It would not be until the following year that they would find out whether their decisions were tenable or not.

After 1990, investors refer to Mexico as a miracle. However, economic growth was at the same level as population growth. Not all capital inflows by foreign investors and reforms carried out were paying off. Mexican politicians and experts of the time noticed no problems with Mexican economy, despite the fact that the trade deficit stood at 8% of GDP. For them it did not matter as long as the current account deficit was relatively low due to high capital inflows.

There is an explanation for the Mexican slow growth and a renowned economist articulated it.

Rudiger Dornbusch knew the Mexican economy very well. According to Dornbusch, the problem laid at an over evaluated currency, which made Mexican products less competitive in the world market6. He continues by saying that the strategy of controlling inflation and putting through good economic reforms were not associated with corresponding economic growth and stable politic reforms. He also argued that as in the case of Chile during 1970s, the growth of Mexican economy would be apparent only after a correction of currency overvaluation. If one takes some time and thinks of resemblances that today performance of Greek economy has with the Mexican one during 1993 to 1994, sees that economic mechanisms are almost the same. These technicalities will be discussed during the next chapter.

The crisis struck again. Several factors biased the way. Country risk was affected by the uprising in Chiapas, assassination of a presidential candidate and corrupt banking practices. The situation was complicated further by low foreign reserves, so much needed to survive from capital outflows by scared investors in a medium with fixed exchange rate. As if it was not enough, the Tesobonos issued to finance the huge current account deficit were indexed to American dollars.

Mexico reacted with devaluation at least halve in value of what was expected. Amid this stirred speculators further to gamble with Mexico's economic fate. The government found itself in the 6

R. Dornbusch, “Mexico: Stabilization, Reform, and No Growth”, Brookings Papers on Economic Activity, Vol. 1994, No. 1. (1994), pp. 253-315.

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middle of a rapid developing financial crisis, for which it was the main culpable. As a result, it cost taxpayers 50 billion dollars7, a 7 percent GDP decline, businesses bankrupt, thousands of jobs lost, and lost confidence.

The way Mexico was rescued is not different from what we are seeing with Greece today. United States had an interest on Mexico and landed a hand. Today, Germany and France are helping Greece. Amid congressional obstacles, US government managed to secure a $50 billion credit line for Mexico. US usually acts fast and in time in comparison with old like moves of Europe and the procrastination that sometimes seem to be good for negotiating purposes.

This procrastination may be good for leverage purposes but it spurred contagion among other European countries. Mexico's officials played with market expectations, they expected more and they gave less and let markets believe that was going to be more. Speculators are infatuated by these cases. Their pecuniary behavior was again proved in Greece's case. European Union institutions dragged the solution over Greece and they were playing with market expectations summit after summit, never giving enough or at least what was expected. This lead to a contamination of other vulnerable European countries, such as Italy and Spain, expressed by rising bond yields at hardly sustainable levels.

Another country that represents the typical vulnerability of emerging countries and the strange habit of excessively printing money is Argentina. Argentina also has the right stature to fit the club of countries with notorious history in international debt markets.

It is not that Argentina came from a good economic situation before 1980s, but the truth is that it went worse. Argentina was characterized by political instability and rampant corruption after 1980s, and the same situation persists today. After the fiasco of the Falkland Islands, the new government installed gave high expectations for the economy. Those expectations were justified by the fact that the previous government was a military dictatorship.

The new government introduced new reforms and a new currency, the austral. However, nothing worked and the country was struck by a rampant hyperinflation that peaked 12000 8 percent. By 7

N.Roubini & S. Mihm, “Crisis Economics. A Crash Course In The Future of Finance”, The Penguin Press Book, New York 2010, pp28 8 Jan Joost Teunissen & Age Akkerman, (Eds.), “The Crisis That Was Not Prevented. Lessons for Argentina, the IMF, and Globalisation”, The Hague, FONDAD, January 2003, www.fondad.org

15

keeping in mind Argentina’s economic history, it looks like the country has been in a continuous crisis ever since. After a hard time the loan was finally secured. At first, the IMF programs seemed promising, but they failed. Once again, Argentina knocked on IMF’s door and surprisingly managed to secure another loan in order to close gaps and finance an economy running amok.

In 1989, a new government was running the country. Strangely, it set the right way for reform.

Privatization, slashing tariffs on imports and exports, and monetary reform made a difference in the country's economy. The monetary reform was needed to prevent hyperinflation and to return the credibility of domestic currency. After returning to peso, Argentina set a currency board. The currency board meant that the peso was pegged with the American dollar at a fixed exchange rate, and every peso in circulation was supported by a dollar of currency reserves. Another relevant measure that seemed to tackle a neuralgic point was legally giving up the possibility of recklessly printing money.

The result of that reform was extremely low inflation, gain of market confidence expressed with capital inflows and 25 percent GDP growth in just three years. However, it did not last for long.

As mentioned previously in 1994 Mexico bothered the region once more. Argentina felt the earthquake waves, even though not so hard, because it went through that turbulence with a $12 billion dollar arranged by the World Bank.

After the 1994 shockwaves, Argentina seemed to be headed for a good uphill. Nevertheless, that was not the case. Profounder issues such as corruption and money laundry accusations for large amounts, and missing funds, resurfaced once again. IMF was there to provide loans and postpone payments. The regional situation did not help either. Brazil devaluation damaged Argentina, as it was its main trade partner. In addition, a revaluation of the American dollar spurred more shocks.

After a long and tormented period, it deteriorated. In 1999, Argentina officially entered recession.

Again the currency peg was the centipede of the state being, even worse was the thought that by freeing the currency political stakes being played were too high. It was something true at this point, if we take in consideration domestic liabilities and corporate balance sheets. The fear of sudden deep devaluation, if currency freed, would have made impossible to bare domestic liabilities in foreign currency. Because of higher domestic interest rates, usually companies tend 16

to borrow in the pegged currency and invest in that domestic one. Another political risk would have been a walk from the currency, and the government spent too much energy to earn the confidence for the currency. To a certain extent, the fight for the currency (partially true argument) brought down the country. Finally, in 2001 amid protests and deep political instability, Argentina defaulted again on its debt.

Another element here to be analyzed is the role of IMF. Besides its financial support, IMF demanded from Argentina 'sadistic' economic reform, which was a destructive corollary for an economy already in crisis and abnormal high unemployment. IMF would write the economic history of the country better than economic historians would. The relation of Argentina with IMF has been debated. It is not the scope of this paper, but harsh measures suggested by IMF and implemented later just made the situation worse. Taking in consideration low budget deficits, low public debt to GDP ratio and manageable current account deficit the default was not purely an conomic consequence.

After all, Argentina came back with economic growth in 2003 letting behind four years of recession. Argentinian growth was helped because of its commodity export that also helped to build a huge trade surplus. The surplus was so ample that made the central bank intervene into the market in order not to let the currency appreciate too much. Further reforms were taken undertaken and the club of Latin American countries at the time writing looks more 'serious'.

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1.3.

The Boom that Came from Asia

It is widely accepted that the Asian financial crisis started with the devaluation of Thailand's currency, the baht. However the statement doesn’t make sense because devaluating a currency is not an action that a government takes just for the sake of taking it, especially with a currency like baht that was pegged with the American dollar to a ratio of BT25.5:$, since 1984 and experiencing only small fluctuations.

Nevertheless, in order to reach such a point there is a need of previous buildup of pushy circumstances that lead a government toward that action. This point is important, because baht devaluation was not the beginning of that crisis, but was a desperate action of a government that found itself with few alternatives left. Thai authorities did almost everything to continue keeping their currency pegged to the American dollar. Just before June of 1997 Bank of Thailand, understanding the severity of the situation, was forced to take extreme measures. One thing they did was supplying finance companies with capital. The bank acted in secret and gave preferential rates. The total capital infused, amounted four times the amount of capital these finance companies previously held. It is still arguable if the Bank of Thailand did the right thing but given the circumstances and knowledge, they did what they could.

More than a decade after the Thailand crisis, in 2007, United States found itself in the middle of a financial crisis. Today, most agree with the idea that 2007 was the beginning of the crisis.

Three years later, Europe all of a sudden lands in the middle of a sovereign debt crisis. Taking in consideration all the cases mentioned before, it would be superficial to accept that everything was perfect until the crisis manifested itself. In Asia, the crisis was conceived well before 1999. In US, the crisis started before 2007, when credit was cheap and taking a mortgage was as easy as taking a trip to the store. In Europe, the crisis started way before 2010, during Greek Olympic Games, when Eurostat found that Greece was lying about its numbers and Greece's budget deficits did ad up only to half Greece's public debt9.

Usually, there is a key expression describing financial crises: "...investors became increasingly worried about…” As it was that all of a sudden investors recognize what they are doing with their 9

M.Lewis, (2010,October 1), “Beware of Greeks Bearing Bonds”, Vanity Fair, Retrieved January 9, 2012, from http://www.vanityfair.com/business/features/2010/10/greeks-bearing-bonds-201010

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money. This behavior is a testimony that investors not only are more than often wrong in their judgment but they do not take in consideration historic data when buying securities or investing.

Often investors do not look at historical values of securities that they are buying 10. When you apply for credit the bank wants to know about your credit score, which is based on past records.

When you apply for a job, the interviewer needs to know about your experience, it is also based on past facts. Investors seem not to care about such extremely relevant information. When saying investors is the same as saying markets, analogue with when saying government is the same as saying politicians.

Nevertheless, the Asian financial crisis was a heard before scenario, and started in 1997, with its origin in Thailand. It is also accepted that this crisis geographically had a wider range than that of Latin America. After Thailand, contagion spread to Indonesia, South Korea, Philippines, Malaysia, Taiwan and Hong Kong. Shock waves were felt also in other regions like South Africa, Russia and Latin America. This crisis was not bigger only in scope compared to the Latin one, but it also impacted excretion on different financial and economic indicators. When expressed as a share of world GDP or as a share of world exports11, this crisis had a bigger effect in comparison with 1980 Latin debt crisis and 1994 Tequila crisis.

This crisis had its own unique characteristics but overall as previously said the fundaments remain the same. Pertinent elements of a typical crisis were developed in Asia before 1997. Real estate bubbles, overvalued equity markets, reckless lending, huge current account deficits, corruption and pegged currencies were things that came from textbooks. Keeping aside currency pegging, all what is left sounds like the 2007 financial crisis, or like every other financial crisis.

However, Asian economies were truly growing. They were and they still are flexible economies that appropriately respond to market incentives. The Asian miracle or the Tiger economies, is mainly a media epithet. A typical frenzy market state expression. Like anytime, market operators do get overemotional. When it came to economic analysis, their growth was not a mystery anymore12. The output growth was in proportion with input growth. In other words, it was a

10

C.M.Reinhart & K.S.Rogoff, “This time is different: eight centuries of financial folly”, Princeton University Press, New Jersey 2009, pp.137 11 S.B. Kamin, “The Current International Financial Crisis: How Much Is New?”, Board of Governors of the Federal Reserve System, International Finance Discussion Papers, Number 636, June 1999, pp12 12 P.Krugman, “The Myth of Asia’s Miracle”, Foreign Affairs, Nov/Dec 1994; Vol.73, Issue. 6, pg. 62

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mobilization of resources rather than efficiency gain, but this topic is not in the scope of this paper.

While looking for potential reasons of this financial crisis one finds it difficult not to point to a self-fulfilling scenario. There was a bubble, and everybody knows that the bubble cannot keep stretching forever. Thus viewed, there is an element of procyclicality in this perspective.

The cycle built up by starting with huge capital inflows and prompted by high interest rates.

Before 1997, Asian countries that were affected by the crises were the destination of more than halve of capital inflows that were being channeled to emerging market economies. High interest rates means that it is worth borrowing in other currencies and investing in domestic ones, example the Baht, and that is what happened. Asian countries borrowed mainly Japanese Yen and as usually American dollar. Borrowing in foreign currencies was supported also by pegged currencies, fact that made the situation more dangerous as corporations and borrowers did not have enough incentives to hedge their positions.

Figure 2 Current account balance as a percentage of country's GDP

Source: www.tradingeconomics.com

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The figure above illustrates a crucial fact that almost every country that is headed toward a crisis has it. The current account balances for four countries that best represent the 1997 Asian financial crisis have a tremendous resemblance. Prior to the crisis, these countries had substantial current account deficits as percentage of GDP. Thailand and Indonesia reached peak values of respectively 8 and 9.5 percent to GDP, with South Korea and Indonesia with values that are more moderate, respectively 4 and 3, 5 percent to GDP. The difference between Asian countries current account deficits and Latin America countries was that in Asia this deficit was private and not induced by government actions. What the picture does not show are the capital inflows that these countries experienced prior to the crises. In the case of Thailand, during 1995 and 1996, capital inflows stood at 13 percent of GDP, while among developed countries (G-7) this number was only 0.6 percent of GDP 13. Besides that, capital inflows were mainly short time; this explains a lot when it comes to investment expectations. It took these countries two years after the peak of the crisis to correct their current account balances.

A chronic thing in financial crises, and mostly observed among emerging market economies is political influence, or corruption Capital inflows were not channeled accordingly to needs.

Money was not targeted on projects with studied fusibility and analytically in good condition.

Contrary, the capital obtained from foreign investors and banks went to people and companies with political ties and close to the establishment. Were investors right? As it appears they were, because nine in ten cases of such companies that got money by foreign investors due to political connection did get government assistance when the crisis hit14.

After all, during July 1997 for different reasons the situation started to slide. External factors had their own influence in the occurrence. One was a depreciation of the Japanese yen that send shockwaves and affected Thailand’s exports. Another factor might have been developments in US. After 1990s, when the US economy was recovering from a recession the Federal Reserve raised interest rates to cope with inflation expectations and to keep the economy under control.

This made investing in US more convenient than in Asia, therefore huge capital outflows

13

Sh. Heffernan, “Modern Banking”, John Wiley & Sons, England 2005, pp. 415.

P.Krugman, “The Return of Depression Economics and The Crisis of 2008”, W.W. Norton & Company, New York 2009, pp. 83 14

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followed as investors choose for more safe and lucrative investments. Besides that, Asian countries had their currencies pegged to the American dollar, thus higher interest rates in US made their currencies appreciate and consequently their exports more expensive in the global market.

As the crisis unfolded governments found it difficult to keep their currency pegged, and as in Mexico's case it was painful. Latter when governments saw that they could not keep up with capital outflows they let the currencies afloat Devaluation was a painful outcome. It made domestic liabilities unbearable and as a result triggered a chain of defaults on debt, the one especially hold on foreign currencies and subsequently bankruptcies. Beside it all, during the crisis the Asian currencies were a subject of heavy speculation attacks.

The aftermath of the crisis is also predictable. IMF came to the rescue by securing billions of dollars’ worth of credit lines and imposing to countries austerity measures. As always, the first buttons to be pressed are interest rates and then austerity measures, which usually are painful and not necessary.

Thailand's economy was hit hard. The construction boom that was previously showered with money, was severely halted, resulting in massive worker layoffs. The currency lost more than 50 percent of its value. Meanwhile, Indonesia did not seem so perilous as Thailand, because economic indicators were stable and in optimal condition. After the baht devaluation, the Indonesian currency became the next prey of speculators, resulting in a huge sell off of rupiah and subsequently floating the currency. Economical complication followed and in 1998 Indonesian GDP diminished by 13.5 percent.

The crisis prolonged to other countries as well. South Korea was hit the hardest. The country's financial system was unique, in part by its large stake in nonperforming loans. Many industrial conglomerates and banks went bankrupt. Other financial institutions and banks were forced to acquire insolvent banks and in the mixed of it all, the currency lost its value. Due to the crises, the National debt increased tremendously. It went from 13 percent to 30 percent of GDP. Analogical effects were felt in other countries like Malaysia, the Philippines, and Singapore.

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1.4.

Conclusions

The most shocking observation while contemplating financial crises history is the tendency of procyclicality in almost every occasion. This tendency is not set rightly in time, which means that it does not have to be every five years, or every decade or more. It is not the placement in time of the event a relevant element of this observation, even though one can find time resemblances related with duration and time that takes different economic indicators to correct to a certain optimum.

This economic inclination is a strange behavior, it is an expression of a boom and bust cycle.

When economies grow rapidly, markets get frenzy, and financial institutions loosen their requirements, policy makers have a lot to say simply because they happened to be in this chain and no other reason. Regulators, beside sporadic episodes, loose the right impression to approach market extemalities.

Everything becomes so obvious because usually growth is not sustainable. This growth comes from one-time reforms and to a lesser extent; they are a result of economic improvements. During the boom period, some cold-headed people sense the storm coming. The brutality of the storm depends on how tangled the previous part is.

The second element observed in this economic behavior is the attitude of self-unfolding.

Suddenly the scenario turns into a self-fulfilling one. While the situation evolves, actors lose control of their actions and often-in desperation to gain control; they end up making things worse.

Here is worth noticing that not all actors are on the desperate part of the story. For example, speculators know what they are doing. Righteously they act as 'correctors'.

Once the boom is exhausted, the bust comes and the scenario is mostly known. Sometimes exacerbation is noticed even in economies that do not deserve it, they just happened to be taken by the avalanche passing by. In the end of a boom and bust cycle comes a rating agency that basically tells you that the economy that you are leading is junk and subsequently you as well.

There are other things to be focused on based on the financial crisis and the historic introduction mentioned before. The inability of these economies to maintain external debt is crucial for analysis. During the boom period, most economic occurrences are easily interpreted. For 23

example, running a trade deficit is always justified with an offset effect by running a surplus in the capital account. These capital inflows tend to be short term and mainly pressing countries for quick returns. In a sudden event, which usually that is what happens, such capitals rapidly flee the country and leaves build up pressure towards the currency.

A very predictable consequence is currency depreciation. In most cases, the nominal value decreases by 40 percent. Than currency becomes subject of speculations. Sometimes speculation on a certain currency gives a push to the whole scenario and things precipitate quicker. A common characteristic during these crises was the pegged currency, usually to American dollar.

The first lesson derived from the Latin American long crisis was that a fixed exchange rate is perilous, especially in markets with free flows of capital. The same lesson should have been learned also from the European Monetary Union crises (1992-1993). A very predictable consequence is currency depreciation. In most cases, the nominal value decreases by 40 percent.

Than currency becomes subject of speculations.

One fundamental problem with pegged currencies, beside artificiality, lack of flexibility and vulnerability, is the fact that domestic economic operators borrow in foreign currencies and do not hedge their positions. They do not have enough incentives to do that because the domestic currency ratio is fixed with the pegged currency, and domestic operators are too optimistic to believe that something bad is going to happen.

If the economy was like fashion, real estate bubbles would be the black of it. Almost every crisis has in its core real estate A very predictable consequence is currency depreciation. In most cases, the nominal value decreases by 40 percent. Than currency becomes subject of speculations.

Always the same smash while landing from skyrocketing prices, and yet most never seem to learn. On the other side, the white of that fashion would be banking crisis. In every crisis, the financial sector finds itself in difficulties, mainly to its own fault and less to others.

Bad financing decisions or credit decisions are subject of corrupt practices or political ties.

Corruptive practices were an important determinant during unfolding events among all countries taken in analyzes. Moral hazard may be as old as the world itself, but it is not a specialty of emerging market economies. The financial crisis of 2007 in US proved that developed countries

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are not prone to sins. Moreover, the actual debt crisis developing in Europe proves that chronic corruption can be harbored within the union.

Sovereign default or a restructuring event, are the other aspects of this short historic resume. As previously said, sovereign default is always a corollary of imprudence, or at least was. In a world with IMF in it, and so many actors interested in a country survival, default of a sovereign seems to be out of discussion. It is simply the last option to be considered in this globalized, interconnected and conductive economy. Markets now days transmit information, emotion and contagion very fast, as they were made of silicon. To default now days a country needs really to be an extreme case (Venezuela 2004), to anger IMF (Argentina 2001), or to have no strategic relevance at all (Ecuador 2008).

Greece fits all the conditions above. A country at the time writing, in reanimation, is being transfused huge amounts of other countries' taxpayer money. Only and only not to default.

Historic precedents and actual examples impose a different angle of view related with sovereign debt, or even restructuration. I will try to explain this view in subsequent chapters. In the following chapters, unfortunately, will be easily observed that change is one thing and progress in another. The latest financial crises and the actual debt crisis constitute almost by the same elements that appeared in previous crises.

Lastly, sometimes it seems easy to find the reasons that trigger a crisis, but it is always impossible to find culprits or at least those that should be kept accountable. The only way that works to make people accountable seems to be the market. Markets fail business leaders and lately markets are getting used in ousting politicians. Markets are not perfect, as I am going to argue later. They are instable, but sure, they are the best option available. Market is the place that holds a massive animalistic insanity. When observing market elements individually, one sees only sanities in their own ways. It is better to leave individual sanities decide for their economic destinies rather have a commanded big one decide for all.

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2. The way to bond serving, the European way

2.1.

Introduction

The European public policy in the past four years has experienced the same exact thing as United States during 'Savings & Loans' crisis or Japan during the burst of its asset bubble, a policy of procrastination that made things worse. However, Europe did not suffer only by procrastination but a policy failure as well. The headlines during these years have been talking about worthless EU summits with high expectations that never delivered and led to worse economic conditions that affected not only Europe but also elsewhere.

The typical indicators of financial crisis were raising red flags all over the place, even before the crisis struck. Asset price inflation, especially housing prices, rising leverage of financial institutions, large, prolonged and unsustained current account deficits and slowing trajectories of economic growth were signals that are supposed to be enough to draw attention toward a raising problem. But these are not signs of a public debt crisis; these are signs of an economic flu or a potential financial crisis, which can be dismantled by lowering interest rates. It was not such an easy job this time.

Usually financial crises do not just come and go. There has been enough talk about the coming, but what is important here is the going. Financial crisis leave behind a toll and someone has to pick it up. It is widely known and painfully accepted that the taxpayer picks up the tab, or the socalled government. Generally that toll is reflected in public deficits and consequently in public debt growth.

These spending explosions by governments are nicely put to be 'cost socialization' and they include different categories like: bail out costs, falling tax revenues, the activation of macroeconomic automatic stabilizers, banking system recapitalization, government subsidies, government guaranties, etc.

Then again, the debt crisis that has stroke Europe is not simply a financial crisis toll socialization.

As usual, problems in Europe are diverse and well rooted; almost wishing the banking system was like that. In Europe's case, the financial crisis only draws attention to structural problems that 26

the previous mentioned indicators should have done. As George Soros says: "It takes a crisis to make the political impossible, possible".

All of a sudden, the European bureaucratic body woke up and the first thing that it thought about was new rules. This is grotesque. As documented in different European Commission documents and reports, fiscal rules go long back in history. After 1945 different European countries like Italy, the Netherlands, and Germany had budget balance rules to help central government stabilization programs. The master of the rules, regarding the EU, was the Maastricht Treaty of 1992. The heart of this treaty was to keep away individual countries from abusive public spending and fiscal policy that was not consistent with the monetary union economic developments.

Now it starts to become grotesque. It is so because it is almost impossible to explain why there is a need for new rules if the existing ones were not respected by all signing countries, except Spain.

By simply rewriting the old rules, does not make them new. This is where it becomes a deep moral problem. Besides that, the European debt problem is not just a consequence of the financial crisis. It is a mix of financial crises with structural deficiencies, which lie in the bottom of EU fundamentals.

Nevertheless, this debacle is not only a problem of morals. Even though most of it, is so. Among different approaches that were discussed when the financial crisis hit, one can find that some of them are the same culprits that brought this debt crisis. For example, deregulation. From 1940s to early 1970s the world did not go through many banking crises, we can also say that there were not many financial crises either, those years were too calm regarding the financial world. During those thirteen years world economy was characterized by heavy repression of financial markets, almost an obsession with capital control. To imply that these two were the reasons that the world did not go through depressions or recessions is too much, especially when it is not backed by empirical data. But as an observation it looks more convincing when adding the healthy and robust growth in world production at that time.

When labeling Europe’s crisis, one should be careful because it is not just a public debt crises. In Greece’s case, it is with at most certainty that it is experiencing a public debt crisis. In other 27

countries, the problem lies elsewhere. In Spain, there is more a private debt issue than a public one. However, how is it possible that a country with such a small share in Europe can bring all countries in to arrears? Nevertheless, it would be more appropriate to call it a “debt crisis”.

Of course, it has to be a way out. However, what are they considering as a way out? What should economies do in such occasions? The main word after 'debt crisis' has been austerity. Actually, according to OECD simulations fiscal consolidation in the name of austerity could cause a GDP reduction of 6 percent. However, is not that the point of austerity under a monetary union?

Deflating the way out of it, and then eventually growth will come.

Looking at the austerity from a historical standpoint Reinhart and Roggof raise a question related to emerging market economies described previously, that before the Great Recession would have sounded different. Concretely: "How emerging markets graduate from history of serial default on sovereign debt and from recurrent bouts of high inflation?"15 It seems that after this recession they got an answer one way or another. One way might be that emerging markets as they are remembered do not have any more the same stature that they used to have. After the crises they come out almost unscathed. No matter how it happened, the emerging market economies managed not to get involved in this global crisis. Another way might be that the definition of 'emerging market economies' does not matter when it comes to such crises.

This was a crisis that stroke right in the heart of the developed world. The developed world got swept by this crisis the same way, with the same symptoms, and by no important of the stature of the country, as emerging economies got swept by their respective crises back in history. Coming back to austerity, the developed world back then demanded Latin American countries (as the best example of emerging economies) austerity, tough rules, and healthy policy. Those crises were studied extensively in order to draw the right lessons from them. But how easy are these demands for Europe, even with more sophisticated political and economic systems consolidated institutions and vast wealth? Nonetheless, all these topics are subject of discussion in this chapter and the subsequent one. But before starting the discussion in details it is important to take a glimpse at the messenger, the financial crisis that the world almost left behind.

15

C.M.Reinhart & K.S.Rogoff, “This time is different: eight centuries of financial folly”, Princeton University Press, New Jersey 2009, pp.278

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2.2. The debt into perspective, theory approach It is not in the scope of this paper to discuss debt as a notion, however, it is worth noticing that debt has been a substantial element of economic development all the way through history, and gaining importance even more during last four or five decades. Debt, and not just public debt, has been rising persistently for more than three decades. That is what statistics of developed countries show. In past thirty years, developed economies have experienced evident growth of indebtedness levels. If taken together: private debt, corporate debt and public debt it has raised by more than 5 percent yearly for the same period mentioned. If in 1980 the ratio on average was 167 percent of GDP, in 2011 it was 314 percent.

Some potential reasons for what has happened with this phenomenon are described as follow.

First, this raise in debt coincides with a great deal of market liberalization that started after 1970s.

Not only restrictions were withdrawn, but incentives to borrow were greater. This liberalization was associated with financial innovation and a better financial infrastructure.

Second, the economic situation after 1980s was stable, making market operators believe that the future would be more bright and lowering the bar of uncertainties. Inflation was low, unemployment was at manageable levels and innovation let to better risk pricing methods.

Another reason might be that interest rates globally have been exceptionally low, especially after 1990s. Whatever the reasons are for low interest rates, the consequence of such policy is widely known. Low interest rates not only give rise to bubbles but also spur borrowing.

Lastly, the tax system might have been another key element in this case. The tax system in different countries favors borrowing by concessions or other incentives. For example, in some countries households were urged to borrow by giving them tax reliefs for mortgage interest payments16, corporates were given borrowing incentives with a tax code that favors interest payments.

16

R.Prifti, “The Financial Crisis and The Canadian Breakthrough�, Warsaw School of Economics, 2011, Pp.37

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Everything leads toward a world of debt, private debt, corporate debt and public debt. The risks that arise from high or relatively high debt levels are different, and the Europe of today is the best illustration of this plethora of debts. Starting from Spain, Ireland and ending with Greece. All countries have different reasons for being at this point now.

Debt impact to economic growth has been extensively studied. Some publications have given threshold levels of debt17, which claim to explain the relation of debt to economic growth. When exactly debt hampers growth and what is a reasonable debt to GDP ratio that would not harm growth. The discussion is complicated, not because most of these studies are being questioned in their fundaments18 but because practice shows otherwise.

There are countries that find it difficult to serve their debt even when it is below 60 percent of GDP; Argentina had an epic default at a rate below 40 percent of GDP. Others are doing fine with debt above 100 percent of their total production, even in some cases such a huge debt is a necessity, Japan. Moreover, it is difficult just to say that the debt to GDP ratio should stay around 60 percent ratio or 90 percent or another, because taking in consideration different studies and the practice these thresholds are easily arguable. The threshold is something but a mountain of debt is another. Once a country climbs a mountain of debt finds it hard to get down from there. OECD reports show that countries experiencing crises, not just public debt crises, but also financial crises that cause public debt explosion, find it hard to bring down debt to GDP ratios. Most countries, even a decade after, had debt to GDP ratios above those before crises.

In order to solve this debacle, in this discussion must be taken in consideration another variable.

This is the political factor. Fiscal policy and especially public debt is extensively related with the political will of the party representing it. The consensus related with public debt to GDP threshold should not be assigned based only on academic empirical work, but it should take in consideration also political implications. For example, Italy has the world’s highest debt to GDP ratio, but it did not just happened yesterday. This ratio has been on high levels for at least a decade. Another example is Greece. The problem here is more complicated because it involves other elements, as falsifying public data etc., but the idea is still the same.

17

C.M.Reinhart & K.S.Rogoff, “This time is different: eight centuries of financial folly”, Princeton University Press, New Jersey 2009 18 J. Irons, J. Bivens, “Government Debt and Economic Growth, Overreaching Claims of Debt “Threshold” Suffer from Theoretical and Empirical Flaws”, July 2010

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Political abuse with debt is always the problem. It happens even in countries like US. The US debt problem is not less obvious than Europe's. The US just got lucky enough because the European soap opera has stolen US's thunder in this show. However, the political gridlock that characterizes the US now (actually for the last three years) is the best of illustrations. The party, which is governing the country, finds it out of options to cut spending, or let us be honest even to raise taxes. The other party wants to cut spending just because it is in opposition, and not because it thinks that that is the right thing to do economically.

In this paper, it is argued that the political element is one of the most important hurdles of developing events. A separate section will discuss its implications in relation with the actual crisis. Again, the debt problem is not so straightforward. Cutting current deficits will not save any country, and especially the developed ones. Public debt is also related with future liabilities, which in developed countries are huge. Unfunded liabilities make up a tremendous amount. The ageing and high maintenance population of Europe has significant implications related with future debt prospects. An old population is not bad only because they save less than the young do, but also because an old society might reduce per capita growth, making it more difficult to serve the debt and implying added risks to the economy as a whole.

Growth is sluggish, both economic and in population. Pension funding and health spending are huge problems for Europe and it fiscal policy prospects, especially those related with public debt.

Such impediments fall into structural problem category, and are hard to fix taking in consideration debates that are still hot on reforms regarding health spending, pensions etc.

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2.3.

The European Way

By the end of 2008, the European Union lunched a program called European Economic Recovery Plan (EERP) as a response to the financial crisis on hand. The name of the plan suggested that Europe was looking to recover from a crisis that was not even recognize at the beginning, at least from a monetary point of view. The aim of the plan was to coordinate the different start up points and fiscal leeway of the governments.

The plan had very ambitious objectives; in fact, it had too many. Aside the idea that it had to provide short-term stimulus to the economy, it also aimed to fasten the transition of the economy to a low carbon one. In reality, some of these objectives were beyond the plan scope, indicating g that EU was not expecting the worse. Supposedly, it had two main elements over which the program was to be laid out.

The first element was to beef up the economy with short-term demand. The second element was to formulate short-term actions to help implementing structural reform among EU countries. .

The second element is paradoxical within it. However; the plan was not the problem, the lack of structure within EU’s body was. This plan should have been a mechanism within the EU structure in order to tackle potential emergency cases, like the one it is experiencing.

Moreover, the plan itself substantiality lacks policy and action. European economies have different needs and when the debt crisis is thrown in the mix, it does not make it difficult to spot coming problems. The biggest setback of the approved European plan was that the short-term goals had in fact long –term aims. Prioritizing was way off. Unfortunately, this is the European way of handling things and the 2008 saga is still going on. It appears that the plan was not enough to retain the continent from a deep crisis and to buffer shocks created from it.

In a way, it is true that 'Europe' regarded the financial crisis more as an exclusive American illness. Sometimes, even when you learn the lesson, there still is the risk of making the same mistake again. It might just seem as a different reason. In 1930-es, the depression that trapped the whole world originated in the United States. By all means, the 1980 crisis had its grounds in US. I believe that the debt crisis unfolding now is a straight consequence of the 2007 financial crisis, which as well originated in US. This might appear as a different debt crisis because is just

32

another crisis. At this point Europe suffers from an old and common sickness that has struck modern economies all over the world and that is the curse of repeating history.

2.3.1. Macroeconomic realia When the financial crisis was about to hit the continent in full speed, its economies were suffering from other problems. Pension reform and health spending were and still are hurdles that hunt Europe. At the event of a potential bailout cost and its guarantees typical during a crisis, the automatic stabilizers need fiscal space to maneuver with public spending. EU countries did not have this space. The majority of the countries had surpassed the 60 percent debt to GDP ratio specified in the treaty. In 2008, the average EU ratio was higher than the official limit. Today, large fiscal stimulus is more common. OECD Studies show that governments restrained themselves when it came to public money usage. It is not clear if this was simply policy or a great fear of using public money to pomp the economy, depending on the perception of times living; or banks for that matter as it is happening these days. The main indicator of such fiscal stimuli is the central government debt to GDP ratio. No matter what those public expenses go for, important is that debt in crisis times explodes. In times of crisis, debt explodes; no matter how the funds are used. Graphs three to seven show the most common macroeconomic indicators for selected European countries.

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Figure 3-6 Unemployment, CPI, Debt ratios, and Annual Growth Rates for selected countries

12

GDP - annual growth rate

10 8 6 4 2 0 -2

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

-4 -6 -8 France

Germany

Greece

Ireland

Italy

Source: OECD

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Netherlands

Portugal

Spain

As previously stated, in the past decade growth in Europe was rather sluggish. Only Ireland had an annual growth rate above 4 percent and oddly enough Greece as well in some cases. What today is regarded as EU safe haven, and one of the most powerful economies, Germany, had a weak history regarding growth rates. In 2002, German economy stagnated at 0 percent, and in 2003, it slipped to negative growth, following by 1.2 percent and a bare 0.7 percent in respectively 2004 and 2005. It gathered steam in 2006, with a fare 3.6 percent growth rate, and slipped again into negative growth in 2009, by -5.1 percent. It came back to positive growth in 2010.

France and the Netherlands experienced the same situation beside the fact that they did not have any yearly negative growth. This was until the crisis hit. Portugal was another country with negative growth like Germany. In 2003, Portugal had a -0.9 percentage growth and later showed anemic progression. In 2008, it stagnated at 0.0 percent.

Fragile growth has been associated with problematic unemployment rates. However, there are a couple of exceptions. Two success stories are Germany and the Netherlands. Germany seemed to be a miracle that managed to bring down unemployment rates for eight straight years. Even during the worst years of the crisis, Germany’s unemployment rate continued to fall, which caught everyone by surprise. The Netherlands managed to have low unemployment rate as well.

For almost a decade, the Netherlands had lower unemployment rates that Germany. Both countries implemented deep reforms regarding the job market.

Meanwhile, Italy and France oscillate around same levels with high and problematic unemployment rates. Both countries have deep structural problems in their highly regulated labor markets, but in Italy's case, informality has its own share. The worst performers were Spain and Greece. Spain has always suffered from high unemployment and as in Italy's case has a high rate of informality. On the other hand, Greece is a more complicated case, but it is worth noting its highly regulated labor market, closed professions and high informality. Lastly, Ireland was doing a good job with its labor market until the crisis hit. In 2008, its unemployment rate stood at 8 percent, to jump later at Greece like levels.

The only indicator that seems to have been under control is inflation. This is true when you take a glimpse at CPI data. When digging deeper, and when comparing inflation rates to central bank 35

pursued rates, other conclusions might appear. Subjectively, ECB targeted inflation rate for each country is not satisfactory, but as an average is adequate. Some claim that in developed economies is difficult to consider inflation crisis or hyperinflation, because central banks are more sophisticated than ever and they have different tools to maintain an acceptable level of inflation. I find this argument questionable and it is not the scope of this paper.

The last indicator to be previewed here is central government debt to GDP ratio. The worst offenders of the 60 percent to GDP rate, according to Maastricht treaty, are Greece and Italy.

Greece is a case study and there is no place for discussion here. In 2003, Portugal also was headed to break the rule. It broke it in 2004, and since then the debt never came down. Debt to GDP ratio also exploded in Ireland, but it was mainly a direct consequence of banking system capitalization and nationalization. By the time, this paper is being written other countries such as: Spain, Germany, and Netherlands have not broken the rule yet. France broke it in 2009, a relatively justifiable economic situation to do that.

An important indicator is also the 3 percent borrowing limit. Germany was the first to break the rule, followed by Italy and France. The only country to have respected all the rules since euro creation, the 3 percent deficit to GDP included, is Spain. This gives Spain top of its class.

Unfortunately, markets did not and do not react the same. Looking at bond rates of Spain, Germany, and France, markets are not sharing the idea of good behavior.

Markets also have been acting in a strange way. To a certain extent markets let down even the greatest believers in them. Before the crisis (whichever, financial or debt crisis) they mispriced macroeconomic basis, and risk related with different instruments. During and after the crisis markets began to take note of individual country's risk, even those under the euro umbrella. The effect of contagion deteriorated borrowing costs among EU countries. When markets started pricing risks related with Greek bonds on country basis, the panic spread easily and affected Portugal, Ireland, Italy and Spain. Under different circumstances, these countries would have not had any problem borrowing at reasonable costs.

It was and continues to be thought that Eurozone economies had different fundaments in comparison to the American one. It is important to notice that in this paper the financial crisis of 2007 will be regarded as the trigger of this debt crisis, which is widely accepted to have started in 36

2010. The financial crisis paved the way towards a debt crisis. Nevertheless, who would have thought that being together would have been more difficult than standing alone? Some EMU countries, in other circumstances, would have devaluated their currencies or in an extreme case would have just defaulted.

To a certain extent the euro as a currency is for some countries of the euro-zone today, what was the fixed exchange rate for Asian countries and Latin American countries during their respective crises. However, devaluation and default are not the only options outside a monetary union. Paul Krugman makes a point that the European debt crisis would have unfolded differently if countries that are in pitfall now had had their own currency.

The argument compares Britain, USA and Japan, which already have huge debts burdens but still are able to borrow money cheaply. On the other side, Italy is having problems with borrowing money from the markets because they demand unjustifiable rates. If the ECB were to stand behind the European debt, the situation would have been different.19 This argument makes comparisons that shoot too straight and are relatively plain.

While at this argument, another viewpoint is that the current debt crisis might be a result of a national systemic risk and not a risk with common European origin. If countries of the European Union had been under the same currency these effects would have been channeled in currency fluctuations. Therefore, the elasticity of national currencies serves as a buffer of macroeconomic risk indicators, but the euro is not flexible in that sense, since it does not take in consideration differences between countries characteristics.

For some countries, the euro is too artificial of a currency. As Joseph Schumpeter puts it "The monetary system of people reflects everything that nation wants, does, suffers, is". The Euro reflects everyone as being happy, which might be true under the curtain. At least that should be true, because the only responsibility that countries have is that toward a currency, and nothing else. That is not enough to keep a union together.

19 http://www.nytimes.com/2011/10/24/opinion/the-hole-in-europes-bucket.html?ref=opinion

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2.3.2. Fiscal Rules and Fiscal Costs Calculating the fiscal costs of a financial crisis is not easy. Even coming out with a definition of what fiscal cost of a financial crisis is, or how to calculate it, is difficult. The methodology is different among different researchers, but there is a common understanding in order to approximate a definition and a methodology. Two main approaches are recognized as the way a financial crisis turns into a fiscal cost. The European Commission calls them: direct gross costs and indirect costs (figure).

Figure 7 Types of fiscal costs from financial crises

Source: European Commission services

As illustrated in the figure above, different under the two main categories of fiscal costs are different contributors. Some of them previously mentioned as recapitalization and guarantees.

One important category of this fiscal cost burden is automatic stabilizers. Since 2008, when financial crisis effects started affect the real economy, the impact has been considerable.

Estimations show that automatic stabilizers and other government expenditures in Europe account for less than halve of the anemic 0.4 percent growth of 2008.

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Even though automatic stabilizers in Europe are more widespread and consolidated than in US, they only absorbed 6 percentage points more economic shock than in US until 2009. This was the reason of a EU - US row in a G20 meeting. US experts think that they should coordinate a wide stimulus plan as a response to the crisis. On the other hand, EU officials disagree because their economic stabilizers are presumed to fill this gap. In addition, there is an economic sense that countries that rely widely on economic stabilizers do not have to implement other stimuli to the economy. Estimations of such European programs Table 1 The cost of Financial Crises cost

are

difficult

to

compile,

but

by

approximations fiscal costs of different programs as part of automatic stabilizers category, are way down the $700 billion cost of one stimulus package that the US congress had to approve.

Other aspect of fiscal costs are related with the financial system, or banking crises. As mentioned earlier, deposit guarantees, recapitalization, and bailouts all burden the fiscal policy, and usually fall under direct fiscal cost category. Implications here are more complicated, and are also related with government accounting these transactions. If we take banks, or other guarantees made on other institutions, the government does not feel the burden until those claims are realized, consequently there is no impact on its deficit or public debt. On the other side fees collected from those guarantees usually government account as revenues. If this is fair or not, it is a topic for another discussion, but the issue will be slightly touched in a subsequent chapter.

Other aspect of fiscal costs is output losses. There is a discussion among academics on how to account output losses. Anyway, here the output loss is the difference between growth estimations before the crisis and actual or registered output. To have reliable numbers for such cost calculations we will have to wait at least several years until Europe returns to its previous trend of

39

growth. Note that output loss in previous crises has been relatively high; it has been on average 23 percent of GDP. There are pretentions that this financial crisis will be the less expensive in comparison with previous financial crises.20 However, the indirect costs of this financial crisis are enormous.

Advanced economies in 2009 had a negative growth of -3.2 percent, after a positive one of 2.8 percent in 2008. This drastic fall was a direct consequence of the crisis. The idea of a cheap crisis is premature.

Looking at the figure 8, which shows selected financial crisis around the world that had a certain fiscal cost, is hard to set a bar of what is expensive. At a first glance, one might say that developed countries such as: Sweden, Norway, and Finland had single digit fiscal costs.

However, this is not enough to draw a conclusion. In many cases Japan is a specific case, that is why intentionally is left aside the developed countries group.

Nevertheless, a measurement problem makes it more difficult to draw a conclusion on what is too much of a fiscal cost. Some more reasons that argue that is too soon to talk about the fiscal cost of the ongoing crisis are as follow. First, because comparisons for the actual one are made based on initial cash outflows, and that is not enough or appropriate because does not give the whole picture. Second, the main characteristic of this crisis is that it hit the industrialized economies that have much more capacities, powerful institutions, wealth, and specific monetary positions. The comparison with Indonesia or Chile is biased, due to different characteristics, criteria and circumstances. Lastly, it is not over yet.

Nevertheless, even when it comes down to practical solutions, still are problems with methodology of estimating the fiscal cost of a financial crisis. Questions rise weather to be based on present value of cash flows or not, and even if using the present value the question remains on the discount factor that has to be used. Technicalities vary from what to use as a denominator, which GDP, to when the crisis ends, or even started.

In order to have fiscal costs at reasonable level strong governance is needed among EU countries, in national level and union level. The policy has to be transparent and all-inclusive, based on

20

Edit. B. Speyer, Deutsche Bank research report, Frankfurt am Main, Germany, May 14, 2010

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consistency and clear rules. This brings us to fiscal rules, another important aspect of the financial crises and mainly to the debt crises.

More and more sensitive is the debate on fiscal rules. The trajectory that such rules have followed in Europe is interesting. It seems that old rules are not suitable so we need new ones, even though no country respects the old ones. If one drives over the speed limit, authorities give him a ticket, and not a new speed limit.

Indeed, usage of fiscal rules in EU countries shows raising trend. In 1990, European countries had 16 such rules; this number grew to 61 in 2005, to add 6 more in 2008. Actually, among member countries fiscal rules have been a practical tool for fiscal policy, even though only few governments respected those rules.

In a survey by the European Commission was found that fiscal rules targeted the most expenditures. Actually, it is difficult to think about any other target. Main problems with the majority of countries that implement such rules are that they do not have reliable monitoring and they lack an enforcement mechanism.

Data shows that in EU countries, there is a positive correlation between the quality of fiscal rules and fiscal policy discipline. The connection is interesting, because analyses the link between the quality of fiscal rules and fiscal discipline, and not the number of fiscal rules and fiscal discipline.

The connection seems to be more than fair. For example, Greece that has no sign of a national fiscal rule whatsoever has also the worst fiscal discipline, not only among EU countries.

Even though during the last two decades the number of fiscal rules has grown, almost nothing has been done to strengthen those existing ones. This shows that reforms in this aspect lack improvement.

In order for fiscal rules to be useful in practice, independent institutions are needed. Agencies that fulfill different functions like contemplating macroeconomic prospects, reliable data, budgetary reviews, and even policy counseling. The need of independent, reliable and credible institutions in this aspect rises from existing problems with fiscal policy implementation and other fiscal constraints. Governments fail to implement rules and policies that are proper to economic prosperity. Therefore, the need for nonpartisan institutions is crucial.

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Why fiscal rules at the first place? Even though, to the fact that public debts have been exploding during last three decades of peace time, countries have responded with numerical fiscal rules as a policy tool to constrain their selves. As previously said, there is a positive correlation of fiscal rules quality and fiscal policy discipline, but assumptions that fiscal rules 'work' have been questioned both in theory and practice.

Nevertheless, in theory there are two main recognized problems that justify rules. First, it is the government. Government’s goals are more short term because of political reasons related with reelection, and sometimes tend to be inconsistent with long-term fiscal policy goals. More than often politician's myopia had proved that bending fiscal rules and putting personal interest before the common interest has been disastrous for some countries. It is politically safer to borrow money and consequently raising deficit and public debt, rather than increasing taxes or cut spending. Second, there is the “common-pool” problem, which best suits EU conditions. The problem takes place when groups representing certain interest, or constituencies, do not incorporate their demands to the general budgetary impact. The common pool issue in a monetary union, such as EU, is a subject of super-national rules that can help not only to incorporate such demands of competing interest groups but also to urge better coordination of fiscal policy among countries and union level.

In addition, some rules or stipulations are crucial not only when enforcing such rules but also related with their economic impact. First, fiscal rules need wide political support. Committing without conditions or policy exceptions is more important than the rule itself. On contrary, it can undermine institutions credibility, and subsequently the rule's credibility. The last fiscal pact agreed by EU lacks from the beginning this political commitment, because the purpose of this new 'old' rule is not fiscal policy discipline. It was bundled to satisfy Germany regarding other EU member’s fiscal policy, before it picks up more bills to pay using German taxpayer money.

Second, there is the economic impact related to fiscal policies. A procyclicality of fiscal rules is observed by different studies. During troughs, fiscal rules do not give fiscal policy too much space by implying discretion. Third, there is a phenomena observed while regulating banks and financial institutions. Those institutions made everything to bypass regulations, by creating securitization, off-balance sheet operations, SPV, etc. The same happens with governments. They will tend to bypass the rules by using "creative accounting", or doing public operations the way 42

they do not leave trace in public spending accounts, or will classify those operations in other ways. This issue is not only related with off budget operations but also with government transparency. The temptation for such actions varies from the scale of desperateness of the government. In Greece's case, it was so desperate that it hired Goldman Sachs to cook its public debt numbers.

2.3.3. Monetary Realia However, the pre-crisis environment was tight regarding monetary policy. The ECB monetary policy kept in mind the inflationary pressures that ECB thought that came from rising oil and food prices. For a while, there was a time that commentators and analysts put too much attention on the topic. It seemed that US in this aspect had a more determined monetary policy whilst ECB run more conservatively accompanied by inflation anxiety.

The pre-crisis ECB monetary policy is debatable. As mentioned it was relatively too tight, keeping in mind that most of the countries in Europe were net savers, including households and non-financial institutions. The situation appears no to be tenable, with households and nonfinancial institutions being net savers, interest rates tight the only way to compensate was fiscal policy. However, fiscal policy is one thing and monetary another. It is easier to judge monetary policy in this case, because is more centralized and harmonized than the fiscal policies of different countries dependable on different governments, or on politician's pragmatic interests etc. alike.

At the eve of the financial crisis, the ECB increased rates. This step was regarded as a wrong monetary policy implementation. On the other hand, the argumentation of such move by the ECB showed its obsession with inflation. Another, less likely, way to interpret that move is that ECB needed monetary room in order to maneuver during future dreadful events. At the eve of the financial crisis, the ECB increased rates. This step was regarded as a wrong monetary policy implementation. On the other hand, the argumentation of such move by the ECB showed its obsession with inflation. Another, less likely, way to interpret that move is that ECB needed monetary room in order to maneuver during future worse events.

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ECB as one of a kind institution should execute its power more carefully. To a certain extent, what is the point of blindly keeping the inflation target as a policy front-bencher while missing what is going on around with the real economy. For example, ECB interest rate after 2000 and prior to the crisis was lower than Irish inflation rates.21 Different inflation rates combined with one size fit all policy interest rates can produce dangerous trends within the union. This, beside Ireland, happened also in Spain. These two countries with relatively high inflation had negative interest rates, which spurred borrowing because actually it felt wrong not to borrow. Meanwhile the opposite happened in Germany.

The idea that European economy fundamentals are different from Anglo-Saxon economies is arguable. Thus viewed, the ECB, just as the Fed, missed a lot of what was going on while the crisis was being conceived. All the imbalances within Euro economies, money demand fueled by and connected with rising house prices and relative low interest rates in some EU economies, which also promoted unsupervised credit growth, went under its nose

2.3.4. Banking System Implications European peripeteias do not seem to end. After the financial crisis hit the banking system, it almost froze the liquidity and cut lending to records low. Tight credit conditions affected small, midsized businesses and corporations as well. The implications for the real economy were disastrous. According to a survey made by ECB main factors behind this contraction are: 

difficult market financing



bank's liquidity



costs of capital



future economic prospects

After the second quarter of 2011, according to the same survey, credit tightening rose by more 20 percent in comparison to the previous quarter. The debt crisis deteriorated market liquidity 21

Ed. Philip Arestis, Rogério Sobreira and José Luis Oreiro,” An Assessment of the Global Impact of the Financial Crisis “, Palgrave Macmillan, Basingstoke, 2011

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further more. Banks hold most of the government bonds of countries that actually are in perils.

Usually banks of a certain country have the greatest exposure related with that country’s bonds.

Raising fears that the country would go on default, automatically implies losses by banks on those bonds.

Banks have a tendency to be more exposed in their own country, and that is usually natural. That is the reason why, now, the banks of some of the most problematic countries find their selves trapped inconveniently. Greek banks have exposure ratios to their sovereign debt at 226 percent of Tier 1 capital. Italy has an exposure of 157 percent, while Spain 113 percent and Portugal 69 percent. On the other hand, Irish banks have only 26 percent of Tier 1 capital exposure toward their sovereign debt. No doubt Greece is the worst case. The issue of exposure is not exclusive to domestic banks, cross-border sovereign exposure is also a hot discussion.

Germany and France as the main characters of this European movie are not just the countries with biggest economies, but their banks have the biggest exposure to the problematic euro countries too. German banks have the largest exposure to Greece, Portugal, Spain, Italy and Ireland. France is not left far behind. It holds the second place after Germany. Another reason for this protagonism of Germany and France is their raising claims on assets in problematic countries. Both countries banks expanded toward south euro countries, which fate brought to be indebted today.

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Figure 8 Foreign Banks' Claims on Assets of Selected European Countries, 1999-2009 (billions of dollars)

Source: Ed. C. A. Primo Braga, G.A. Vincelette, “Sovereign debt and the financial crises�, The World Bank, Washington, DC, 2011, Pp. 251

Sovereign risk influence in banking system funding is channeled in different ways. For example, potential losses on government bond holdings make bank's balance sheet weaker, thus raising their own risks. High risk related with government bond holdings weaken collateral's quality that they can use in funding operations. When a sovereign is downgraded, additional pressure is applied on its banking system.

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When a sovereign is downgraded, it affects banks because actual guarantees or potential ones have not the same value any more. The downgrade is treated as impossible by government to be able to infuse cash in its banking system; no matter the form of it.

As an illustrative example are banks in Spain, Ireland, Portugal, and especially Greece. These banks had found it hard to finance their operations by selling debt or even deposits.

Consequences for the economy are obvious, but all this makes banks to rely more on central bank funding.

However, the effect that sovereign risk has on its banking system is not the full story. A vicious circle goes around through interconnected channels. In addition, a feeble banking system affects the sovereign almost the same way it is affected by the last one. Weak banks require cash infusions to be capitalized, action which drains public funds, weakening further the sovereign.

Weak banks hamper economic growth by not taking up shocks, but leaving the economy fully exposed.

Another aspect of this vicious circle is the uncertainty in government budgetary prospects after they support their domestic banks in different ways. Most measures that governments take to help their banks burden the gross debt of a certain government. During this crisis was noticed a phenomena that was not discussed enough, or it was forgotten. When governments rescued their banks, in most cases they transferred risky assets (toxic) from banks to government balance sheet.

The effect in government deficit might be netted because of the claim that the government gave money but acquired assets with the same value. The real problem here lies in the value of those assets. When the market labeled them toxic and couldn’t give them a fair value, how will a government put a price on such claims? It is not just the shift in risk from banks balance sheets to government balance sheets, or the moral issue, but is the net effect that those assets will have in government budget. Being a part of the cost of a systemic rescue, their future fair price will also affect the cost of banks’ bail out that public finances have to bare.

Banks are suffering from contagion from their countries that are deeply indebted, but another substantial problem is their own debt holdings. As previously said countries in euro zone have debt to GDP ratios below 70 percent, except Italy and Greece, while their banks have tremendous debt to country GDP ratios. French and Dutch banks, have liabilities to GDP ratios of 300 47

percent, number applies also to Germany. Ireland has a whopping ratio of 700 percent, and Spain 289 percent (2007 data). Such huge amounts of liabilities are associated with problems in bank's financing structure. For banks, the rollover ratio is 10 percent of total liabilities on daily basis, while a certain government has a rollover ratio of 10 percent on yearly basis. This tremendous difference explains the exacerbated thirst for funds.

Quenching this thirst is not a job for markets any more. The ECB had to swoop in and pump billions into the market. This is the function of a central bank, to act as a lender of last resort for banks and not for governments. The ECB resisted to enormous pressure, mainly coming from media and other influencing personalities from the financial world. There are claims that this move was not effective, but simply legal.

Assuming that such a baseless pretense is true, acting legally and according to the rules suits to the moral and the very existence of the institution. Europe, and not only, is at this point because of countries and institution not respecting the rules that they made. The experience of the American Fed shows that such semi-fiscal policy, which categorically is not a domain of a central bank, might jeopardize its authority and expose the institution at best to political pressure, and at worst to demands from pretentious politicians.

The fact that some politicians in US are demanding insanities like auditing the Fed, or even abolishing it, it is more a consequence of Fed's actions rather than a breeze of reform related with monetary policy. It involved itself in fields that were not its domains. However, this case study falls beyond the scope of the paper.

The ECB played an existential role for the European financial system. By the end of 2011, loans lent to European banks totaled â‚Ź1 trillion. The ECB even made sure that markets did not feel the dollar absence by swap agreements with the American Fed. In order to help the worst trapped banks ECB changed the rules of accepting collateral. It removed the requirement that government bonds or other securities with government guarantee had to have a sufficient rating to be accepted as collateral against borrowing from ECB. This step helped especially Greek, Italian, and Spanish banks. Until now ECB policy has been the most coherent with the situation, also it did not let itself to be carried away from this crises frenzy.

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The financial crisis in Europe did not just hit countries that suffered from inflated real estate prices like Spain but it went all the way through the continent. It affected trade, bank-lending power, it hit hard the investment sentiment and customer purchasing power. Depending from the viewpoint this is also a consequence of 'core EU' policies. The so-called core EU looked at peripheral Europe as emerging markets, or as markets for expansion and not as future equal markets.

Thus viewing, the lack of competitiveness in peripheral EU is a consequence of such policies from core EU, and is easily justifiable. This crisis brought these disparities into disclosure.

Competitiveness in EU is a fundamental problem. One reason why no one believes that Greece will come back to growth by 2013 or 2014 is that it lacks a great deal of competitiveness. Greece is not the only country, but others are not on such bad levels. For example, in Germany unit labor costs, from 1996 to 2010, have seen a raise of 8 percent. In France, it was a moderate 13 percent, but when it comes to problematic countries or the emerging economies of Europe, those numbers are on steroids. Unit labor costs increased in Portugal by 24 percent for the same period, in Spain it was 35 percent and Italy 37 percent. Again, on the top of the class is Greece with a frightening 59 percent. That is economically shocking, such an increase without even producing anything.

The consequences of such numbers are also disparities in trade, expressed in huge current account deficits. Practically Germany, which has a huge surplus in its current account, is exporting to Greece (example) and at the same time giving them money to buy its products.

Actually, this imbalances are regarded as the main reason of this debt crisis, and not just debt crisis. Lately there are discussions arguing that these imbalances are part of the culprits squad that caused the 'Great Recession'.

The imbalances argument emerged lately, and some of the main ideas are related with the world 'saving glut'.22The mechanism that explains this idea seems more than grounded in economic logic and might also explain the imbalances in US, but it does not justify, yet again, the debt crisis.

22

B. Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit�, Speech At the Sandridge Lecture, Virginia Association of Economists, Richmond, Virginia, 2005

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2.3.5. Shaping a Reaction European reaction on both crises, as always, was characterized by the typical bureaucratic sluggishness. Sometimes the situation was comic because in 27 countries, there is always one that disagrees, and one small country holds back all what is presumed to be panacea. This was the case with Slovenia lately, even unwillingly 2 million people held a decision concerning 500 million people.

However, problems in the old continent are not new. Some of them have been growing for several years now. Differences among economies within the union are obvious, starting from economy competitiveness, labor productivity, innovation etc. However, the most important of all is that even in union for more than a decade, countries never learned to think as a union. Always, in their rhetoric predominates nationalistic behavior and individual obstinacy.

Nevertheless, beside the plan mentioned at the beginning of this section, the EU reaction to the crises was a number of summits that mainly deteriorated market emotions and wasted almost four years. After some years in crisis mode and feeding world papers with plots, finally an accord was met to write some new rules, that to be fare look like the old ones, the ones agreed back in 1993.

This reflects the lack of leadership, and a presence of a fear to move forward or backward in the union.

The new fiscal agreement was met after some tentatives that failed to calm down markets. A â‚Ź750 billion package called the European Financial Stability Facility (EFSF) was introduced on May 9, 2010. The facility's purpose is to provide financial assistance to EU member countries. In practice the facility could loan money to countries in arrears, officially it can intervene in debt markets, and recapitalize financial institutions through their governments. The facility is registered as a company in Luxembourg, and it is owed by euro area countries.

The biggest shareholders of this company are Germany with 29.07 percent, France with 21.83 percent, and Italy with 19.18 percent. After comes Spain with 12.75 percent. The only countries with 0.0 percent share are Greece and Ireland. The company got maximum rating by all rating agencies, which should be enough for the facility to raise money for cheap in the open market.

However, its construction is paradoxical for some reasons. First, is Italy safe enough to bare the share of the third biggest fund guarantee? Second, the second biggest guarantee is France, the 50

question was if France was able to maintain its triple A rating, now that France is downgraded those questions are not any more. In January 2012, a courageous rating agency like S&P took of the triple A rating from the ESFS fund, arguing that countries that guarantee the fund are not safe anymore. S&P might be the worse institution to judge a financial institution, but in this case is right. The fund was constructed wrong from its basis, as most of European things are. Until now, the fund lent Greece €109 billion as a part of several bail out series.

By the end of October 2011, another attempt for an agreement was quite successful. Successful was only the attempt, not the agreement. It was a three in one package. First, it was concurred that the private sector will have a 50 percent loss regarding Greek bonds. Supposedly, it was voluntary. Second, the EU will have to make the rescue fund bigger. Lastly, European banks will have to be recapitalized. After negotiations with the private sector, banks accepted ‘voluntarily’ a loss of 50 percent. By the time writing, European powerhouses are pressing for a sort of fiscal pact. Objections to this pact skipped negotiations from end of 2011 to late January 2012. By the end of January 2012, the fiscal pact was signed, with only two objections, the UK and Czech Republic.

The pact was a set of rules for EU countries in order to harden the way toward future budget deficits. Before going to what the pact really is, other pieces of regulation were represented by European Commission. For example, rules regarding comparable budgetary rules. Creation if independent bodies like fiscal councils that will oversee how governments implement fiscal policies. According to this rule, EU countries will have to check their budgets before they approve them. There are two checkpoints, the budgetary draft will have to go first to the Commission and then to the Council.

The other regulation aims to toughen monitoring procedures for EU member states. Each of these so-called regulations have a bundle of other semi-rules attached. Actually, none of them are rules as long as they cannot oblige or force an action. If neither the Commission nor the Council can veto those budgetary drafts, there is no sense in implementing such regulation, which at the best of it will be just paper headlines. Both the Commission and the Council, only opinion those drafts, if those institutions (France and Germany) do not agree pressure will be applied to nonabiding members. This seems to be a de ja vu. Implementing such rules adds instability to the EU

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structure. The lack of accountability is also essential not just to financial structures, but fundamentally to the edifice holding it together.23 The chronicle of semi rules and bendable reality whenever it is in interest of a country shows the lack of understanding that EU leaders have when it comes to governing a union. Their fatigued probes toward semi federalism also add strength to this argument. EU projects always end in practice with a ‘semi’ in front of it. European experience shows that none of the countries, even German and France that are playing the bulldog in the room, have enough saved face to preach stability, respect for rules, and austerity. In 2005, Germany succeeded to pressure member countries to let free fiscal constraining rules, and it announced that was going to break the rule for the third year in row. After that France followed and others.

Took 27 countries four years to write down a new rule, which remarkably resembles the old one of the SGP. The goal of such policy is always noble; sustainable and stronger economic conditions and robust growth for European economies, closer coordination of policies etc.

However making sure that adhering countries respect those rules is always uncertain.

The new fiscal treaty sets some ground rules that do not differ from the old one. However, the first rule this time practically outlaws Keynesizm, because it states that government budgets have to be in balance, or in surplus. It is not just a rule; it is a knot, which ties different political and economic questions. This rule says that governments cannot spend more than their revenues. It makes arithmetic sense, but economically it is more complicated. It is not about borrowing or debt theory, it says that the bailouts, bank recapitalizations, public spending directed to boost demand in times of crisis was flat wrong. However, to bring down such questions and to make things clearer, the sub point b) of point 1 of the treaty comes in rescue.

Under this sub point, the idea of a balanced budget or in surplus adds a big IF in front of it.

Therefore, governments have to respect the rule IF: “the annual structural balance of the general government is at its country-specific medium-term objective as defined in the revised Stability and Growth Pact”, and this time the structural deficit should not exceed 0.5 percent to GDP ratio, in market prices. The first rule also specifies that governments can break the rule only in special or emergency cases, such as economic downturn, or en event not in control of the government. In 23

R.Prifti, “The Financial Crisis and The Canadian Breakthrough”, Warsaw School of Economics, 2011, Pp.27

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addition, in good times when risk prospects are low and the debt to GDP ratio is below the 60 percent criteria, the structural deficit of 0.5 percent can go up to 1 percent.

The other interesting part lies in article four of the treaty. It says that when the 60 percent debt to GDP ratio is exceeded, the contracting party, the government that broke the rule, will have to reduce it every following year at a rate of 1/20 as a benchmark. The sinful country, are subject to different procedures. They have to implement partnership programs with the EU that have to set in details the structural reforms that have to be carried out. An interesting and good example of this treaty without being ratified yet is Greece. Greece is under certain conditions and has to disclose budgetary plans and other reforms to EU. The treaty also requires parties (governments) to report any debt issuance plan before going on the market and ask for money. This procedure will be part of specific legislation, and is nicely called “procedure of economic partnership”. Nevertheless, all these criteria do not differ very much from the old treaty, and this is obvious. The problem here is who is going to be responsible to enforce these rules, because they basically existed but were not respected before. The trick this time involves the Court of Justice of the EU. The EU let the decision to be taken by a court.

Seems to be fair enough. However, after a court decision assuming that it was against a breeching rule government, what happens afterwards?

The answer to this question is not too complicated. Beside the fact that the new treaty will not be enough, it is not even a set of rules because there is no enforcement, not even less commitment.

The considerable pitfall here is that this treaty does not take in consideration the real problems of Europe. In almost every article is the word convergence, yet convergence cannot be achieved by just approximating some numbers, and underlying the real economy. The real economy that has to converge is not a part of this treaty, because it is impossible to treatise such things like competitiveness among EU countries, or current account imbalances. It is impossible to treatise such variables.

The message included in this treaty is the same old one: “We will play politics, but none will be out, because we need you in”. It is not Europe in action; it is part of European procrastination over problems. The answer to “What happens afterward?” is as said not too complicated. In Europe’s case, people always ask what next, but when it comes to a union like US, it does not 53

happen. This is a direct consequence of neither thinking as a union, nor acting as one. Between EU and Greece’ game people ask weather Greece is going to leave the union or even be expulsed from it. In US, people do not even think of problematic and indebted California of leaving the union, and that is the answer.

2.3.6. Political Resistance Looking at the situation in Europe it is easy to notice governments ousted because of accepting or sometimes asking for international help. Examples are Ireland, Spain, Portugal, Greece and lately Italy. In all these countries governments were ousted more because they accepted harsh austerity measures and not because they accepted money from let say the IMF. Opposition parties in these countries asked for ruling parties to resign. One of the reasons opposition parties asked for resignation is also the set of austerity measures forced unfairly by market forces and by the rest of EU. Practically in all the up mentioned countries happened the same thing, stubborn and short sighted opposition leaders did the same. Asked for earlier elections and pressed governments down. The political bias here is obvious. What if these opposition parties come to power? Does it mean that they will not enforce austerity measures pushed by market forces or even EU? For example, Greek opposition leader didn’t agree to enforce economic sustainability measures while he was in opposition, but suddenly after the prime minister resigns and a government of unity is formed He endorses the measures as a nation saving package. The same happened in Italy and something alike in Ireland and Spain. A correlation shows that countries that recognized the highest growth since the formation of EU are also the countries that experienced the highest drop in output during the recession. These countries are Greece and Ireland. Another analysis why this happened could explain more about their structures and the fallacy of sustainability.

However, Greece has no similarities with Ireland or any other country. Greece is a European mistake recognized in silence. The protest in Europe is coming mainly from countries that have a notorious economic history. The fiercest protests and the longest political deadlock happened in Greece. Theoretically, Greece has to be the country with the least to say or to protest about it. It is not a moral case at all. It is a known fact that they have a huge underground economy, despite a lack of innovation, competitiveness and great tax evaders. Thus it is not a matter of morals here, 54

but weather these people are going to understand that living beyond their means is not an option any more. Again, this is not moral advocacy. It cannot be more practical. .

Decision-making is always the problem. As so in the European case. The original sin of accepting a country when not ready to adhere was the first bad decision. Resolving the Greece debacle with more lending is a dubious decision. If a country is insolvent, is there any rationality in saving that with more lending? A question might be raised in the direction of weather Greece is insolvent or not, but that is an easy one. When a country is insolvent, lending more money to it will just push the crisis forward without resolving it. The debacle between willingness to pay and ability to pay is heavily explored in public debt literature, but this is not the case for Greece.

The Euro area economy is headed for a hard future. Reports predict that in 2012 the continent will go into a recession. Sovereign instability, risky markets, banks still deleveraging from the financial crisis, austerity measures regarding worst hit countries are some of the reasons to predict a weak short term future. Those reform pieces undertaken, do not awake enough belief in the markets.

If EU did not manage to introduce so much needed structural reforms in order to increase the elasticity of European economies individually, why should not market operators be skeptic now when EU introduces a legal piece, which barely stands as a sophistication of Maastricht treaty?

3. Country Briefings

3.1. Germany Germany has managed to be the epicenter of European history since the beginning of it. The subject here is the EU history and not the continent history. The country has managed to impose its will to all other European countries since the formation of the EU. This is not just because it has the biggest GDP or a powerful economy, but there is something more metaphysical that gives to this country a luster. It may be related with history or their strong working culture or something else, however the fact is that that is Germany, and till now has always had its own way.

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Calling Germany's economic performance a miracle is somehow related with this luster, even after being 'the sick man of Europe' for a long time. Nevertheless, this luster is only part of being a miracle. German economic performance has been remarkable in one aspect, in the aspect of conformity. Germany's economic run has been a straight story pulled from theory books. One cannot blame journalists for their politician like shortsightedness, journalists live with the present, and they want to know what is now , now and only now. Journalists almost never go back in history, because back is history, and not news. However, one can blame economists.

Economists are not to be blamed for calling Germany a miracle, but for calling a miracle something that is extremely normal and within the 'rules'.

It is difficult to find something miraculous in German economic history after WWII. One cannot be impressed with the idea that a war-devastated country has a growth rate of 8 percent. On contrary, one should be stunned if it does not happen. It is not to be impressed when an exportoriented economy has a positive trade balance, because that is the economy orientation. It is not to be impressed when an economy moderates wages and keeps them low and as a result has a low labor cost, that is why one does it. It is not to be impressed when domestic demand is weak because people do not spend, that is what happens when no one spends money. A recent study24 tries to explain the German current account surplus after 2000s. The idea is that this surplus is a consequence of a gap, a gap that according to the study is between growth in manufacturing and a slowdown in service industry. Therefore, investing in manufacturing and not enough in services has created a gap between these two industries, which is the reason of the current account surplus. Anyways, claiming that a surplus in the current account is a result of a gap of investments between two industries is courageous. However, the topic will be discussed later on.

After the unification, German real exchange rate appreciated, and the trend lasted until 1995. in five years the real exchange rate had appreciated by 30 percent. The impact of German unification had to be economically corrected. There are certain ways to do that, and countries usually would go for a boost in competitiveness by investments or reforms, but Germany chooses another way, which might be called the hard way.

24

C. F. and A. Wörgötter (2012), “Structural Change and the Current Account: The Case of Germany”, OECD Economics Department Working Papers, No. 940, OECD Publishing. http://dx.doi.org/10.1787/5k9gsh6tpz0s-e

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It chooses wage moderation with a downward pressure on wages and labor reform. The pressure was so strong that caused a decline by 20 percent of unit labor costs in comparison with the rest of the union, this decrease occurred from 1994 until 2009. Maybe selecting this path was the reason of such anemic growth for more than a decade. This feeble economic growth stipulated ECB monetary policy, creating a monetary oasis for the so-called peripheral Europe.

After creation of the European Union in 1999, German economy was finding a stabile regime. In 2005, the economy was almost there, centering attention toward production costs and competitiveness. Wage reform was giving its effects. German unemployment felt for several years in a row, the manufacturing industry was robust, the economy was specializing in investment goods, and during 2008, the real effective exchange rate adjusted to levels where it was in 1990.

The German economy is an open one, which means that relies heavily on exports. When an economy is opened, domestic demand plays a secondary role on its output. Indeed, domestic demand was weak even though the household saving rate was historically stable with negligible fluctuation. Thus, the main factor of economic growth in Germany was export.

Roughly, 40 percent of German GDP is direct result of exports. Such vast volumes of exports boost the current account. In 2007, 60 percent of its current account surplus was related with other union members, and 80 percent with countries of EU-27.

The openness of German economy and such trade volumes with EU member countries increases the impact that this country has over the union. That actually happened. Germany was a essential factor in causing Europe imbalances. Its exports were one part; loose monetary policy was the other. Even though the money was cheap, the investment rate in Germany was low. The private saving rate surpassed the investment rate. Data shows that the household saving rate remained stable, what really caused the raise in private saving rate was the corporate savings. German corporations were net savers; therefore, those savings were channeled in other European countries where the return rates were higher than in Germany. This was the resume before the crisis hit.

The next chapter for German economy is more interesting. Maybe this crisis will have historical implications for the country, although Germany does not seem to like being a lead actor. The 57

crisis for Germany was specific; it caught it in a cyclically appropriate moment. The economy came after long period reforms in different sectors of the economy, and most importantly during two subsequent years before the crisis it had a balanced budget.

The economy fully felt the heat in 2009 with a sharp fall in output by 4.9 percent. Due to its economic model, the economy was exposed to global downturn, and especially an European one.

The main impact in this decline was due to a fall in its exports as a consequence of falling global demand. The deficit in 2009 stood at the very limit of the treaty, around 3 percent, and the gross debt at 76.5 percent. In 2010, the deficit reached 4.3 percent. However, the output in 2010 grew, thanks to a strong demand for its exports, elastic labor market, and investment in businesses. It continued growing also in 2011 by 3 percent. Such growth gave a boost to tax revenues and helped the country deficit decrease in a level of only 1 percent.

The financial crisis in Europe complicated when it opened the Pandora box. The financial crisis put into surface too many problems that European countries and Europe as a union had before.

After the real economy took a hit, the crisis then turned into a debt crisis. Fiscal policy was the main phrase, and it still is.

However, Germany had enough fiscal space to introduce an ample fiscal stimulus to the economy. The fiscal stimulus package in 2009 amounted around 1.5 percent of GDP, and in 2010, it was 2 percent. It went through a budget consolidation, then through reforms that the country had already started. It also helped the banking industry, and a set of reforms regarding a labor market in a crisis mode.

They responded to the financial crisis with a fund called 'The federal government’s financial market stabilization fund' (SoFFin). The fund purpose was to absorb crisis shocks by issuing guarantees, recapitalization, purchasing assets, and establishing winding up institutions. The worst part of this fund was when it had to deal with banking industry. At the beginning, it announced a €700 million profit made from fees on guarantees for debt issuing and equity support.

Nevertheless, it was not the case, because the ownership stake that it acquired in Hypo Real Estate, the failed mortgage giant, would cost the fund more than €1 billion. Actually this mortgage mammoth has cost to German taxpayers more €102 billion. An assessment on the 58

global impact of the financial crisis Beneficiaries from the fund were also other banks like Commerzbank, Landesbank BayernLB, and HSH Nordbank. Moreover, to help the banking sector the government set up a guarantee scheme with a â‚Ź400 billion or 16 percent of GDP. In addition, a 'bad bank' was created to buy toxic assets from commercial banks.

German banks beside the fact that had to shore the effects of a toxic financial crisis have another problem related with the ongoing public debt crises in Greece. Not precise estimations show that German banks hold around 14 percent of the Greek public debt. On top of that, reports show that during the last two years banks have made too little to get rid of those holdings from their balance sheets. Moreover, banks covered only a small part of that debt by buying CDS as insurance in case of failure. However, such an exposure, which in nominal it varies from â‚Ź14 billion to â‚Ź30 billion, might not be too much even for the low earning German banking sector. The problem lies elsewhere, which will be discussed in other chapters.

The performance regarded so far as the best is the labor market reform. Germany is the only country that even through the peak of the downturn experienced a decrease in unemployment levels. Every reform has its down aspects but overall it proved to be successful. The labor reform had started long time before the crisis, that is why German unit labor costs are relatively low in comparison with other EU countries, and that is what makes them so competitive. This down pressure that reforms have put on wages might have affected the structure of the labor market.

Data shows that five years prior to 2010 the low wage sector grew threefold faster in comparison with other wage sectors growth. This expands the low wage sector, makes it more elastic, but exposes workers to vulnerabilities that during rough times are tough even to comprehend.

Nevertheless, German labor market was introduced with crisis time reforms in order for employers not to lay off workers. For example; companies reduced overtime working by taking advantage of flexible arrangements, thanks to reform introduced the duration of short time work was extended to 24 months, thus companies took advantage of this flexibility and other government offered incentives, also companies did not lay off workers based on reciprocal understanding, especially with well-educated ones. Another substantial element that kept unemployment low, was the fact that long time reforms have lowered structural unemployment in Germany.

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The reform that is directly related with the actual debt crisis is the fiscal reform. Fiscal policy is the other part of the medallion. Actually, Germany announced a reform including national fiscal rules before the crisis hit. In 2009, it revised its constitution in order to include a deficit rule that aims stability in public finances. The rule will be effective starting from the third quarter of 2011.

To the federal government will be given a transitionary time until 2016, to states this period will be until 2020. The constitutional provision stipulates that in the federal level the structural deficit cannot be more than o.35 percent of GDP. In case of states, they need to have a balanced budget.

The procedure states that if the structural budget is more or less than 0.35 percent, the difference is allocated in a 'notional control account'. When the negative difference in the notional account reaches 1.5 percent of GDP, adjustments are triggered o constitutional basis. The procedure of adjustments is set to start after crisis times, or during recovery, in order to prevent procyclical effects taking place. A parliamentary majority can approve exceptions from these rules in case of natural disasters or other emergencies. In the context of fiscal rules as Stability Council will be created in order to oversee public finances and give potential warnings, however all the procedure falls short when it comes to sanctions for rule violations.

Other measures taken to cope with the crisis and in order to consolidate the budget were cuts in social security and unemployment benefits, the implementation of two new taxes, a nuclear fuel one and a financial transactions one, despite pressures from health care and pension spending.

The second tax is the famous FTT that is supposed to finance the cost of future financial crises.

Despite all, the politics plays a greater role than economics in Europe. Germany in national level might be quite normal taking in consideration their cultural characteristics. In union level Germany lacks a clear identity. It is not clear whether it wants to be a neutral country or a power imposing its will to other countries.

That is an opened debate, that at first sight seems a German issue only, but it is not. Germany has to establish especially its EU prospects. There is a deep problem with the perception of the EU. Lately the chancellor Angela Merkel said: “We must re-establish the primacy of politics over the

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markets.25 This idea is plainly wrong because there lays the fundamental problem of Europe as a whole.

Bureaucrats always had struggled to set the primacy between the two, and never tried to find a balance. Markets are not perfect, but governments are not responsible. Both are a sine qua non for prosperous cooperation among countries and for the best of their peoples. Indeed, it will happen only when there is no primacy between the two. The other problem is that Germany sees the union as an escape from national conflicts among countries. Being together because of fear is a curse more than a premise for future economic success and thriving social conditions.

Another issue is the exaggerated pragmatism. For example, the latest fiscal rule was created only to please German politicians that were deeply unsatisfied with reckless south European countries, but the new fiscal pact was not created having in mind the very existence and prosperity of a real European union. That is also wrong; this might be a reason but not the essence of the union.

Germany should and have to take a lead in this direction if it really wants the union to be directed toward peaceful and prosperous future and not toward one that looks like a cage of complexities.

3.2.

Greece

Oddly enough, the first default recorded in history is related with Greece, and it dates almost four centuries B.C. Back then, ten Greek municipalities failed to pay back their loans from the Delos Temple. If we take in consideration that Greece in 2012 was shortly pronounced in default by rating agencies, it also makes it the last default up to date. Today, the only problem with Greece is that it is being treated as a special case, and the only advantage that it has is thank the world that is interconnected.

This is not a special case; this is just the worst case of governance. It is a pure case of irresponsibility, corruption, tax evasion, cultural bias and the worst is that nobody seems to be shocked by such behavior. Greece after its independence, after 1821, has spent more than halve of the time in default.26 Spending so much time in arrears can causes a modification in behavior, 25

â&#x20AC;?<http://www.economist.com/node/21538749> C.M.Reinhart & K.S.Rogoff, â&#x20AC;&#x153;This time is different: eight centuries of financial follyâ&#x20AC;?, Princeton University Press, New Jersey 2009, pp.98 26

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the subject customizes then the way it acts with the new behavior. It is difficult to find another example in economic history that can resemble to Greece. Many countries have experienced devaluation in their economy like Argentina or Baltic countries, but none has been as bad as Greece today.

Greece might be a special case only because its entry in EU had proved to be a curse for it.

Greece might have reformed differently if it was not in the EU, actually, after that happened it did not reform at all, only to wait for the cheap money to pour in and everything else is history. The effect of EU accession can be seen in ten-year Greek bonds. In 1993, the interest rate on such bond was 24.5 percent, but in 1999, it dropped to 6.5 percent.27 Markets believed that EU convergence would decrease risks in other countries also, perceiving every country in EU as being a Germany.

If, in other cases, the financial crisis of 2007 was the event that surfaced other boiling issues, in Greece's case there was an additional one. The revelation that Greek authorities have falsified or manipulated public data was another 'financial crisis' event for Greece. Actually, the 'statistics' or data reliability issue started to smell since 2004. Eurostat back then, issued a report stating that Greek deficit and debt data have been under reported prior to 2004, and Eurostat cited eleven issues on the matter. After that, the official institution dealing with statistics in Greece never issued a report without Eurostat consent; always Eurostat interfered before or during the release of data to correct them. When the news surfaced in 2004 and afterwards, it did not seem to have any effect on markets pricing Greek bonds.

However, the matter becomes problematic after the financial crisis. Also after the financial crisis, the EU came out with e report that cited severe violations in Greek statistics and data publication.

The irregularities included submitting incorrect data, breaking accounting rules, lack of cooperation among national institutions in data compilation, inappropriate accounting, absence of accountability etc. It was data falsification in open day, conducted by government officials and carried out by civil servants. After a while, the worst part of this financial system, rating agencies, triggered a chain of rating downgrades. Following the events, some economic

27

R.M. Nelson et al, â&#x20AC;&#x153;Greeceâ&#x20AC;&#x2122;s Debt Crisis: Overview, Policy Responses, and Implicationsâ&#x20AC;?, Congressional research service, August 2011, Pp8

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indicators were revised. The deficit for 2009 first was revised to 12.7 percent from 6.7 percent, in the end, it was corrected again to reach 15.4 percent of DGDP. However, economists new, that the best option for Greece was an outright default on its debt.

Economically it was healthy because Greece would have started from the beginning and reckless lenders of Greece would have been taught a lesson. However, as previously said the only advantage in Greece case was the interconnected world, and this occurrence 'saved' it. The specific economic situation and the risk that a potential Greek default poses toward other vulnerable member countries saved Greece from the outright default, or at least for now.

Actually European banks exposure to Greek sovereign bond is rather manageable; the real fear is the domino that it might trigger. Long negotiations that followed actually gave banks and other bondholders enough time to save their selves. It is interesting that during this time; more than two years, almost halve of the bond holdings changed hands from private investors to public institutions, or to be more precise to taxpayers. The scheme was not to save Greece, but more to save the EU countries, to give them enough time to fasten their belts in order to endure more shocks. The lack of pressure on Greece, the long time it is taking to reform, the enormous numbers that are not in favor of the situation, and the fiscal pact, show that the strategy is more to safeguard the Union than to be the shepherd of Greece, and that is a good idea.

Yet, the Greek economy since the formation of EU was a champion of growth. Until now, growth data have not been revised, so it has to be true. Greek growth during the decade that followed 1999 was simulated from excessive public and private consumption. Crediting the private sector, from EU accession to 2009 almost doubled, measured as a percentage of GDP. Taking in consideration that the saving rate was low for a long time, this consumption was possible thank to cross border capital movements, especially after euro adoption. Such capital inflows led to a widening of Greek current account deficit. Since its entry into the union until 2007, the current account deficit jumped from 7 percent to 14.7 percent of GDP. As a result, Greece is suffering from a twin deficit. As said previously, the private saving rate deteriorated to 7.6 percent, from 15 percent of GDP, also public saving rate fell by 4.2 percent.

Greek economy suffers from a plethora of issues. The economy was (is) mainly state controlled.

During 1990s, government controlled 75 percent of business assets in the country, this share 63

came down, still not enough, to 50 percent in 2008. Government expenditures are reported to be the highest among OECD countries. Expenses on public payroll in 2000 were 38 percent of state revenue, in 2009 such expenses reached 55 percent. Government recklessness is one side of the medallion, the other side is related with private sector, taken together turn this into a cultural problem rather just economic. Widespread corruption, tax evasion, fictive public salaries, dysfunctional labor market, are other deep structural related issues that make the Greek economy impossible.

Table 2 Greek tax evasion and government revenue data.

Source: IMF report

Tax evasion is so widespread that in 2010, only two third of what was owed was collected, the one third left out was almost the same amount as the budget deficit of.28 The tax issue is complex because is not only related with incapacity of authorities to collect the necessary revenue, but also with a cultural bias. Not paying taxes is a part of doing business routine, and is socially accepted.

The table above shows huge differences in comparison with OECD countries. The VAT gap in 2006 was more than twice of the OECD average, and the shadow economy is more than a quarter of the whole. Such illustrative numbers show how much reliable a country could be. The question of reliability will be in discussion later when talking about IMF intervention into Greece debacle.

Greece had a crisis inside that was waiting to surface, the financial crisis that hit after 2007 found the country in a bad shape. It found it with an economy run by fakelaki, corrupt institutions,

28

J. Suroviecki , â&#x20AC;&#x153;Tax evasion and the Greek Economyâ&#x20AC;?, The New Yorker, July 2011

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irresponsible politicians and no fiscal policy in place. Greece had broken the Stability Pact rules since it entered in the union. Its deficit was never under 3 percent of GDP, as the rule requires it, nor was the public debt ratio under 100 percent to GDP. Greece, with the fiscal positions it had was not able to withstand such shock.

Table 3 Government Deficit for Greece

Officials reported for 2007 a deficit of 2.8 percent; Eurostat did not certify this. Only after it was revised to 3.5 and then to 6.4 percent, it earned Eurostat validation. As previously stated, also in 2009 the deficit was revised to 15.4 percent, whilst in 2010 it was 10.51 percent.

In 2007 according to not easily accessible data by Eurostat, the economy was still experiencing growth by a ratio of 3 percent. The downturn for Greek economic growth started in 2008, and after that, the economy contracted for four years in row. Data for GDP growth are conflicting because are being revised due to Greek unexpected economic performance. Since 2009 the output had decreased by a cumulative more than 13 percent, according to IMF output contraction in 2011 was sharper than expected.

Nevertheless, these numbers are stating the obvious. Yet, strangely, it was not that obvious for a long time, because these indicators show now what have been showing for more than a decade.

Unexpectedly, the Greek debt became unbearable and Greece itself dangerous for the whole Eurozone. The soap opera that has been playing now for more than two years started in an odd way. All of a sudden, markets woke up and reminded that the sovereign bond market needs to burst. It is not a matter of speculation, even if it was in this case it served as a wake-up call for both parts, for governments and as well for sleepy markets.

Whatever the trigger was that made markets aware that countries were in arrears it is not important now. Economic history tells us that there is always a trigger, and when historians tell the history of an economic crisis, the most debatable part is the trigger. In most cases, the trigger remains unfound. One way to describe the trigger might be the one that Paul De Grauwe 65

describes.29 It started with Dubai sovereign bonds, and then rating agencies deteriorated the situation by exacerbating the problem in other countries by overreaction.

The justified, but late, market hysteria spread the sovereign bond virus all over Europe. It is strangely enough, because the US also has exaggerated deficit and public debts, stuck into a political gridlock with a congress that seems like a big Greek government, but there is no run from its bonds. Even this is a very interesting point to discuss, falls out of the scope of this paper.

Whatever was the trigger, we are here now. The position of Greece is specific because of its unknown future in the union. Keeping in mind what said before for Germany, Greece is the antidote of this issue, almost in every way. As previously the numbers have put, the country has an unsustainable debt, a deteriorating public deficit, a huge current account deficit, and bad growth prospects and on top of this add a total lack of fiscal discipline.

When the markets shut it out by demanding high interests on its bonds Greece started to pose a systemic risk for other union countries. Hence the interest of EU for Greece. Because frankly speaking, why would other countries put in risk their political credo in front of their electorates and what is more important, why would they waste taxpayer money to bail out another country, which for what it matters happened to be irresponsible and happened to be Greece?

Germany under the fear that a possible disordered default of Greece could threat the union itself decided that the union was to intervene. After long reluctance, hard negotiations, and preconditions for their action to save Greece the response came. The EU, IMF and ECB will be the three major players for the years to come for Greece, with be its bond market. In May 2010, troika orchestrated a plan, which included a rescue package o €110 billion. The amount lent was more than halve of Greek GDP. They thought that this was all, or maybe not. The first €110 billion were lent at market interest rates. Conditions of the loan were deep austerity by Greek government.

However, the government decided to adopt those measures. From that package to 2011 Greek conditions deteriorated, besides that, it was affecting market conditions for other countries and

29

P.De Grauwe, “The Greek crisis and the future of the Eurozone”, March 2010, http://www.econ.kuleuven.be/ew/academic/intecon/Degrauwe/PDG-papers/Discussion_papers/EuroIntelligenceMarch-2010.pdf

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risking a contagion that Europe feared much. During this time in Europe several governments were toppled by market pressures, one of them was the Greek one. When the situation was getting worse, and all the indicators were revised upward, in June 2011, came the second rescue for Greece. It was a €109 billion with more favorable conditions in interest terms. Troika demanded more and deeper austerity; in addition of austerity a private involvement was required.

Troika wanted bondholders to share the burden by taking a haircut, and consequently a loss on Greek bonds. It was more than right, if it were to pay, everybody was enough guilty to cheap in.

Was it done the right way? As always, no! At the end of the day, the taxpayer takes the toll.

Meanwhile, the economy was headed toward a slump. In 2011, the public debt increased 23 percentage points, to 166 percent, according to IMF forecast by 2012 it will go to 172 percent. In 2011, unemployment went to 15.8 percent, from 7.7 percent that it was in 2008. Domestic arrears in 2009 were at 2.5 percent of GDP. Collecting revenue issues continued, even measures to crack down tax evaders were intensified. The numbers do not show the chaos that Greek society has been experiencing lately.

To a certain extent, such aggressive and social reaction is understandable, but digging deeper that reaction starts losing its sense. Greek issues cannot and should not be attributed only to irresponsible politicians. Politicians to people are like the hat on the head, one gets the hat after his head. Metaphorically, in this case the hat fits perfectly. Keeping in mind the hat metaphor, this is not only a politician’s problem, it is a society problem, it is a cultural issue. However, sociological and behavioral implications of the case are not subject of the discussion.

Greece was the only EU country that did not have national fiscal constraints, or fiscal rules 30, and during 2008, despite the financial crisis, government did not take any measure at all. Even with an almost default economy and unsustainable public debt, government revenues and expenditures showed no change since 2007.

30

“Public Finances in EMU”, European Commission, Luxembourg, 2009, Pp88

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Table 4 Greeceâ&#x20AC;&#x2122;s Revenue and Expenditure dynamics 2007-2010

Source: March 2012, IMF Country Report No. 12/57

2007, was the last year that Greece experienced economic growth, since then till 2011 the output decreased sharply and the public debt ballooned. Not adding the fact that it was shut down from market access, and in the near future, it has no chance to regain it.

As the table above shows, despite the deep economic decline expenditures remained quite stable, and strangely enough, the revenues have a flat trend.

Beside all, the plethora of issues, there are still two that affect substantially the economy and have implications for its future. First, the economy is not competitive. Wages are fictitious, thus unit labor costs high in comparison with other EU countries. The rigidness of labor market is a huge obstacle for its development. Closed professions, collective bargaining public sector jobs are in a desperate need for reform. The competitiveness gap in Greece varies from 15 to 20 percent, which is a huge difference with other EU countries.

Second, the organ that pumps blood into the economy, the banking system had suffered heavily from this crisis. Market confidence has eroded tremendously. In discussion is not just the liquidity of banking system, but its solvency. The private sector mandatory involvement has complicated the issue, because banks have to recognize losses on Greek bonds haircut.

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Table 5 Greek Bank exposure to its sovereign debt

As figure above shows, domestic bank exposure to its sovereign debt is more than considerable.

According to IMF calculations, the private sector involvement will mean that banks will have to recognize considerable losses, and for four of them the regulatory capital will be depleted, and the others will remain undercapitalized. These four banks represent a little less than a half of system's assets. Besides that, by the end of third quarter of 2011, the share of nonperforming loans has reached 14.7 percent.31 System liquidity has dried up, until 2011, banks have lost 30 percent of their depositary base. One fourth of these withdrawals have flowed to safe heavens outside Greece. Deleveraging has characterized the banking system, thus corporate and household loans were heavily cut off, giving a negative shock to the real economy.

After problems with deteriorating collateral quality, the ECB changed the rules of accepting collateral. It came in help not only to Greek banks, but also to all banks holding Greek bonds.

After several downgrades that Greek bonds incurred, the ECB changed the rules in order to accept that kind of quality collateral. Besides that, Greek banks have taken advantage from the ELA, or emergency liquidity assistance supplied by the Bank of Greece. In 2008, the government introduced a package to assist banks with capital. The scheme seems laughable because the authority that is backing the package is the Greek government. How can a government lend to its banks when it has no money and is heavily indebted? How can a government guarantee up to â&#x201A;Ź15 billion of bank loans, when it has no credibility at all?

31

IMF Country Report No. 12/57, March 2012

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However, Greek authorities tried to do at least something. They set up a Financial Stability Committee in 2008; this new institution took the place of the Crisis Management Committee. In addition, a manual was developed for managing the crisis. If paying attention enough, one here can notice that the way of doing things is reforming without reform. Please notice: Replacing old institutions with new ones, even if they have the same functions and the old one were not proved that did not function. The same logic followed by the EU with the new pact, creating a new rule almost exactly like the old one, and with no proof that the old one does not work.

As will be argued later, even though Greek numbers do not add up to give a solution for this 'tragedy' the country has implemented some measures, some of them introduced with domestic will and others without it.

First, Greek government was required to broaden its tax base. Therefore, it did. It introduced several taxes like a 10 percent tax on capital gains and dividends and additional tax for those earning more than â&#x201A;Ź60 thousand. The government increased taxes on tobacco, fuel, alcohol and luxury goods, green taxes, real estate, and VAT. Government in the name of consolidation also changed the framework for several revenue channels like the gaming industry, income tax, real estate, and social contributions.

From the expenditure side it froze public sector wages, reduced public sector wages, reduced pensions, freezed pension indexation, reduced military spending and other expenses. It also took aim at social spending, which deteriorated fiscal positions, and accounted almost by 6 percent of GDP. Retirement age was increased to 65, previously being 60. It changed contribution schemes and other reforms.

Labor market also was not left outside. Tenure was removed from existing contracts, maturity coefficients were stopped providing automatic indexation despite growth in productivity, reducing non-wage labor costs was part of reform also, and other measures.

Greek economic adjustments until now have not followed the path they should have, which is going through structural reform. Instead, the only adjustments that it made went through other channels, mainly through forcing down wages and as a result prices. Its twin deficit problem has no ending prospects, at least in the near future. Internal and structural adjustments did not work as they were expected, thus the economy remains too uncompetitive. The EU after seeing that 70

productivity remained poor; to improve unit labor cost they suggested wage moderation. It gave some results by reducing unit labor costs by 9.5 percent in 2011, but still not enough to be in satisfactory levels.

The political will, which is very crucial in this case, is not sufficient from all parties involved in the matter. The hard time negotiations regarding bailout packages might seem like a Greek theatre just for bargaining purposes, but to a wider extent the reluctance is a result of different factors. Among these are economic, political, and deeply cultural, all very interconnected with each other.

Some analysts expect Greece to reach long-term growth by 2030. Even though such far estimations rarely prove to be true, the outcome of such analyses might be more valuable in short and midterm economic application. These conditions are far from optimal and far from what are assumed to be. Assumptions are related with bailout packages that European countries need to justify before their national parliaments. It is widely and silently known that economic growth in Greece will not return in 2013 as assumed, that the budget deficit, again for several times now, will not be as said it would be, and there is no chance that Greece will bring its public debt to GDP ratio under 160 percent before 2020.

The public debt ratio prediction would be impossible to achieve even with previous assumptions taken for realistic. This fact adds another important implication to all this: If the debt to GDP ratio and other macroeconomic indicators will be at such levels Greece would find it impossible to access markets in order to borrow money. This means that Greece will tap European and IMF funds. Without crunching some numbers this scenario seems more costly than default of Greece within the Eurozone, or even out of the Euro area.

The recovery of Greek economy will be poised by the same assumptions that are made by politicians in order to kick the debt swap deal. First, the recovery will be slower than what is modeled and this for different reasons. Keeping track of records from the last four years, Greece does not seem to be a marathon runner in structural reforms division. Second, Greece is resisting privatization reforms. It is assumed that until 2020, from privatization, it will collect â&#x201A;Ź66 billion but instead by all chance the sum will be only â&#x201A;Ź46 billion. Third, and perhaps one of the most

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surrealistic assumptions is the one that Greece for 2014-16 is expected to run a primary budget surplus of 4.5 percent of GDP. It does not stop here; the primary surplus is expected to be 4, 25 percent during 2017-2020 and 4 percent during 2021-25. Personally, I will not attempt to give credit to a ten year planning strategy. Nobody would do that in today world and today economy. Especially to planning on assumptions that I believe that are intentionally inflated and that represent a bended reality. Few countries have made it with primary surplus for a couple of years, and countries that have wellfunded economic principles and renowned policy credibility. To think that Greece will go through more than a decade with primary budget surplus is not just mission impossible, but is also ignoring economic fundaments, ignoring history and also 'outlawing' Keynes.

Fourth and one of the most important is that Greece with such economic parameters will be left out of market financing for long time. It means that the EU and IMF, because other countries are extremely reluctant to step in, will keep financing Greece for almost a decade. Setting aside the discussion on how logical and economically healthy it is, this looks more like a damage management program than an economic rescue, maybe there is not much of a change between both.

In this case, some rules are agreed with the so called PSI or private sector involvement in order to give Greece some future chances. To gain market access Greece would have to fulfill three conditions: it should have three years of growth, three years of primary budget surplus in order to reach debt stabilizing levels and the debt to GDP ratio should fall below 150 percent. So even within EU optimistic assumptions Greece is not expected to tap international markets until 2021.

Additionally, Greek population is estimated to contract 1/2 percent annually for the next 30 years.

This complication undermines future growth prospects for the economy to grow itself out of the debt.

Another misleading approach of how to deal with the Greek crisis is the fact that the Greek ability to pay its debt is assessed based on the whole country income, and not on government ability. In this case, government ability is related with budgetary constraints. The ability of Greek government to generate or collect enough to serve its debt is more than dubious. Structural problems and others related with collecting revenues, and political will issues are widely known 72

in Greece's case. Thus, the measure of debt-GDP ratio should not be an indicator on its ability to pay back its debts. It all seems a mirage.

Amid market fears that the union might come down because of Greece, this one, Troika, and the private sector agreed to a deal that in paper is called a debt swap, but practically is the biggest restructuring of a sovereign debt in history. It was announced in February 2012, and carried out in March of the same year.

Such participation of PSI was said to be voluntary, even though it might be hardly true, the Greek Parliament approved collective repercussions to make it appear that way. Collective actions were not taken only to make it easier for the swap deal, but also to impose on small potential not agreeing creditors. In order to abide them also a law gimmick was used. They changed retroactively the law under which those bonds are written. The idea is that, if the Greek government will pursue through negotiations a certain number of creditors, others left will have to join the deal, because the new law bounds them.

The controversial debt swap was called voluntary in order to make creditors accept the conditions and the haircut. On contrary, it would have been a clear default and triggered a set of credit default swaps (CDS) that would have had other implications for the market. The term voluntary served exactly to this cause, not to trigger CDS-s. However, some estimations show that there is a small amount of CDS bought to cover Greek debt, thus it does not have to be a problem because are manageable amounts.

Nevertheless, PSI exchanging the old bonds with new ones will have to take a haircut of 70 percent, or 53.5 percent in face value. The swap will reduce Greek debt by â&#x201A;Ź107 billion. During a summit, the participation of PSI was agreed to be not more than 50 percent, but this hit on private investors was made to satisfy IMF that wanted Greek debt levels at 120 percent in order to be a part of the bailout.

The part that set other discussions was that ECB holdings were relieved by losses on those bonds.

There have been claims that this is not fair because investors should be treated the same. The problem is that investors are never the same and will never have the same stature. The ECB and other national central banks are institutions with special positions in the deal, as so being, they

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cannot take losses on the name of the taxpayer. However, central banks resigned from any profits on Greek bonds by transferring those, if some were to be made, to Greece.

A special, called escrow account for Greece was set up. This account will be supervised by official creditors and is an account to receive aid payments, but it will be subject of conditions related with Greece following budget targets. The deal was left in Greek hands in order to convince the creditors to be a part of the deal, and on the other side EU countries, participating in the rescue will have to approve the deal nationally.

At this time, the deal is still being carried out in different phases. The second phase recorded a 96 percent participation rate by investors; this had to do with Greek bonds under foreign law. If the deal succeeds, it is a partial default at its best, and will be a full one in the near future. Even if it does not succeed it will be a full default, even though Greece for a short term was pronounced by rating agencies to be in default. For now the deal will have to work because the exposure due to contagion of other countries in EU is still considerable. Italy, Spain and Ireland are still vulnerable, and a Greek default would potentially cost around â&#x201A;Ź1 trillion to the euro zone.32 Such estimation are too inflated, because one doesnâ&#x20AC;&#x2122;t have to assume that in case of a sovereign Armageddon the EU fund to stabilize European sovereign bond market will have to be equal to total debt of Italy and Spain taken together, this number given by Institute of International Finance (as reported by Reuters) is too journalistic.

While the saga continues, this situation has left room for debate for different issues. First weather being under a monetary union is more favorable for Greece or not. Because supposedly in a monetary union Greece lacks currency flexibility to depreciate or to maneuver in one way or another. If not in the union, Greece would have been probably another Argentina. Inside a monetary union Greece will have to devalue its way out of debt, additionally it would have been better if it had grown out of it by producing more and being competitive for international markets.

It also need to produce cheap in order to export more, thus the current account can breathe. Baltic countries experience showed that internal adjustments could work. They experienced sharp declines in output, but eventually managed a way back. Another example that will be suit for the 32

http://www.reuters.com/article/2012/03/06/us-greece-bonds-idUSTRE82412N20120306

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syntheses here is Argentina. Devaluating internally, in Argentina proved to be useless in its case.

Therefore, taking both cases in consideration the Baltics and Argentina, one can say that it is not just an economic problem. Countries in the Baltics swallowed what was bad and looked forward.

In Argentina, it was different, lack of discipline, lack of market commitment, lousy policy and social anarchy.

Greece resembles more to the second one. The economy has not a sizable factor of mobility, and it is relatively a closed one. Labor markets are not flexible in terms of wages and prices. Political support in order to back up reforms insignificant. Social problems are deeper than economic problems. All these taken together make it impossible for Greece to internally devaluate.

Therefore, turning to the question if EU was bad for Greece, one could say that it was bad because the Union did not manage to educate a bad behaved child, on the other side Greece did not manage to take advantage of opportunities. Now the country is at a point that even if the debt burden is cut by 50 percent, it still will have a deficit of 120 percent by 2020.

As allowing Greece to the EU was a mistake for other member countries, getting out of the union would be a deadly mistake for Greece. The consequences for Greek economy, banks and businesses will be catastrophically. First, private sector debt that is denominated in euro will suddenly be impossible to pay consequently declaring bankruptcy, and such examples the economic history has seen plenty. Market access will be impossible, and probably the market in that scenario would have to be again the IMF. Banks would be out of system, deposit flight if not happened previously, would be enormous thus drying up their liquidity and making them insolvent. A potential inflation would make all savings worthless and spur deeper the economy to a recession. The economy would chock and eventually leave place for a social chaos to which the Greek society is so vulnerable. In this scenario, external consequences for other countries are not taken in consideration.

Not defaulting in the midterm is a perquisite of the EU and the IMF with the blessing of ECB. The role of IMF is as much substantial as much dubious. This discussion is out of the aim of this paper, but the precedents that the IMF sets are debatable. If the IMF role has to be a prerogative of certain conditions, then those conditions is suitable to be bound. The IMF in a 2003 report

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states that: "...in a situation in which the debt dynamics are clearly unsustainable, the IMF should not provide its financing." In Greece case, the dynamic is more than clearly unsustainable.

Concluding, the tragedy that is being ugly played is not a result of the absence of economic fundaments or rules. They are, and are effective. The problem is with respecting those fundaments and abiding to those rules. Therefore, it makes this tragedy, a tragedy of values and morals. From the country that thousands of years ago, wise man taught the world what moral and value was, is coming the opposite of those lessons. Maybe they are not the same people.

3.3.

Ireland

The Celtic tiger or the tiger of Europe was the champion of growth for more than a decade in Europe. Dynamic economy, competitive labor market, business friendly, robust exports, hightech oriented economy, and a real estate bubble that cannot miss in such situations.

The Irish economy 2000-2007, grew by an average of 5.6 percent. Private saving rate was quite stable, only public saving rate noted a slight decline. Sizeable investments taken out after EU access were mainly financed by easily accessible money in mid-bank market that was channeled from other European countries. A fascinating economic growth that was an example for a long time.

When the crisis hit Ireland was in a specific position. First, it was dependable on external markets. Second, its exposure to the housing fiasco was substantial. Third, it had a defunct banking system, which later was about to be the premise for Ireland failure.

As in every case, problems are boiling under the surface. It takes a crisis to bring them above.

The financial crisis, not only made recognizable the fact that property prices had gone out of control, but also showed that Irish banks had many problems. If in US, the property bubble burst was mainly due to subprime lending, in Ireland it was a result of high speculation. Whatever the reason was, the bubble burst, and left the banking system with plenty of difficulties.

However, related with housing prices there is a sort of complication in this case. If we take Lehman Brothers failure as a turning point of events, as the point in time when the global 76

financial structure started shaking, then the event did not have any influence on housing prices in Ireland. Lehman Brothers went down on September 2008; data show that housing prices in Ireland had started falling more than a year and a half earlier.

Figure 9 House Prices in Ireland

Source: Department of the Environment, Community and local Government. (www.environ.ie)

So, by all means Irish banks should have started to feel the pain earlier. This is a bad thing for two reasons. First, banks had more than a year time to understand that something was going on and did not take any measure at all. This was proved later by the losses that they incurred.

Second, Irish financial market regulators should have seen the stress coming. Even though, this authorities or regulators problem is difficult to explain, because were countries with more severe and obvious problems that just passed under the nose of the regulator. Nevertheless, banks are definitively responsible because they knew what was going on, it was an inside job.

The financial crisis for Ireland would not have been so harsh if it was not for its banking sector bailout. Ireland emerged from 2007 with a budget surplus of 0.2 percent, modest but still a surplus. In 2008, it slipped into -7.3 deficit, and a sharp decline in GDP by -5.24 percent. This decline in production was even sharper in 2009 when it reached -10.75 percent. At this point data are controversial, because are different numbers for the decline in 2009. Different reports from the same institutions have different numbers, the IMF, the European Commission, and even the Central Statistics office of Ireland.

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Table 6 Ireland Main Indicators

The debt situation has the same history. From a mere 25 percent in 2007, it rose twice in 2008 to reach 44.4 percent. The hit the economy was taking was from falling tax revenues, especially those propriety related, and automatic stabilizers that started working. The exposure of Ireland to the real estate market was considerable. For four years, until 20006, when the peak of housing market in Ireland was registered, government revenue rose by 3.75 percent of GDP. Estimations show that 2.75 percent of that raise came from propriety taxes and others with that related.

Later on, the debt would balloon to unprecedented levels. It was the result of huge budget deficits. In 2009, the deficit was -14.2 percent and the debt for the same year 65 percent. In 2010, Ireland would report a deficit that widened eyes all over around the world. It was a deficit of -32 percent, which raised the debt burden to 95 percent. This was on time toll mainly from the bailout of the country six main banks.

To a certain extent, Ireland did not experience a financial crisis, but only a banking crisis. The response the government reserved to it is still debatable. It was the first country to extend a guarantee on its banks. When the money started flowing from Britain, France, Germany and other countries European to Ireland, then these countries followed suit to guarantee their depositors as well. However, it was not the part that changed the way in which history should have gone.

Weather to bailout banks or not, is a debate that will go on for a long time, but in case of Ireland, circumstances were for it. If Anglo Irish bank, which grew around the scale of half of the Irish GDP, had failed, it would have probably brought the whole nation down. The question that rises 78

here is whether was another way to do it or not? This question poses a challenge because the authorities guaranteed everything. They were not restrained only to saving and checking accounts, but they went all in by including everything. It is difficult to know what government officials had in mind when they guaranteed also bonds purchased by investors. Guaranteeing people savings is one thing and guaranteeing their investments is another there is no logic to argue that this was right, and it was definitively not.

These guarantees were the reason that brought the nation down. The real estate bubble worked in two directions for Ireland. First, as previously said tax revenues related with the subject were ample and provided a good part of the growth. Second, when the bubble burst banks financing it were caught in the middle of a catastrophe. The financial rescue that the government provided reached unprecedented levels. If in Britain in 2008, it reached 29.6 percent, during the same year in Ireland the financial rescue reached 235.7 percent.33The kind of bailout that Ireland carried out is the typical case of moral hazard. The case of Anglo Irish bank proved it later when events unfolded. Its abuses and internal conflicts between shareholders and the CEO of the bank, did not justify the good intentions that the government had, assuming that they were good. According to bank annual reports, Anglo Irish lent money to big customers in order to buy shares of the same bank. This complication raised public outcry that was already huge against bank bailout, and it was right because government should have guaranteed only people saving and not throwing a full blanket to defunct institutions lead by corrupt people.

All the failure brings us to the deal that presumably Ireland was forced to make with the EU and the IMF. After the government extended a financial bailout that was unprecedented, it needed one by itself. There are claims that the government was forced to accept the money from EU and the IMF. Taking in consideration budget deficits that followed, the public debt that exploded, and most importantly, the economic situation that came after with the debt crisis that followed it was probably the wisest thing to do.

In 2011, the government announced another consolidation plan for its budget, making it the sixth consolidating tentative in two and a half tears. After the deal, Ireland committed to the conditions in a respectful way. Not only with excellence in in government performance, but the social 33

Ed. Philip Arestis, Rogério Sobreira and José Luis Oreiro,” An Assessment of the Global Impact of the Financial Crisis “, Palgrave Macmillan, Basingstoke, 2011, Pp 138

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cohesion was also admirable, comparing it with Greece where people took the streets without having any reason, or other countries when people burned down other peoples proprieties and went to strike heavily as if not working is the answer to economic stress.

Commitment is one side of the medal, but harsh reality is the other. House price have fallen little less than 1/3 from their peaks, and unemployment is still high, 14.4 percent. In 2011, the country came back to growth thanks to robust exports, but still this does not give too much to the GDP. The phenomena here can be explained by looking at the GNP value, because in Ireland's case that is important. Different multinational companies that have operations in Ireland, took advantage from the conditions, finished their production, and took the profits out of the country, mainly from the pharmaceutical industry.

However, the flexibility of Irish labor market made that reforms turn into advantages relatively quick. Improving competitiveness is the main factor behind the sizable export growth.

Competitiveness rose again in 2011 and unit labor costs fall for two years in a row, and an accumulative of 20 percent since 2008 up to date, this shows how fast adjusting the economy is.

In terms of labor market, reform Ireland has the greatest sanctions in case of refusing training offers or even jobs. Still, the developments are characterized by a weak internal demand and emigration.

In addition, the problems with credits related with the propriety market persist. The percentage of mortgage arrears to total is high and continues to raise significantly, besides that, 36 percent of households that have mortgages are in negative equity. Arrears are mainly a result of high unemployment and difficulties with servicing debt, thus hurting internal demand.

Beside internal developments, the main threat that comes to Ireland is the weak external demand and the mere economic developments in the Euro area. External economic developments have considerable implication for Irish economic prospects because of its economic model, which is reliable on exports.

It is strange why markets treat Ireland, as it was Greece. Such observations ad up to the plethora of metaphysical arguments for market imperfection, and sometimes of total dysfunctionality.

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It is not just a matter of straight economic indicators, but also something more. It is a matter of quality in its economic structure and cohesion in its social one. The late 2011 report by IMF states that: â&#x20AC;&#x153;All quantitative macroeconomic targets for this review were achieved, and the applicable structural benchmark was observed".

34

The report even took the effort to emphasize

that macroeconomic targets were only 'quantitative'.

Nevertheless, the prospects of Irish economy look good, not forgetting that to a wide extent it is related with EU developments. At the end of the day, it does not matter if the government was the victim or markets were, it does not matter as long as the people will be the casualties.

3.4. Italy Italian economic shortages had no connection with the financial crisis or even the debt crisis that came after it. The Italian economy has been suffocating for more than a decade due to different reasons. It just happened to be in a middle of a tsunami with a huge debt burden.

As in the case of Ireland, the financial crisis surfaced problems that most new about but were not willing to take any action for different reasons. However, unlike Ireland the issues in Italy were deep rooted and structural. As the table below shows, Italian debt burden has been more than 100 percent of GDP since 1992, while the treaty has a limit of 60 percent. The same thing happened with the central government deficit. It was below the limit only in 2007 and 2008, about the time when the financial crisis was taking shape.

34

App. A.Chopra & L. Giorgianni, "Ireland, Fourth Review Under the Extended Arrangement and Request for Rephrasing of the Arrangement", Washington D.C, November 29, 2011

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Figure 10 Italy main indicators

Before the recession was about to hit the Italian economy grew by a mere 2 percent for the whole decade. The crisis in comparison with what the economy has been suffering is almost nothing.

Between 1999 and 2007, unit labor cost grew by a cumulate of 25 percent. The economy lost competitiveness vis-a-vis to almost all EOCD countries. Poor and exaggerated regulation has been a snag for economic development. The heavy and inappropriate regulation, public administration inefficiency, an ageing society, and a dysfunctional labor market are the main obstacles that the economy faces.

The economy structure is based on small and medium size businesses, which are mainly family owned. This comes because of labor market laws, regulatory hurdles and cultural reasons. Such businesses beside the fact that find it difficult to grow due to up mentioned reasons have low efficiency and a small propensity to spend on investments and research. Thus, slowing innovation and making it difficult to compete with their counterparts in other European countries.

Italy has one of the largest tax burdens among OECD countries. The heavy toll that businesses have to bare is not justified by public expenditures, which are inefficient. Italy has been known for its disparities between north and south. Disparities are obvious when it comes to deep differences in income, unemployment and also output. Tax evasion is also an issue. Reports say

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that Italy revenue losses mount to â&#x201A;Ź120 billion yearly. After pledges to tackle the issue, in 2011, it collected from evaders a hefty â&#x201A;Ź12.6 billion.

Oddly enough, Italy has been criticized almost in every report for its tertiary education.

University achievements are low, amid high investment per student. It has the lowest educational achievement level among developed countries. In OECD countries, 26 percent of working age have a university degree, or like one, while in Italy this ration is only 10 percent.

The Achilles heel of Italian economy is the labor market. Its rigidness and especially the productivity that has been deficient for more than a decade have been real hurdles for economic growth and business development. In 2009, an agreement was signed between 'social partners' and the government, to relate wages and productivity more in order to improve the situation.35 The idea of such agreement is hollow for some reasons. First, if one wants to link wages with productivity in a better way, it does not make an agreement. Because an agreement in such cases, does not show stability for the future, particularly, when the counterparts are not the proper ones.

Second, assuming that an agreement would be enough, why should social partners be involved in this agreement? The only and only part sitting in front of government bureaucrats should be parties concerned with the matter, or related with that directly, which are businesses. Third, if government intentions are truly noble, the best way to raise productivity is reforming the system by laws as the only and most effective instrument in government hands, and not making agreements that are a promise for instability and future risk. The support that the government gave to such incentives by reducing taxes in wage increases that are related with productivity is not economically sound. First, how will be identified in practice a wage raise that is a result of productivity? Second, why is needed a tax subsidy if the mechanism of wage-productivity is working.

Of course, the recession hit the Italian economy as any other in Europe. In 2009, the GDP fell by 4.7 percent, exports slowed and private investment levels dropped sharply. Private consumption was relatively unchanged during the recession. It stayed at the same levels even after it. Due to a fall in disposable income, the private saving rate fell considerably. The current account is not a emergent problem in Italy's case. It has a manageable deficit, but with slow temp of reform it 35

OECD Economic Surveys: Italy 2011, OECD Publishing. http://dx.doi.org/10.1787/eco_surveys-ita-2011-en

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might be an additional risk. Unemployment during 2011 reached almost 9 percent, and youth unemployment stood just above 30 percent. The economic situation during the crisis was bad, bud did not experience the shock that other countries experienced.

Strangely enough, even during the peak of the crisis concerns were related more with its heavy debt burden than with its economic prospects. The huge amount of debt stressed the EU and made Italian bonds subject of heavy speculation, followed by fast sell-off of its bonds. However, its stability the economy owes to a healthy private sector. Authorities as an argument for not comparing Italy with other indebted countries, and for stability economic stability cite the fact that private debt levels are very low. It is true, Italians do not borrow money as much as their peers in other developed countries. Roughly, 60 percent of the huge debt amount is held in domestic hands, it is an indicator that shows how much they save.

Italy did not have enough fiscal space to introduce an ample stimulus to the economy as other countries did, it just reallocated budget funds to other projects. While public debt was the main subject of the market frenzy, the debt management authority has managed to raise the debt maturity to 7.1 years from 5.7, even during the crisis. In fact, this long maturity was an element that stemmed markets toward destabilizing moves.

One positive thing was that Italian banks during the recession remained healthy; therefore, the government did not have to bailout or recapitalize them. It was mainly due to their conservative lending policies. However, the debt crisis that followed worsened their prospects, as they were heavily exposure to sovereign debts of different European countries, especially that domestic.

Besides that, the biggest Italian banks in 2011 took heavy losses, not just right downs from sovereign bonds, but also goodwill write-downs from investment outside domestic market.

The country had to bring its fiscal house in order, for markets to calm down and demand reasonable interest rates on Italy's bonds. In this case, fiscal austerity is not so important as deep structural reforms, because Italy managed to stay with that debt level for more than two decades.

Actually, for some years government tapped the market only to pay interest of the debt and not to add more to its nominal amount.

The government undertook many fiscal consolidation reforms. It introduced new taxes and reduced the ones related with women and young people. It also reformed the pension system, 84

which in comparison with other European countries is not expecting spending increases in the future due to ageing society and health care. The pace of reforming is relatively slow. The unionized labor market is causing more damage to workers rather than resisting for them in the name of principles. More pressure is needed in order for the government to feel the heat and to take the power of the unions. Growth and productivity cannot come without competitiveness and free labor market. An overhaul of the tax system is necessary, reducing bureaucratic load to the business is essential, and reframing the court system to be more efficient would be helpful.

Nevertheless, most important of all is the labor market reform. Being not flexible and noncompetitive makes it the most problematic market in EU.

3.5 Portugal Calls for striking against austerity measures that have been placed in many countries, only Portugal did not respond the same way they responded in Greece or Italy. Social and economic adjustments with the recession seem to be in silent in Portugal. For different reasons the country has been coping with the situation in a respectable way.

Table 7 Portugal main indicators

Nevertheless, concerns related with Portuguese economy are not related with the financial crisis.

Portugal had the same problems that has now even before 2007. The problem was that the economy grew without growth in productivity; it expanded just because it was fueled with cheap money. It had the signs that a typical economy in crisis or in lethargy has. It was characterized by sluggish growth, not enough accumulation in human resources, lacking productivity and always the chronic current account deficit. In 2003 the economy felt into a negative growth, followed by anemic growth, in 2008 it stagnated with a 0 percent growth.

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Figure 11 Portugal Current Account Balance

The main reason why the country is in this state today is mainly lack of reform. After joining the EU, interest rates became too low, causing a drop in private saving and at the same time an expansion in investments. The result of this was a widening gap in the current account, a gap that did not recover until today speaking. As can be seen from the graph above, the current account deficit has not been just vast but also sustained during a long period. The future related with the current account does not seem so optimistic either. Beside the deficit in the current account, Portugal had suffered also from high central government deficits. Usually government budget deficits have been above the Maastricht limit, also the public debt.

Unemployment has been in a critical state. For more than two decades, the increase in unemployment rates has been structural. More than the seasonal or this cyclical unemployment, the real challenge for the economy and government reform is the structural one. Labor market reform is necessary in order to minimalize labor market dualism and to improve its structure in order to be more flexible. The economy has also suffered from a raise in unit labor costs, hence losing competitiveness.

The financial crisis, as in Italy's case, made all these problems visible and the need for reform more acute. The pressure from the markets was so huge that on April 2011, asked the troika for a bail out, after refusing previous calls to accept one. Accepting a â&#x201A;Ź78 billion bailout package with the hope that it will return to markets by 2013 made it the third country in the Euro zone to do such thing.

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Since then, the government has implemented a program of austerity measures that has been doing relatively well. However, the country is heaving hard time to recoup market trust. It might be because, in order to meet the budget deficit targets for the last two years the government went through accounting tricks that had a substantial effect on it. During the first year, 2010, it transferred Public Telecom pension funds to state accounts, accounting them as revenue. As a result, the 9.8 percent deficit was reduced to 5.9, even though technically it was not registered because the government did not manage to timely carry out needed procedures. In the second year, government is planning to do something similar, and it is in negotiations with private banks in order to meet the targets for the budget of 2011. Austerity measures have worsened unemployment indicators. By the end of 2011, it had reached 14 percent, and the worst age, as is usual for Europe, youth. Youth unemployment in 2011 reached 30 percent.

The banking sector has been relatively resilient. Actually, Portugal is one of the countries that have not been through a banking crisis since 1945. The absence of liquidity in European markets is compensated by ECB operations. Portugal banks heavily rely on ECB for funding. Amid expected deleverage from the financial crisis and other difficulties, Portuguese banks did not rush into buying government bonds, hence the do not have a big exposure related with potential sovereign write-downs.

On the fiscal prism, fiscal rules on national basis were results of initiatives that started before the burst of the crisis. It was mainly based on the creation of a new institution to support and assist the parliament in budget and public finance matters. The institution is responsible for working macroeconomic prospects, overseeing the budget, and assessing the impact of law initiatives related with budgetary issues and public finances. Its competences are limited only to issuing reports.

Nevertheless, the future of Portugal does not rely only on necessary internal reforms, but also on Union future events. The government needs to implement the so much needed measures in compliance with the bailout agreement and the EERP. Besides bringing the fiscal house in order by bringing down the deficit and public debt, the government should speed up reforms related with labor market. The Portuguese economy in order to compete with its peers in the Union, needs to improve its productivity and unit labor cost. One way to achieve this is by wage

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adjustments, a step that government went partially through. Lastly, very important is to create market incentives through reform with the purpose of lowering youth unemployment.

3.6. Spain The ongoing situation in Europe is a result of extreme political mismanagement and also of market failure. The discussion for both topics will be wider later, but if there is something wrong with markets pricing sovereign and also other sovereigns pricing sovereigns, Spain is the appropriate illustration of this.

However, before going there, it is important to see how the Spanish economy had been performing during the last two decades or less. After joining the Euro, the Spanish economy experienced a satisfactory growth for more than a decade. The growth trend had started even before joining the Euro, making it the second highest growing economy after Ireland.

The main reason of the growth as in every European Union country was the cheap money, after the market discounted their national currencies risk. The cheap money that flooded markets gave more incentives to invest. Taking in consideration that the inflation rates were usually twice the EU average, and that the ECB borrowing rates were too low, real interest rates in Spain were almost zero, making it similar with Ireland where real interest rates in some cases were even negative.

The specificity in Spain's case is the high inflow of immigrants. From 2000 until 2007, the number of immigrants that entered Spain was 3.6 million, making it a total of 4.5 million. Most of them were in working age. The inflow continued and in 2010, the number of immigrants reached 5.7 million, making them 15 percent of the Spanish labor force36. Immigrants did not just raised consumption in society but also raised the number of social contributions, therefore contributing to fiscal balances.

However, the longtime growth had its own good and bad consequences. First, it came with the cost of external imbalances. At the beginning, imbalances seemed to be manageable taking in 36

G. de la Dehesa, â&#x20AC;&#x153;Spain and the Euro Area Sovereign Debt Crisisâ&#x20AC;? , Peterson Institute for International Economics and Bruegel, Chantilly, France, September, 2011

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consideration the net investment (foreign) position that Spain had but later the current account ballooned, as can be seen from in figure ten.

The current account imbalance might have been deteriorated from the sort of domestic investment that was spurred due to sustainable growth.

The most developed sector of the economy was construction, and here is the starting point of most issues with the Spanish economy. The construction sector was so significant for the economy that at a certain point it reached 16 percent of it, and employing 1/5 of the total employment during its peaks.

The implication of this development with the current account is the high needs for investment that the sector has, and also long the time commitment it needs. The high need for investment in the sector and wider was met with the supply of cheap funds that were widely in Europe. The argument for this is that the household saving rate was relatively stable for a long time, and domestic investment rose rapidly. Public saving rate did not offset the effects of high private investment, therefore the current account deficit widened. So domestic investment needs were financed with other European countries savings. Moreover, as said previously, the sector demands high input investment and long time commitment; it means that the outflows as returns to investors were not as fast as the inflows. If the inflows were to be invested in production, returns for foreign investors would have been faster. The situation in Spain was typical with that of an emerging market economy, when the current account deficit is high and justified due to high demand in long-term investments as industrial machinery and construction, a deficit that supposedly will be later recuperated.

Second, the sector is much leveraged and bank financing is necessary, therefore in times of crisis amplifies the risk for banks due to fast dry up of liquidity. Beside the fact that bank channel the funds they also leave their selves exposed.

The other complication that came most probably because of construction sector development is related with labor market. Employing a big chunk of the labor force made it significant in the labor market, as a result, concentrating labor needs. It helped the economic growth to be a result of more labor accumulation due to sector needs, therefore affecting the labor market as a whole

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and its productivity. To a certain extent, the aggressive development of the construction sector predetermined the development path for others and to the economy in total.

The labor market is also specific in the Spanish case. Data shows that 25 percent of those working in 2009 were on temporary basis. Spain, the time writing, has the highest unemployment rate in Europe and one of the highest in the world. First, when the construction bubble burst it was the first obvious red flag that pointed toward a raise in unemployment, due to reasons previously explained. Second, if almost 1/4 of the work force is working on temporary contracts it makes them highly vulnerable through crisis times, actually giving unemployment a high rate of procyclicality. Third, during crisis emigrants are the most vulnerable part of the work force, therefore it adds to the procyclicality. Lastly, in Spain the structural unemployment is also high in comparison with EU countries. These reasons explain the explosion in unemployment that Spain has experienced after the financial crisis burst.

Beside unemployment problems, the labor market has its own issues. First, as previously noted, it suffers from high structural unemployment. Second, high dependence on the economic cycle.

Third, protecting employers with permanent contracts is very ineffective and causes market rigidness. Fourth, the competitiveness of its working force. During the years, Spaniards have lost competitiveness and the unit labor cost has risen, even though not too much as in other countries.

However, it has become more convenient to hire in Germany than in Spain. The analysis here goes deeper, because it is related with its exports structure and market orientation. For example, domestic demand has risen visibly more than that external one, thus raising demand for internal usage.

Another reason of losing competitiveness among other EU countries is that wages in Spain were indexed to inflation. The inflation in Spain has always (at least since joining the EU) been almost twice that of the EU average. Moreover, wage extensions were automatic at industry level, complicating more the wage-productivity relation. This raise in wages caused a raise in unit labor costs, hence losing competitiveness as an economy. Such indexation would have helped if wages were tied with productivity.

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Figure 12 Spain main indicators

Source: OECD

The global financial crisis burst and affected Spanish economic conditions as elsewhere, but it did not stop here. After that, a debt crisis came and is still going on. After a remarkable long period of prosperity, Spain found itself in the deepest slump. The Spanish fiscal house was in order, actually it was better than every other European country. It was characterized by balanced budgets, with modest deficits and sometimes in surpluses. The public debt to GDP ratio stood at remarkably low levels.

When the crisis hit, Spain responded with a big stimulus plan that reached almost 3 percent of the 2009 GDP. From a surplus in 2007, it went to a huge deficit in 2008 and later on. Deficits that at the time writing, the country is having hard time to tackle down. Consequently, these deficits expanded the public debt, yet still one of the smallest among EU countries. Unemployment, as noted before, rose at critical levels, the banking system went through a consolidating process, domestic demand plummeted, therefore the economy went into a heavy recession for two consecutive years. In the deterioration of fiscal indicators, a substantial role played the sizable economic stimulus that the government put together, falling tax revenues, and the work of automatic stabilizers in order to support the economy.

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Nevertheless, Spain is the case that shows that fiscal rules are not enough to maintain sustainable macroeconomic indicators and economic growth, especially the three rules of the growth pact.

However, this outcome is not just a result fiscal policy failure, it is more, and it goes further.

Spain, and to a certain extent Ireland were economies that had the potential to weather a financial crisis. First, because they had strong fiscal positions and both were wealthy countries. Second, their deterioration was not structural, but a clear result of unfolding events. Lastly, both governments had the political will to go through painful reform, a will lacking in many countries even beyond Europe.

On the theoretical plan, there are claims that in the Spanish case, fiscal deteriorations are structural37. To imply that deterioration in one year is structural and taking in consideration the circumstances is difficult economics to swallow. The economy has its structural problems, for example in the labor market, but having more than fifteen years of bullet proof fiscal history does not saves Spain from being a PIGS community. There is another theoretical approach, which takes aim at the implications that the real exchange rate has with Spainâ&#x20AC;&#x2122;s risky position in the market, but the idea stands for all EU countries hence will be discussed in a subsequent chapter.

Lastly, there are some opinions maybe from semi economists (and the other semi journalist) that Spain has a big probability to slip into a Japan style ten-year-old recession. The arguments for such pretentions fall short, because the situation in which the economy is now is not worse than that of other countries. The budget deficit and the public debt are not premises for Japan style recession. The government is undertaking tremendous reform, reform that other EU countries will find it impossible to go through, with the only purpose to satisfy the EU with its budget consolidation obsession. The opposite would have been a sound economic move, because Spain has enough fiscal space for such maneuvers, but as previously said this is not an economic crisis, this is a political crisis, a crisis of the worse management ever. That is what happens when incompetent politicians do economics and markets are flagships for speculators.

37

Beynet, P. et al. (2011), â&#x20AC;&#x153;Restoring Fiscal Sustainability in Spainâ&#x20AC;?, OECD Economics Department Working Papers, No. 850, OECD Publishing. http://dx.doi.org/10.1787/5kgg9mc37d8r-en

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3.7. Reflecting Imbalances

3.7.1. The Current Account Imbalances and the Twin Deficit

Routinely imbalances are associated with globalization; as if it was not for it, imbalances would not have become an issue. In absence of globalization, imbalances would have been internal economic problems for a certain country. Globalization does nothing more than adds options on the table, with more options the chances grow bigger, but also grow bigger the stress of choosing and the risk that comes with it all.

Historically, imbalances are noted before financial crises, the relation is also proved empirically.

This means that unusual capital flows often are followed by financial crises, currency crises or even debt crises. However, movements in capital flows show that something is going on in the economy that those flows are directed to, and vice versa is true; something is going on in the economy that those funds are coming from. That said, we see that imbalances are more a consequence of other economic developments, they are more reflections. The principal question that rises here is "Reflections of what?" The answer is not straight, but neither complicated.

When the financial crisis hit, imbalances were not a big problem, because they were not part of the mainstream discussion. Economists with a certain right rushed to blame regulators, subprime lending phenomena, monetary policy, and bankers for what nearly brought down to its knees an entire system. While all this happened all economies, mainly industrialized ones, were characterized by imbalances that kept building up no matter what.

The crisis served to unwind most of the positions that were taken before it. It was the trigger that cramped the 'imperium of imbalances' that was built during prosperity times. Like in Latin American economic crises, something had to trigger it. However, here we are now blaming more than ever imbalances for the subsequent crisis that has plunged Europe. The same situation is in the US actually, but until now, printing money has proved to be sufficient, some are waiting for the American ticktack.

History of economics has plenty of examples where after the fact, economists claim that the problem was obvious, hence the solution. The financial crisis of 2007 was one. Imbalances in

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Europe's case have a specific meaning, but they remain just reflections. The specificity is related with the unusual nature of the union, just monetary and no strings attached. Nevertheless, the American economy also is characterized by huge imbalances. Why its situation is so different from Europe? During the first crisis, imbalances were not mentioned, because it was more a crisis of ashes, a crisis of the virtual economy, and that was in US. After that turned into a real economy crisis the US had taken the steps that authorities thought to be right, there is still time for them to be proved right.

If back then the main culprit was subprime lending, why is it not today? Is it not subprime lending when lending to Greece? Is it not the same process that took place during the financial crisis? There are banks that lend without taking in consideration risks and betting with people's money. Then, there are rating agencies, the worst element that the history of economy could find, that basically did the same thing during the financial crisis and the sovereign debt crisis. After that, are markets that after a long period of drunkenness with prosperity have no idea what are pricing and how are doing that. Lastly, we have a subject with zero credibility that lives beyond its means and even chances, so Greece. Why is this an imbalance problem? Do here apply the same principles and issues of the previous crisis? Not to mention the political implications, which both crises have so much in common. A plethora of problems that translate into lack of means to live, work, and buy normally have been expressed in borrowing from outside the country.

Nevertheless, borrowing to pay a previous debt does not get you out of indebtedness but builds up more and more, where Greece is today. Therefore, here the imbalance in the current account is created as a reflection or consequence of other internal issues. Therefore, the problem appears to be the same in both crises, yet with the first one economists thought that washed their hands.

Now we have a new crisis and therefore we need new culprits. So back again, to the same logic mentioned previously, new crisis, new rules, and new culprits.

The European Union is specific in its being. Comparing it with the United States there is little in common besides the monetary union. Fiscal policy in Europe is carried out in national level, and countries seem to not have anything in common besides some rules that they do not bind to.

However, the problem of imbalances in EU is more amplified than it is in reality. Today there are imbalances in journalism, reporting and politics, and these too are reflections. These are reflections of biased behavior, or a modern homo economicus.

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However, the crisis that some European countries are experiencing is the best examples to illustrate imbalances as reflections of problems that economies are undergoing. First, it is important to emphasize that no matter if it is a crisis or not imbalances will always be. They have to be because show differences among economies, differences among different markets and their level of development. They show differences in institutions, in labor markets, industry, and competitiveness and further. For as long as economies as systems and their elements as subsystems will be different, imbalances will be out there as a barometer of those differences.

Therefore, imbalances are inevitable, not only because of globalization, but they are reflections of differences among economies and express their imperfections. Usually capital flows, especially inflows, are correlated with rises in asset prices, therefore creating asset price bubbles.38 The six countries taken in analysis here, each represent a different reason of these imbalances, in case they represented such problems. The European Union economic development after 1999 was more like an asset bubble development on its own, because countries were let free and supervision was the worst. Not supervision of indicators such as competitiveness or trade imbalances, but even the ones that were supposed to be obvious, the fiscal rules needed to maintain the game within the rules.

Some of the countries had current account deficits that were not sustainable, some of them deteriorated after the 1999, and some of them had surpluses that no one calls unsustainable.

Actually, when the world slipped into a recession, there were discussions weather the economic model of Germany was sustainable or not. Those discussions were related with the exportoriented economy of Germany, and weather was it able to always keep it surplus.

However, those discussions faded quickly mainly because of senseless arguments against the model and partly the debate was posed wrongly. One of the famous arguments was that Germany in order to bring down its surpluses had to decrease its competitiveness. This was the case that being too good was supposedly bad. The idea that even the surpluses are bad in a certain economic sense is debated with halve voice, while on the other side countries with deficits are relatively marginalized, and to a certain extent this is right. It is better for deficit countries to improve, than the other way around.

38

C.M.Reinhart & K.S.Rogoff, â&#x20AC;&#x153;This time is different: eight centuries of financial follyâ&#x20AC;?, Princeton University Press, New Jersey 2009

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The graphics below show some indicators that could help understanding the imbalances of a country. The data represent a decade period, except of some cases when the data was not available. However, the data are not meant to serve as an important empirical backing of certain arguments, but are to be treated modestly as auxiliary to arguments that were mentioned and others that will be exposed later for the case.

Figure 13 Selected Countries main indicators affecting the current account balance (as percentage of GDP) 25 20

Germany

5 0

15

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

10

-5

5

-10

0 -5

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-10 35

-15 -20

Ireland

25

40

20

5

10 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

0

-15

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-25

-10

-35

-20

25

Spain

30

15 -5

Greece

Italy

20

30

Portugal

20

15 10

10

5

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

0 -5

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-10

-10 -20

Source: OECD, EUROSTAT, AMECO

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In Europe, the ECB, like its sister in US the Fed, kept interest rates low for a long time. As a result domestic spending was enhanced, or at least in some countries, and such cheap money played an important role on inflation levels, at least for some countries. The cheap money by enhancing domestic spending, at the same time raised demand for imports, on the other side by raising inflation made some countries decline in competitiveness.

Well, the mechanism economically makes sense, especially if it was to be applied as an explanation of an historical economic occurrence. However, looking at different European countries one can sees that this is not the appropriate mechanism. First, a reasonable economist cannot blame ECB's monetary policy for Greece. It cannot be blamed for neither the Spanish, nor Portugal loss in competitiveness. Of course, it is difficult now to divide exactly the monetary policy role in the happening because it leads to other discussions. However, one thing has to be cleared out, the discussion if one size fits all, monetary policy is right or wrong, is out of table.

Such pretenses could have been legitimate for countries that would have been not in the EMU, but for those that actually are it does not make sense at all to even discuss it.

Assuming that the monetary policy was too loose, why did not the same effects appear in Germany, France, or even The Netherlands? Form the figure above, we can see that in Germany the total investment rate from 2000 until 2007 and later had been decreasing, and the rate had fallen by 4 percentage points. While the public investment rate for the same period had been relatively stable in a decade, it had decreased with only 0.3 percentage point. For this decrease in investment actually there is an interpretation, it says that low opportunities in Germany and excessive growth in other Euro countries promising higher rates of returns made the money to flow to those countries, like Spain, Greece and Ireland, hence the imbalances problem.

Assuming that this is true, what would have been the interpretation if for the sake of imbalances that money were blocked their way to those countries? Is it not one of the Union centerpieces, the idea that capital has to flow free and the market to be unified? Even if it was not about the Union, under what argument someone or some institution, could have channeled those investments toward another way?

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Another point grasps attention is the wide current account surplus that Germany has. Besides emphasizing it as a fact and noting that in Germany's case, imbalance is a reflection of a good and disciplined economy, or at least an economy that was improving and adjusting for long time.

In case of Ireland, the discussion is short, because the imbalance problem does not seem to be problematic and it was swept by the crisis for reasons that do not have to do with strict economic problems. Household saving rates were high even in comparison with Germany; public investment relative stable had its peak in 2006 by 27.1 percent of GDP. Was it high taking in consideration that it was a developed country? This is another discussion. Lastly, the fiscal discipline could not have been better, thus Ireland is not a good example to be taken in analyzing the imbalances problem; therefore, there is not much to reflect about.

Italy is the example where reflections are boring. The household saving rate could not be more stable for the whole decade since 2000, also the total investment rate for the same period, in both cases as a percentage of GDP. If there is not much going on the current account balance reflects nothing or almost nothing, and this is the case of Italy. As previously sad anemic growth for a long time, and structural labor problems that are not fully reflected in imbalances due to the specificity of Italian economy. Specificity here is the substantial underground economy and the fact that labor market problems are resolved outside the market. Therefore, for as long as problems are resolved internally reflections in the current account balance are low. Italy today is a part of this crisis just because accidentally it happened to have a huge debt burden.

On the other hand is Greece, which is not hard to analyze but is too specific. Frankly speaking, the difficulty to find data about the country is frustrating, and even if they are, they cannot be more dubious. Strangely enough, the only data available (at least I am aware of) were public investment and during the last decade, they have been relatively stable, with a slight decreasing trend. Some data not included here, as a reference because of dubious reliability, show that the household saving rate in Greece had been negative for some years. However, even if it was true does not necessary mean that the Greek do not have money, it might mean that they are depleting their savings. Ironically, the current account balance could not illustrate better the lack of other data. Even though in Greece the problems start from A to Z, it is worth emphasizing that reflections are specific to country's characteristics.

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Spain is the best example for this discussion and for the one that will follow on the twin deficit hypothesis. From the graph, we can see that household saving rates were relatively high and the trend during the decade was upward. The public investment rate had been stable thus little effect on other indicators. However, the total investment rate kept growing from 25.8 in 2000, to its peak of 30.7 percent in 2007, subsequently declining due to the crisis. The reflection in the current account is graphically a mirror of the total economy investment rate. In this case, reflections include almost all internally felt symptoms of an economy, and some external.

Namely, the inflows related with an asset price bubble, and the bubble was in real estate.

Overinvestment in one sector, and in Spain it was construction. Substantial credit growth within the country was also an element reflected in the current account.

As previously said, money was not channeled toward investments that raise productivity but toward investment in construction and consumption, following after with the effects discussed previously. In Spain's case, another external element is reflected in its current account balance. It is the low growth experienced in other countries. The point was touched slightly while on Germany's discussion, but it is worth emphasizing that mainly money was channeled to countries with high growth and subsequently high potential rate of returns.

Lastly, Portugal seems to be the only country suffering chronically. The current account reflection is mere showing problems that have been lasting for too long in the country and that are not related with the financial crisis, neither with the debt crisis. Portuguese economy is so fragile and unsustainable that chances to collapse are bigger than not to, especially if Greece goes down. The economy had a good chance to absorb those imbalances and channel them toward investments that enhance productivity, and to seize opportunities that came with the EU entrance, but it was satisfied with the initial money accumulation and never improved. Beside that there is no reason to blame any crisis for Portugal actual situation, it is worth noting once more that reflections in the current account balance indicated (and further do) internal problems and the specificity of the country.

One measure that is not sized in the graphics above is the consumption rate among these countries. The consumption rates in Ireland, Spain and Greece from union formation to 2007 rose to high levels, respectively by 55 percent and 35 percent for the two countries. Actually, the data of consumption explains a major part of the current account, especially if keeping in mind 99

saving rates and total economy investment rates. The only exception in the case is Germany; the consumption rate was stable reflecting the stabile nature of the economy and consumer behavior.

The implications of current account balance are related with national savings and national investments to a certain accounting extent, and not only. Analyzing the balance one should take in consideration whether it reflects changes in savings behavior or investment, or even both. In Greece's case, it was so extreme that the country was borrowing just to consume. On the other hand, Ireland experienced a surge in foreign capital due to high investments, and in fact, those investments were not only related with construction as in Spain's case, but also with productive entrepreneurships that gave the Irish economy an edge. Therefore, there is not a one size fits all explanation for reflections of the current account balance, first because they express specificities, and second because they are foretellers of the past.

Nevertheless, there is another issue about the relation that current account balance has with the problem that most European countries have actually, the budget deficit, namely the twin deficit hypothesis. The discussion about twin deficits has been dim for a long period, but lately many empirical researches have touched the idea.

The twin deficit hypothesis argues that government budget deficits create or have an effect on the current account deficit, which means that a rise in the budget deficit is reflected with the same direction movement in the current account.

If we treat the current account balance from an accounting point of view we know that: Current Account (CA) = National Savings (NS) - National Investments (NI), therefore every influence that has to come from the fiscal effect has to be either on savings or on investments on a national level in order to move the CA balance.

Two main approaches are considered in the relation that fiscal consolidation has with savings and investments. The first, which does not suit the hypothesis, is the Ricardian approach.

According to this approach, potential fiscal moves are anticipated by people, and absorbed in a way that does not affect the current account. For example, if the government is going to raise its deficit by issuing new debt in order to finance different tax cuts, people expect the government to offset this movement by raising taxes in the future, thus people get a head of this move by

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hoarding the freed amount from tax cuts. Therefore, the effect of the tax cuts on the national savings is null.

Different studies have considered this implication, and have found that the reality is more close to a Ricardian approach. Tax cuts are believed to spur consumption but in reality for every dollar of tax cut not more than 35 cents goes to consumption. However, the Ricardian view is not the subject of the discussion.

The second approach that mainly justifies the twin deficit hypothesis is the one attributed to Keynes. According to this approach fiscal expansion, no matter if it comes through tax cuts or debt issuing, depletes the national pool of savings. If we turn to the accounting equation previously presented, we see that when there are not enough savings for the needed investment the current account goes on the red, due to foreign borrowing in order to make up for the funds needed for domestic investments. So, the government deficit leads to a CA deficit.

Almost all the studies done on the topic find a weak link between the two, but none of them finds no relation at all. Different papers provide different empirical evidence for the relation. Some say that an improvement in the government budget deficit by 1 percent improves the current account by almost 0.35 percent. However, a study39 by the IMF persuasively argues that consolidating the budget by 1 percent of GDP improves the current account balance by more than halve percent. This comes usually due to decreasing domestic demand; hence, less imports, and export growth in the case when the currency can depreciate, this is not the case for the EMU countries.

Even in the case of a monetary union, the depreciation goes through other channels, and as the last experience shows they tend to be painful and burdensome However, the importance of the study is that it takes a different approach toward the twin deficit debacle. Concretely, not like the wide literature on the topic, it takes two factors in consideration.

First, the current account and the fiscal balance have cyclical behavior. Second, the government balance is not characterized by reciprocal sway with the current account balance. It means that changes in government balance are a result of economic developments that might have an impact on the current account balance, but vice-versa does not have to be true. Therefore, the research tries to statistically isolate these patterns in order to get a more clear and comprehensive result.

39

IMF staff report, World Economic Outlook, â&#x20AC;&#x153;Slowing Growth, Rising Risksâ&#x20AC;?, September 2011, Pp135

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Important, is that the research emphasizes that even in monetary union conditions when currency adjustments are almost impossible the same adjusting relation is noted, this case specially suits to the EMU countries analysis.

The new approach seems very comprehensive. It takes a different path from every work done by now. However, it explains the actual Ireland situation, which automatically explains Spain's. As said in case of Ireland and Spain the cycle came with asset boom prices, which created much revenue for the budget, thus improving fiscal positions.

Nevertheless, the approach seems to go too far by 'removing' from the empirical sample data in order to bring the sample to a more analyzable one. Removing from the equation the cyclicality of economic developments does not make the analysis more comprehensive. Because we accept the cyclical character of economies, at the same time, we de-characterize it and as a result, we study something that does not exist in reality. Besides that, economies studied and taken as data to be analyzed are so different that it makes the process almost impossible to go through, consequently is better to analyze them separately than to remove elements that are far from the mean.

Analyzing the twin deficit idea, one should take in consideration that in different countries are different reasons for fiscal imbalances and in different countries are different reasons for current account imbalances. For example, in Spain and Ireland fresh cases the twin deficit idea does not seem to work. From 1999, the budget deficit stood at low levels, and from 2005 until 2007, for three consecutive years it was in surplus. During this time the current account deficit kept rising, at least from 2002 and later.

Meanwhile, in Greece, the deficit in the current account, among other problems, reflected a low saving rate, and this might be a result of irresponsible fiscal policy. Nonetheless, the study explains it with the asset price boom that lead to high tax revenues, thus keeping the budget at reasonable levels. However, the boom itself was blamed for imbalances created to a certain extent, the asset price boom was the reason for to many things and among them the crisis per se, if it were not for the price bubble there would not have been a crisis at the first place. The question that rises now is: Did the government create the asset price bubble? The answer is plain no.

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Table 8 Pearson correlation for government budget deficit and current account balance (2000-2007)

The table above presents the correlation between the government deficit and the current account balance of countries selected from 2000 till 2007. The modest sample is to provide an idea for the movement after the creation of the union until crisis eve. Paradoxally, the highest correlation runs Germany. When the budget balance deteriorates, also does the current account, when it meliorates the same happens in the current account. However, Germany together with US and Japan are not the right examples to argue for the twin deficit hypothesis, on contrary such countries show that a surplus in the current account can live with a relatively high deficit in the government budget and vice-versa. In the other cases, the correlation in movement is neglectable and in Spain's case, it even has a negative direction.

The twin deficit problem should not be so twined. Beyond the empirical part of the problem there is a conceptual lone. One should keep in mind reasons why both deficits happen at the first place and what are the circumstances and the processes that lead to both, current account deficit and budget deficit. First, budget deficit is more idiosyncratic and internal kind of problem.

Generating a deficit, governments donâ&#x20AC;&#x2122;t always have economic reasons behind it, or at least not strictly market related ones. Second, budget deficit is an outcome that can be controlled directly, even though sometimes it comes with severe consequences. Moreover, to a certain extent deficit is mainly the result of free decision making. Decisions made, as previously said, not always based on economic principles or interests.

On the other side, current account deficit, taking in consideration today openness of economies, is a bit more complex of a problem. The reason for it is that the CA deficit itself is a result of free movements of capital among markets rather than peoples decision-making. The generation of a current account deficit is the result of many inputs, and many of them are hard to control directly. At most, governments can have an impact through different policies on some elements 103

of the current account balance, policies related with imports exports and capital restrictions.

Among these policies mentioned, all tend to be problematic in implementation. Policy should not hit people why they buy, or why they create enough demand for goods, and especially in Europe.

Policy should address another problem, such as; why imports at the first place, or why not producing domestically, or is the market enough competitive.

Experiencing both deficits at the same time does not mean that they have to be correlated. Of course both have implications with each other because have to do with economic aggregates.

However, keeping in mind the current situation, if the twin deficit hypothesis is right, the problem then is fiscal discipline, and if the hypothesis is wrong, still fiscal discipline remains a problem.

Lastly, imbalances are a reflection of phenomena that is going on for a long time in Europe, declining competitiveness. In order to illustrate the problem here in this discussion, as a measure of competitiveness serves the unit labor cost. The indicator includes wage movements in Euro area countries and labor productivity. First, data suggest that in problematic countries analyzed here wages have been rising disproportionally with productivity. As previously sad, in Spain wages were indexed to inflation, and inflation rates in Spain have been relatively high in comparison, let say, with Germany, therefore eroding in competitiveness. The same problem can be noticed heavily in Greece. Second, it is not that such wage hikes have been offset by gains in productivity, and these movements in different directions have been accumulating for long time now. This brings us to the unit of measurement, the unit labor cost.

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Figure 14 Relative Unit Labor Cost in Manufacturing

Source: M. Higgins and Th. Klitgaard, â&#x20AC;&#x153;Saving Imbalances and the Euro Area Sovereign Debt Crisisâ&#x20AC;?, Current Issues in Economic and Finance, Volume 17, Number 5, Federal Reserve Bank of New York, 2011

The graph above, shows how this indicator evolved from the EMU formation till 2010. As usually, Germany is the benchmark, and here can bee seen that it stays highly competitive. The same can be said for Ireland, which stays strongly competitive despite the fallacy of its economic fate. And as can be seen Greece and Spain have lost more in comparison with other countries, with Portugal staying moderate.

Competitiveness is important in this discussion because it affects exports, which are an important element of the current account. Data suggest that there is a heavy correlation between declining competitiveness expressed in unit labor costs, and falling exports in volume, as a consequence a shrinking export market share.

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Figure 14 Export Market Share for Ireland, Spain, Germany, Greece, Portugal

Source: M. Higgins and Th. Klitgaard, â&#x20AC;&#x153;Saving Imbalances and the Euro Area Sovereign Debt Crisisâ&#x20AC;?, Current issues in Economics and Finance, Volume 17, Number 5, Federal Reserve Bank of New York, 2011

The graph above illustrates the argument made previously. Ireland and Germany remain highly competitive and as a result, it comes associated with high export market share. While Spain, Greece and Portugal from 1999 have lost too much in their export market shares, thus deteriorating their current account balances.

The discussion about competition is more complicated than that of how to bring fiscal order.

This comes because of difficulties to concretize steps toward rising wages or declining productivity. In case of deficit, it is obvious that the government has to consolidate its budget.

However, the problem with rising wages is laborious, because different experiences in practice have not proved to be so effective. Some countries tied wages to inflation, some to some productivity indexes and some indexed them with trading partnerâ&#x20AC;&#x2122;s developments in these areas.

The results in all cases gave mixed results at the best.

Such imbalances express differences that economies have in their development levels, differences in their characteristics and it is a circumstance that cannot be changed, even by unifying all economies together. In this aspect, there are claims that a mechanism to guarantee a 106

convergence of competitiveness among union members would be a good solution. This is a wrong approach, as many approaches that come from politicians or journalists. Adding another bureaucratic institution to bend market development would be another de-democratizing brick added in Europe's wall, it would be more like a second central planning adventure.

Figure 16 Current Account Net Balance (from 1999 in millions of euro, millions of ECU up to 1998) x 10000

20

15

10

5

0 198119821983198419851986198719881989199019911992199319941995199619971998199920002001200220032004200520062007200820092010

-5

-10

-15

Germany (including former GDR from 1991) Greece Italy Portugal

Ireland Spain Netherlands France

Source: EUROSTAT

Lastly, let us look at the figure above. It represents the net balance of the current account for some European Union countries expressed in millions of euros from 1999, and in millions of ECU up to 1998. The graph is interesting for a couple of things. First, note how oscillations in current account balances were prior to the Union formation. The tranquility was provoked from 1999 and forward, since the adoption of the common currency. From the countries selected here seems that the common currency worked well for Germany and the Netherlands. France had an initial push but later stabilized. The graph raises two questions. First, if the project of the European Union was a good idea? Second, if it was a good idea, is it time to integrate more than

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just monetarily after risking so much during this ensemble of issues? The answers to both questions will be elaborated later.

3.7.2. Monetary Policy, the Absent Tool Every discussion on monetary policy, especially on the one provided by ECB, should bare first the idea that its main purpose is price stability of the Euro area. Therefore, every other pretention on monetary policy during crisis, and before it, has to take it in consideration. After the adoption of common currency, the only institution that had been authoritative and to a certain extent successful has been the ECB. Nonetheless, the role of ECB will be a discussion in the next chapter.

However, monetary policy in EMU has been relatively a success. Saying relatively, because in this case, as in any other, are many ways to define success. The kind of success that is meant here is, as previously stated, the maintenance of price stability, and ECB on that extent has done a good work.

Figure 17 HICP for Euro17 Harmonized Consumer Prices 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0%

1999

2000

2001

2002

2003

2004

2005

2006

2007

Annual Percentage change from previous period Harmonised consumer prices - all items

Source: OECD

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2008

2009

2010

Euro area (17 countries) European Union (27 countries)

The figure above shows the harmonized consumer price index for Euro area 17 and 27 countries, which is widely used as a measure of inflation. The index has been stable with few oscillations.

In 1999, both indexes are relatively out of target, even though officially the 2 percent HICP target was adopted only in 2003. It stabilizes in 2001, and until 2007 when the crisis hit it was within the target. In 2008, indexes spiked not because the crisis happened but more because of a spike in food and gas prices.

Nevertheless, the discussion on monetary policy that is taking place after the financial crisis hit is not focused on the central bank's priority, but rather on other topics, of course, the tongue goes where the tooth hurts. Most people are discussing how the ECB missed so much going on while conducting monetary policy. The institution missed asset price bubbles being created under its nose, growth trends discrepancies among EU countries, and fiscal issues. Some even claim that the ECB did not focus enough on unemployment and financial stability. From all these claims, the financial stability issue is the only one that ECB can be blamed for, even only theoretically, because after it formation there was nothing that could have troubled financial stability.

Most of these claims are baseless because all issues are beyond the scope of ECB monetary policy. Unemployment, as a part of central bank focus is in debate for a long time, but it is not only the case for ECB. However, the ECB has positioned itself well in asserting its scope and purpose. When the crisis hit, too many issues surfaced within European structure, but currency management had nothing to do with it. The institution managing it was (is) reliable, independent and conservative, with clear scope and probably the only institution that has played according to the rules.

There are two sides of an economy, at least from one point of view, the monetary side and the fiscal side. In this case was the fiscal side that lagged behind. Nonetheless, discussions on this topic are related more precisely with the role of the ECB in the monetary unions structure, a topic that with be discussed later.

However, the instrumentalisation of monetary policy is not as possible in a monetary union as it might be out of it. The idea here is that, if countries that are in arrears now could have had their own currencies they could easy devaluate the way out of debt or other imbalances, as if

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devaluation of a currency is a panacea. The problem here is that claims are so powerful on the topic and the energy spent on them might have gone on other problem solving ideas.

Italy, before joining the Euro did devaluate the Lira quite regularly, not only officially but markedly. Exporters were used with the idea that whatever they did, they were going to sell products because the currency will weaken. However, for how long can such thing go on? The currency cannot devaluate forever, there is going to be an understanding point when is realized that the economy is not competitive and we cannot devaluate any more, thus reforms are a necessity. Having a national currency could serve to a certain point as a tool to maneuver, but it only serves in cases of sudden economic shocks or short term shocks, none of the issues in Europe now is short term, or sudden.

The first chapter, mentioned crises that experienced Latin American and Asian countries, they all had their national currencies; some of them were pegged to the American dollar. History shows that in these cases, the mechanism that goes through national currency was not so effective either; from a point of view, it might have been more painful and drastic than current experiences. What is now happening in countries like Greece, Spain, Ireland and Portugal would have been amplified to extreme levels, if people in these countries would have seen the value of their savings drop to nothing by a sharp devaluation of their 'would have' national currencies.

Not to mention here the value of debt in a foreign currency that would have been unbearable.

To a certain point, the Euro for problematic countries stops being a national currency and starts being a foreign currency. The moment they need it the most, they cannot print enough of it, the same handicap that emerging economies had while they needed dollars to finance their debt. This situation is the outcome of an independent institution from governments, in order not to finance public deficits. The questions that rise further are related with the way imbalances should be restored without leaving the monetary union.

Once more, competitiveness, to certain extent unemployment, and labor market problems are not competences of monetary policy. So why so much pressure on something that is almost unchangeable, and no pressure for concrete reform? The debt crisis is not a result of monetary policy, it is a result of fiscal disorderness and bad governance but still there is not enough pressure on those aspects.

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The fallacy of the discussion on monetary policy is noticeable not only through baseless paradigms of supporting arguments, but is also reflected through biased arguments on the function of the institution implementing the policy. First, when signing up for a monetary union countries knew that for every shock economies would experience, the way out would be everything, but currency devaluation. Second, blaming the absence of such tool, as currency devaluation, as an impossibility to recover from the crisis and to adjust internally is at the best biased pretention and at the worst not recognizing the problem. In absence of the common currency events would have unfolded differently. Greece and Portugal with their own currencies would have been statistically, because in practice is a question of judgment, on default and would have had the fate of Argentina.

The debate on monetarily devaluating the economy should cede at all, because it is obvious that the only way for it to take place is a country to leave the Euro zone. Whether leaving it or not, and what are the pluses and minuses of doing so is not a matter of monetary policy. However, when countries are committed to stay within the union, wishing to have a national currency for a while just to heal the economy, and especially after more than a decade of harvesting benefits, is more like a seventy years old man wishing to be young again.

3.7.3. Under The Shadow of Definitions When a financial crisis strikes, the probability that a debt crisis will follow after, raises.

Nonetheless, during crises public balance deteriorates not just from falling revenues due to slowing economic activity, but also from excessive spending. There is a part of this fiscal deterioration that official numbers, like public debt, or central government to GDP ratio, do not grasp. This contingent is a potential future claimable debt. The risk that comes from it depends from future events, usually default of private entities, but not only, depending on what kind of future liability is that.

This risky, shadow part of government debt, is not included because it is a matter of definitions.

Usually under the shadow of definitions, fall transactions like unfunded liabilities, guarantees, government loans, different insurance schemes, state agencies that are off the official budget, funds provided to bailout banks or other systemically important institutions, etc. Actually, most 111

of the up-mentioned are potential future claims; hence, they are excluded from what really constitutes public deficit and then cumulatively public debt.

During a crisis not only the central government is affected by fall in tax revenues or other forms, municipalities, states (in US case), or other administrative divisions like in Spain or Germany, are also indebted. Depending on how developed is the muni-bond market.

However, the most important part of this invisible debt that official statistics do not show is the government guaranteed debt. This sort of debt during periods of financial crises expands noticeably, especially nowadays, that government intervention is the new normal and that governments are held accountable for failed business decisions made by individuals or private institutions.

The shadow part of fiscal imbalances is disturbing when it comes to accounting. As said, during crises, public finances bare the burden of market failures; hence, a number of easily debatable transactions takes place. For example, when governments bought the so-called toxic assets from financial institutions, the transaction did not affect the fiscal balance because presumably a fair value was paid for those assets. The transaction would have left a deficitary mark only if the price paid would have been higher than the fair value, or because those assets were bought not directly, but by SPV-s set up by governments and backed by directly transferring funds to them.

In reality, most of measures taken by governments during the crisis had almost no impact on their official public deficits.

However, in some cases the effect was more than obvious. For example, Ireland's public deficit, and subsequently public debt, ballooned due to massive write-downs of losses from nationalized banks, after the government through full loss coverage on its main financial institutions. The amount of guarantees written down by the Irish government reached 125 percent of GDP, if it was not for the blanket guarantee, the number would have been smaller. Another example, which is shameful because the same institution was bailed out twice within three years, is the some Belgian and some French, Dexia bank. The total exposure of Belgian taxpayers for the second bailout only , which unfortunately included other banks too, reached to 41 percent of GDP. From

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this exposure, 5.7 percent of GDP constituted capital acquisition, and 1540 percent of GDP was the overall direct impact from the financial sector stabilization plan, on government liabilities.

Meanwhile, Germany, the benchmark country, is not left behind in this aspect. Starting from 2008 until 2010, buying shares in tittering financial institutions reached 1.9 percent of GDP, purchasing assets and injecting capital in banks like Commerzbank and Landesbank reached 11.1 percent of GDP

ibid

. The overall impact of such measures on government debt was 13.5 percent

of GDP, not a small number for a benchmark country.

The shadow public debt is also a challenge from an accounting point of view. Governments account transactions in a way that they do not leave track in budgetary statements. For example, a loan given out by a government is a financial transaction that does not affect the budget unless debt obtained by the loan is canceled. From the same sort of transaction governments account the loan given out as an off balance item, but fees collected on such loans and on other guarantee schemes account as revenues. Such accounting is arguable when it comes to national accounts, because they create discrepancies in reporting the reality.

As we see, governments also do accounting tricks. Exactly, is a quite reasonable argument against fiscal rules, because as is the case with private financial institutions, more rules raise incentives to find a loophole and bypass the rule, to do creative accounting, or just put transactions 'off-balance'. Nonetheless, sometimes also governments have hard time accounting those transactions during financial crisis. This comes due to a lack of a fair value price that market at the moment is unable to provide. The lack of a price in such cases can cause problem in reporting and give way to potential abuses of transparency.

Another concern in this aspect is the notion of unfunded government liabilities. Here is the idea about future spending related with health care and pensions. The problem seems to be acute especially in rich industrialized countries, and especially in Europe. Ageing societies present potential risks related with raising costs of health care, and raising expenditure related with pensions. As previously discussed, an ageing society makes it more difficult for an economy to grow, therefore, actual fiscal consolidation and future prospects of unfunded liabilities seem dim.

40

D. Hartwig Lojsch, et al, â&#x20AC;&#x153;The Size and Composition of Government Debt in the Euroâ&#x20AC;? ECB Occasional Papers No 132, October 2011, Pp. 26

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These unfunded liabilities are promises that governments make to their citizens for future claims.

In wide lines the situation appears to be worrisome because the numbers of this liabilities are relatively high. For example, unfunded government liabilities in Japan are 150 percent of GDP (2010 data). When looking at other countries like France, that has a ratio of 330 percent of GDP, or Germany 190 percent, or Italy that has the same ratio as Japan of 130 percent, one would thing that the Japan ratio is low taking in consideration the society structure and its prospects.

Figure 18 35%

Public and private social expenditure in percentage of GDP in 2007 31.3

30%

20%

24.4

22.9

22.3

22.3

22.1 17.8

20.1

15% 10%

16.3

21.6

24.9

19.3

18.7

21.3

22.5

3.0

3.6

1.5

1.9

2.1

Greece

Portugal

Italy

5% 0%

1.5

0.5

Ireland

Spain

OECD

Japan

Public

28.0

27.0

27.0

25%

6.9

Private / Privé

Netherlands

25.2

28.4

2.9

2.9

Germany

France

Total (↗)

Source: OECD

Looking the problem from another angle, the figure above shows (latest available data) public and private social spending as percentage of GDP. Except Ireland and Spain, the rest of European countries presented are well above the OECD expenditure, at least public expenditures the one we are interested here. However, social spending as a measure is different of spending on social security pensions. For example, from a total of 25.2 percent of GDP of public social spending only 10.441 percent is related with social security pensions, still a considerable number.

In France, from 28.4 percent of public social expenditure, only 13 percent constitutes spending on social security pensions. In case of Italy from 24.9 of total, only 14 percent are for social security, which constitutes the biggest number in EU. In Greece, from 21.3, only 11.7 is for

41 W. Eichhorst, et al, “Pension systems in the EU – Contingent Liabilities and Assets in the Public and Private Sector”, Brussels, 2011.

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social security. Ireland and Spain have the lowest numbers, respectively 4 percent from a total of 16.3 percent, and 8.4 from 21.6 percent.

The discussion in this point for as long as it concerns fiscal stability is vague. First, usually large numbers are used as a tool to impress for a coming Armageddon from these unfunded liabilities.

Second, the numbers are associated with models that claim to predict twenty years from now or more. This late crisis was a good example that those models are unreliable tools to predict the future. Some researchers42 claim that EU countries in order to provide future benefits promised until now, by 2020 will have to bring the tax rate up to 55 percent, and fifteen years later from that to 57 percent, and by 2050 to more than 60 percent to deliver on promises given to citizens.

Governments are more notorious when it comes to transparency than private institutions. When looking straight at the numbers, for examples of guarantees that a certain country gives to its banks, concerns grow because in case those guarantees are claimed the consequences would be disturbing. Germany approved a guarantee fund for its banks that totaled â&#x201A;Ź400 billion. Even though, the country can afford such number, yet in a worst-case scenario it would deteriorate government fiscal balance and put Germany under market pressure.

To a certain extent the shadow of part of public debt is not so shadowed. While the data are public and relatively accessible from the public, the real problem lies elsewhere. It is not about including these guarantees in public debt accounts or not. It is weather these guarantees should be at the first place. Moreover, weather socializing all costs of every crisis is the right thing to do, not only morally but economically too.

From the other side of unfunded liabilities, in Europe the expenditure that mainly constitute of entitlement programs are an essential part of the system. Even here, the problem is related with future reform in aspects of fiscal consolidation, and not weather it is in shadows or not.

Furthermore, the reform to this extent touches pensions, healthcare, and other social programs that add to the public burden and make fiscal policy ineffective, or even unsustainable.

42J. Gokhale, â&#x20AC;&#x153;Measuring the Unfunded Obligationsof European Countriesâ&#x20AC;?, National Center for Policy Analysis Policy Report No. 319, January 2009

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3.7.4. A Self-fulfilling Scenario The best way to understand a self-fulfilling financial crisis is to live it, and while you are doing that, it is necessary to read the daily financial news. During times of crisis, the news makes the chronicle of a self-fulfilling financial crisis, or debt crisis as in the case. Even though, financial journalism is only an extension of a bigger instrument, fact is that what is often written seems a mean to a certain cause. What isn't?

Usually, currency crises are the ones prone to self-inductive movements. Like those in Latin American and Asian countries, when suddenly investors decide to pull out of the country by selling assets denominated in domestic currency and abruptly raising the demand for assets denominated in foreign currency. In most cases, central banks cannot meet market demand due to depleted foreign currency reserves, hence the crisis. With banking crises is something alike.

Banks suddenly, at first by no explainable way, find themselves impossible to finance their operations. All of a sudden markets are illiquid, after a while the illiquidity problem turns into solvency problem, and this becomes worse when people start to withdraw their deposits from banks. As in case of fiscal crisis, governments suddenly find it hard to finance or even roll over their debt due to an abrupt raise in interest rates demanded for their bonds. The situation is slightly more complicated when a certain government issues debt denominated not in its native currency. The self-fulfilling idea in all cases is that the fear of insolvency brings to insolvency.

In all three mentioned crises, the common denominator is the word sudden. Also in common, are the characteristics of history that follows the sparkle that made it all to happen. A fundamental dilemma here, is whether this vicious downturn is a result of market expectations or is something more intentional behind it? The second is always going to be a part of conspiracy stories, and whoever starts a debate from that extent is not taken seriously.

Conceptually there is no difference when it comes to 'market expectations' and intentionality.

Market expectations are a collective moving judgment of elements with clear intentions, it does not matter whether intentions are right or wrong, it is important that they are conscious.

Therefore, whether saying that the cause of a crisis was due to market expectations or because of some market operators acting intentionally, is the same thing, it is actually a matter of interpretation.

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When analyzing a self-fulfilling scenario of a crisis one should take in consideration the market behavior after the sudden moment, and not the trigger that initiated the scenario. The trigger per se is not important, because always is going to be one, a policy mistake, an economic or political shock, or some other event.

The aftershock period is usually an economic and mediatic frenzy run. There are two main behaviors of market operators. First, is the part that acts based on pure concerns for its investments and wealth. Moving to save his or her interests and acting cautiously in a market where no one knows how tomorrow will look like is how the concerns look like. The other part is the one widely called â&#x20AC;&#x2DC;the speculatorsâ&#x20AC;&#x2122;. Speculative movements are the torque of self-fulfilling crises. The debate on the topic is wide, but here the discussion treats the moral issue and the systemic importance of such movements.

First, morally such movements are regarded not suitable, and usually speculators are the bad guy in the room. However, most of this moral judgment comes due to the orthodoxy that one cannot take advantage from others weak points. To a certain extent, this is wrong, and the situation resembles the one when religion condemned lending money with interest. In economy, a weak point is not a weak point, and even if it is, is only for the one that has it, for others it might be whatever the interest needs it to be.

Nonetheless, the morality of such movements is put in question when it comes to financial journalism. In a world, and specifically in a world of finance, where the role of information is so important and critic to the very existence of the system, the instrumentalisation of media channels and other information channels in order to financially benefit by deteriorating the position of 'others' is wrong, and not only morally. Reflecting to the wide public something in a pretentious way is morally wrong, amplifying the shock that a concrete entity or the economic system is experiencing, is also wrong.

From the moment when the fear of insolvency starts, until insolvency, even though it does not have to go to insolvency, the frenzy that characterizes market operators is made frenzier and worse by speculating transactions. If the world was not so interconnected, and economies not so inter-dependable, these transactions would 'hurt' only the entity that is vulnerable. For example, only the bank that is mismanaged would be subject to speculations and not others, or only 117

Greece and not the whole union. But, in a globalized world the stakes are bigger and the risks higher, hence the speculation has more leverage. Therefore, the self-fulfilling crisis has the potential to include the whole system.

Speculators operate in a relatively free market. Markets sometimes have issues that undermine their role in the economy; therefore, not always market logic is justifiable. For example, when the authority of Dubai declared that it will postpone its debt payment markets reacted not properly. After that, markets were looking for other vulnerable, not in condition, governments that were prone to similar problems. Speculators rushed to find other targets elsewhere in the world. At the time US and Japan would have been perfect targets, but both are countries that is impossible to 'fight' speculatively. Latin American and Asian countries were well prepared for such attacks, so the target left was Europe.

The idea here is that, problems, suddenly identified from markets in Europe and specific countries were there for a long time. Markets were not able to identify, or price them appropriately. Therefore, self-fulfilling crises are a result of market dysfunctionality. Is like the experiment with the frog, the from does not feel it when the water is boiled gradually, in this case markets do not notice when conditions deteriorate gradually. Nonetheless, with markets comes a point that system requires a change, for different reasons. When the point comes, markets wake up from a lethargic sleep and recognize that need to adjust. The need of adjustment means that the conditions are not right. Potential economic losses spark a fear that later leads markets movements, hence the self-fulfilling crisis. Sometimes, such crises are considered illogical, well, they are a cause of fear and lead by fear, it is difficult to find logic behind fear.

However, even this discussion partly remains on liquid grounds because it is difficult or impossible to prove something in concrete, thus the debate is concentrated mainly on moral bases and meta physical arguments.

The second issue, the systemic importance of such movements is of the same importance and partly a corollary of the first one. Actually, the self-fulfilling crisis happens when speculators are unleashed. They identify the most weak points of the system and try to take advantage. To a certain extent, speculators just point to vulnerabilities of the system. In the case of European debt crisis, they fulfill the function of fiscal rules. It would have been a different story if they were 118

working full time, but it cannot happen because they work when markets work and have the same characteristics as markets do.

In conclusion, the self-fulfilling crisis is a result of markets dysfunctionality. It takes a sparkle to initiate the vicious process, which is then lead by the fear of market operators. However, fear is a factor only through the initial phase of the crisis, afterwards intentionality and a plethora of interests influence the outcome.

3.8. Conclusions After five years of financial crisis and at least two of fiscal one, the downturn one way or another swept almost all EU countries. Economic deterioration, market fears, lack of confidence in the system and other factors made that even other healthy countries join the crisis dance. The transformation of the crisis into different forms and its duration brings it every time closer with the one during the Great Depression.

However, the chapter emphasized that the crisis might be collective but the reasons that different countries find their selves amid it are different. Nonetheless, they share common characteristics that historically every crisis had. From profligate economics in Greece, poor performance in Portugal, sluggish growth in Italy, to fate deciding economics and poor decision making in Spain and Ireland, the equation of imbalances cannot be more expressive.

After reviewing the situation prior to the crisis in countries analyzed, the more one looks for an economic problem the harder is to find one. This is not only bad politics and a bureaucratization of economy, but a pure case of mismanagement.

History shows that what Europe is experiencing now is not new; symptoms were not different from those in Latin American or Asia serial crises. The resemblances are tremendous. For example, think about Greece and Argentina. In this case, the European Union for Argentina is Mercosur. Of course, there is not the same level of integration between two unions and countries taken in comparison, but the resemblances are substantial when put in their contexts. Corruption and signs of crony capitalism in both cases, incompetent governments, and societies living beyond a normal reality, a reality backed by sustainable economic principles. Then is the IMF 119

that in these cases just postpones the inevitable and sets the way for aftershock debates related with its role in the system.

The EMU countries when signing in for a common currency weighted the costs and the benefits of their actions. That saying, it does not even make sense to discuss the monetary policy in the sense that could absorb shocks the same way it does without a monetary union. A monetary devaluation is not an option taking in consideration the circumstances, but also it is not a measure worth taking because it will only postpone so much needed reform and make the economic situation worse.

Therefore, imbalances that characterize the EU, as argued in this chapter, are reflections of EU structural problems, moreover, of internal structural problems. Important is to note that the EU as a whole has a positive current account balance. It does not mean that the reflection that comes from it is necessarily good. In this case the current account balance is like a mirror, and whether the reflection that comes from it is beautiful or ugly, it is a matter of stand point and interpretation.

The positive balance as a whole reflects internal imbalances within the structure. Internal imbalances within EU reflect individual problems with economic structures of each country.

Issues start from the most historically common, like asset price bubbles and their implications, bank bailouts and moral hazard, lethargic reform, and to the specificity case of Greece. Note that Greece is not a specific case because it has problems never noticed before. On the contrary, the country demonstrates the same crony issues that are associated with many crises, but the specificity stands in the fact that almost never a country before had all these issues at the same time for a relatively long period and let hazardously loose.

In addition, the association of current account imbalances with budget deficits through the hypothesis of the "Twin deficitâ&#x20AC;? is not of great relevance in the case. Because, whether it is right or wrong, fiscal policy in EU is a relevant cause and part of the crisis. However, in most countries problems arising from labor markets, law enforcement, market rigidies, and a substantial lack of wide area reform are the causes of imbalances within the EU structure.

Lastly, the self-fulfilling part of the crisis should be taken as a urgent call for reform. After all it is difficult to find reason behind fear, but in most cases there is a reason of fearing something.

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Markets do not fear Germany or the Netherlands, but they fear Greece and Portugal, seems that something is right here. In this aspect, the self-fulfilling scenario also demonstrates an uncontrolled unfolding of events, where governments are incapable of managing in an efficient way and within a reasonable time the crisis caused by their own wrongdoing and misbehavior.

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4. The Future of EU

4.1.

Introduction Into a Real Union

Up to date, the most successful monetary union is in United Stated. Nonetheless, the political and cultural consolidation was the basis for further unionization movements. As Germany today is the Benchmark for almost everything in Europe, in the aspect of unionization the US should be held as an example. Not that there are no other well achieved unions like Canada or Germany , but historical similarities, and especially the diversity of US union suits more to the EU case.

In US it started otherwise, political integration came before monetary integration. Therefore a consolidated political and real economy system paved the way for monetary unification. In Europe monetary integration was the mean for the previous one, hence the case is somehow different. Unifying European countries was, yet still is, a difficult task to achieve. Starting a unification culturally would have not been a smart move, because each country individually reserves to much pride. Trying to unify them politically would have been not only impossible, but probably taken as offence and would have ignited another war. So who ever had the idea of unifying European countries monetarily had been (is) a very wise statesman. In this context, the monetary union seems to have been a necessity.

However, the question that rises, is a necessity from what? Beside economic benefits, the other reason is that Europe was (is) relatively vulnerable to wars, and binding countries together would have lowered the risks for this to happen. Whether it is a union created from fear or a union created from benefits, this depends from which reason prevails. However, this is difficult to argue with assurance because with always be a subject of subjectivity.

Since when it started, the monetary union was more a project that expressed pure political will that a well analyzed economic ideal. As said above, the currency was more a tool to bind together all countries, since other elements were excessively different in order to create something stable. From the beginning, the project was structured in order for countries not to come as a shock. The premises were good because monetary union intensifies economic integration and arguably reduces asymmetric shocks. However, some of the pure economic criteria of the currency union theory weren't met, or just as always EU does, were push by 122

closing one eye for the sake of something big enough that justifies the previous action. It means that economists new from the beginning that Europe was not an optimal currency area.

The success of and longevity of a monetary union relies on three pillars: real integration, monetary integration, and political will. From these three pillars, the only one that has moved toward the right direction is the monetary pillar. It sounds paradoxical, but to a certain extent, this is the success of ECB role in the system.

The real integration seems to have fallen in that lethargic sleep discussed previously. As markets were getting used with good economic developments, European countries also were reaping the benefits that the unification brought. Thus, the necessity to push forward with reform did not had the same feel of urgency. As George Soros put it: "It takes a crisis to make the politically impossible, possible" The real economic integration is essential for Europe to exist as a union. Technicalities such as factor mobility and wage and price elasticity that give way to necessary economic adjustments in order not to evoke a crisis that might arouse from the impossibility of exchange rate adjustments, were left aside for a long time. The lack of real integration, reflected in internal balances, brought today crisis. The main problems that, in comparison with a 'real union', Europe experienced are as follow: First, starting from hurdles that seem harmless to the integration process, differences in legal systems create deviation in financial markets, and especially in labor markets. Even though to this extent has been reached good progress due to directives unifying the law, but still lacks behind from the US benchmark. The problem with legal hurdles is that it also creates abnormalities in working conditions, making the labor market more rigid, a characteristic that seem to be chronic for the EU labor market.

Second, differences in country inflation prospects and real inflation did not only affect competitiveness but also their bond markets. This concern was real especially before Euro creation because what happened after was somehow biased. The idea is that in countries with low inflation expectations investors are not afraid to invest in long term bonds, but the contrary happens in countries regarded as less stable, for example respectively Germany and Greece.

However, in practice data shows that it is not necessarily true.

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Figure 19 Average term to maturity for total outstanding debt (1997-2010)

8 7 6 5 4 3 2 1 0 France

Germany

Greece Ireland Average

Italy Median

Netherlands StDev

Portugal

Spain

Source: OECD

The figure above shows the average, median and standard deviation of average to maturity fort total debt for selected countries from 1997 to 2010. In theory markets should have not invested in long term bonds in countries that have high inflation perceptions or high inflation in reality, countries like Greece or Italy. In practice, Greece has the highest average term to maturity for its debt, which shows that markets were mispricing sovereign bonds. However, when the crisis hit, such a detail was of a little help for Greece taking in consideration the dare circumstances it was.

The rollover time for its debt was the last issue to worry about. However, together with some other elements this detail played an important role in Italy's case. As previously said, Italy lately rose the term to maturity above the average that is shown here to 7.1 years. It scaled down the need to rollover debt quickly in a panicked market, and gave it time to take other measures.

Therefore, in this case inflation prospects seem to have hurt only in relation with competitiveness, thus again related with labor market, because the implication with government bonds proved to be wrong.

Third, fast growing economies in theory have a higher propensity to import, thus in order to create a balance with exports will have to make their products more price competitive for foreign markets. At the beginning, no one would tell whether differences in growth would harm structurally the union. It was taken for granted that fast growing countries could balance their 124

demand for imports by exporting similar values. Nonetheless, some arguments were put forward, for the idea that different growth trends are not an issue in a monetary union. Technically, should not be, but a preemptive condition for this is the flexibility of labor market, and idea that will be elaborated later.

However, the first argument that was put forward was an interpretation of Paul Krugman's43 explanation of differences in income elasticities and trends in real exchange rates. The theory states that growth in fast growing economies comes because of new products or the improvement of old ones. Furthermore, income elasticity of export products produced by fast growing countries is higher in comparison with the one of slow growing countries, and higher than the income elasticity of their own imports. Therefore, countries can manage a fast growth without worrying for trade balance issues. The argument is right, but in today Europe case, only Ireland and partly Spain fulfill the conditions. Greece, even though was a growth champion, during the last decade incurred huge balance of trade problems. Even in this case, economic reality worked differently than the one on theory. Greece, and partly Portugal were not innovative enough to introduce new products, or even improve old ones. Elasticities of income of their export products were not higher than those of import products, or even than those of slow growing countries like Germany.

Another argument for the idea that different growth rates would not create imbalances due to high propensity to import from fast growing countries, is that the balance of trade would be offset by the capital account. This is based on a simple explanation that in fast growing economies, the rate of return of capital with be higher than in slow growing ones, thus capital inflows will pour in and will balance the potential trade deficit, therefore balancing the current account. Well, that happened in reality, but capital inflows did not balance the current account.

Inflows made things worse by rising claims of slow growers to fast growers.

That was one side, the other was that in order for this theory to work, capital inflows would have to be invested in tradable products and engaged in productive investments able to pay back foreign investors. Huge inflows require productivity of capital that some of the countries lacked,

43

P. Krugman, â&#x20AC;?Differences in Income Elasticities and Trends in Real Exchange Ratesâ&#x20AC;?, NBER Working Paper No. 2761 Cambridge, November 1988

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or did not grow into it, again the case of Greece, Portugal, and Partly Spain, with exception of Ireland. Moreover, the logic of offsetting trade deficits with capital account surpluses cannot go on for a long time because is economically counterproductive in the long run.

Finally yet importantly, the most problematic part of the European Union, the labor market. The rigidness of the European labor market is well known. Comparing the EU labor market with the American one is easy to find elements that show the lack of integration of the first one in comparison with the second. For example, a worker in Italy, that has lost his job, or even wants to move for a 'better life' in another European Union country, would find it almost impossible to do so. It is not only because of rules, but also because of differences in culture and language. In US, these movements are quite usual. The mechanism of labor market in US absorbs economic shocks and does not amplify or localizes them.

However, when an economic shock hits Michigan, job seekers do not find it hard to look for work elsewhere, in another state. The market is fluid, flexible and no rules hamper movements from different zones. In Europe, the same worker would be just unemployed. Thus, shocks in one part of US, mean movement of workers toward other parts where conditions are better, a similar shock in Europe means rise in unemployment. This is an interpretation of labor market differences based on Krugman's analyses44 on migrations and real wages. On the other side, shocks due to non-cooperative national policies, the core problem of today Europe imbalances, are localized because of low integration level and high rigidies due to heavy regulation in individual European countries.

This means that when an economic shock hit Italy, due to lack of integration the effect remains local. In full integration, the spillovers of this shock would disturb balances in other countries.

Nevertheless, theoretically, spillover effects from one country (state) are easily absorbable in union level, that is why with a more fluid, flexible and liberalized labor market imbalances would have been less problematic.

In a monetary union such as EU, imbalances have to be corrected only through two means remained after entering a union, wage adjustment or labor market mobility. Both these seem to

44

E. S. Brezis & P. Krugman, â&#x20AC;?Immigration, Investment, and Real Wagesâ&#x20AC;?, NBER Working Paper No. 4563 Cambridge, December, 1993

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be the cause of imbalances in Europe, internally in national level and in union level among countries. Almost every country in crisis today suffers from labor market inefficiencies.

However, channels that can possibly dissolve such imbalances or insurance schemes as described

by De Gruawe45 like fiscal transfers or through market solutions are difficult to be achieved in practice due to the nature of the union. With a government solution, there is not enough centralization or fiscal cooperation, and with market solutions, there is not enough integration in order to sooth the operations.

The late events of this debt crisis, remembered EU that a fiscal integration is also needed in order to maintain/obtain the coherence among adhering countries. Fiscal integration is a matter of political will. The political will is of extreme importance in holding together a union. Actually, this will is poised by trying to fulfill different national interests that usually have not the same scope and bare only individual nationalistic character; hence, the lack of political integration leads to a buildup of economic and budgetary divergences leading to a crisis. The actual crisis made obvious that in order for the union to continue to exist, further steps toward integration are needed.

Since from the beginning, the existence of national states was a source of economic shocks and disturbances for the union. Economists doubted the union for a very simple reason, it is practically unmanageable a group of countries with a common currency that bind to national fiscal policy.

What if Greece would have never lied?! The question is not cynical at all, because in a butterfly effect timeline, thanks to the first lie European countries lost almost a decade of economic growth and experienced tremendous costs. The first lie is the original sin, but why should be this one the original sin and not some other event? The point here is that whichever the original sin might be, the outcome would have been the same. Why can such a country bring the whole EU into the verge of collapse? Greece has a small share of GDP in comparison with all EU countries, a small share of public debt stock to that of all EU countries, etc. The crisis was not about Greece, it was about the fundaments and the architecture of a union that thorough its history remained a union of gentlemen and never made its way to a union of countries.

45

P. De Grauwe, â&#x20AC;&#x153;Economics of Monetary Unionâ&#x20AC;?, Oxford University Press, New York, United States, 2003

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It is important to emphasize again that political will is sine qua non condition in a fiscal and monetary union. The difference between EMU and one of the most successful unions in history, the US, is that in Europe the political will is a matter, and relevant, only for elites. In some cases, it is almost irrelevant how the feelings deep among the population are. Meanwhile in US it works more down-to-top, because decisions are not only matters of elites. This issue has to do will the political structure of the union. There is no accountability when there is no electability. Some of EU working bodies are not elected, and it is practically impossible to elect them directly due to the specific structure of the union.

In conclusion, to let markets know that countries are serious about the future of Euro there is no need to take rushed steps to prove that. It is sufficient to show the right political will and less nationalistic egoism. After all, it is all politics.

4.2.

The Role of ECB

The role of the European Central Bank is essential in the Euro system. Not only because monetarist views on economy have gained much importance, thus making monetary policy fundamental, but also because of the model of the institution. So far, to certain extents is the most independent central bank in the world. The main objective of the European Central Bank is solely price stability, and this was sanctioned in article 105 of the Maastricht treaty and remained the same with the Lisbon Treaty. Without undermining the primary objective of price stability, the ECB can engage in supporting other economic objectives such as unemployment, soothing the economic cycle and others.

Nonetheless, the scope of this sub chapter is not to discuss the model of ECB policy where price stability has primacy as an objective, or the model of the Federal Reserve where objectives are several. This dilemma is not a matter of arguments anymore; it is a point where the science of economics looks like religion, because it is a matter of belief, whether economists believe the first one or the second one. From this aspect, it is difficult to judge which is wrong and which one is right, in practice both models seem to be doing good. Even though it is relatively soon to say so while the crisis is still around.

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While the crisis has been around for a while, many issues related with the ECB have been discussed, even though it is the last institution, or policy, in this emergency that requires reform.

Whether the ECB has structural problems or not it is another discussion. If the decision making is optimal or not, if it is more decentralized that it needs to be, or if some countries are overrepresented in the decision making organ or not, are issues that need debate. Nonetheless, none of the problems above have hampered its operational functions, neither before nor during the crisis.

The ECB is known for its independency to all extents. When it was conceived with such a large scale of independency from politicians, it anticipated future problems in times of crisis or economic shocks. Eventually, market 'voices' and politicians would have required the ECB to take a leading role during economic shocks, when unemployment is high and economy slow.

That is the case now, and it was the case for the last two years.

The question is not whether the ECB should be active or not. It has to be, because what the need for price stability is when the economy offers not many things to price. Well, as many things this is not so easy, because one may argue that if price stability is in place than the economy should work well. Not necessarily. However, as a fundamental part of the system it has to be active. The problem that rises is: Active how?

During the crisis, even though with great restrain and under pressure, it intervened in certain ways, with some of them being very effective. Actually, only after the ECB went for quantitative easing, and facilitated cheap money to commercial banks through the new window it opened to provide long-term funds up to three years. Markets tranquilized, and this step bought EU leaders time in order to react. The ECB did in one-step what European bureaucrats could not do for more than three years of senseless summits. This explains the importance of the institution in the system.

However, some claim that this did not resolve the issue of potential insolvencies in the Eurozone.

If the claims are against the ECB they are baseless, because monetary policy, or concretely that step taken by the central bank, first did not address the problem of insolvency, and second it is nor a competence or neither a domain of the ECB. The other important intervention was related with the banking system. First, the ECB changed the rules of accepting collateral, thus it could 129

have accepted Greek bonds. The problem with this measure was that ECB was buying indirectly Eurozone government bonds by transferring them from commercial banksâ&#x20AC;&#x2122; balance sheets to its own. However, the measure was temporarily, and the institution covered the taxpayer from potential losses on those bonds when negotiating the Greek haircut. During negotiations, the ECB was honored with preferential treatment among all investors, which means that the bonds in its portfolio did not undergo a haircut. Second, the banking system was bleeding liquidity, not only, it was also in an urgent need for reserves. The ECB also provided such needs through National Central Banks operating in European countries. Commercial banks beside the fact that were supported with capital and overcome big financing difficulties, used some of the cheap funds from the ECB financing window to buy high yielding Eurozone bonds. As previously said, these steps were not meant to solve problems directly, these were meant to buy time and to tranquilize markets. With tranquilized markets, less pressure over governments and more time to find solutions. Well, it does not work that way with politics. Unless it is a calamity or an urgent need, there is no will to turn the impossible into possible.

However, the steps that the ECB went through were not without consequences, or at least potential ones. Flooding the market with cheap money not only raises inflationary pressures, but also might create new asset price bubbles. For the time speaking, it is difficult to see new bubbles while economies are still very fragile and the debt crisis is still boiling.

Another neuralgic point is the idea the ECB should intervene further. Some claim that ECB should have played the card of being a lender of last resort. The so-called bazooka of the ECB, for many was the solution to this debt and moral crisis. Beside all improprieties in conception and different issues involved here, one is the most important. The central bank of every country does not serve as the lender of last resort for governments, but for the banking system. Not only the orthodox definition of a central bank states that, but also the very being of such institution, which is embedded in its functionality as independent and responsible strictly for the value of the money. Such demands compromise the idea of central bank independency, raises inflation pressure, spurs moral hazard among governments and lastly it might bring to a point that the ECB will risk its reliability.

Nevertheless, quantitative easing is in a certain way playing the lender of last resort. The best experience in this field is that of the Federal Reserve in US. Has the Fed proven to be right? That 130

is a tricky question, and the answer of it is at its best subjective, and in worse case unknown.

Subjective because the US case is more complicated than it is described to be. It happens because the problem is a mixture of monetary policy and several other interests at the same time.

It is unknown, because only future events will have the last say on this unprecedented precedent.

Again, saying it was right or wrong is not only insufficient but also misleading. The real problem lies in the precedent that it has been set. By being instrumentalzed this way, a central bank would be just a supplement of any government or generally speaking any political project.

In addition, there is another problem. Finding it difficult to bend the institution obsessed with price stability some pose the discussion from other aspects. Emphasizing occasionally that the ECB lacks accountability does do nothing more than avoiding real problems that Europe is now experiencing. Since its creation as an institution, the ECB showed full integration with the system and a good operational functioning. Posing the ECB issue from an electability perspective, as a democratic requirement, is plainly wrong. The ECB is not a political institution where power is delegated, it is a technical one and should be regarded so.

For example, the Bundesbank president can be changed with a simple majority of the German parliament, while to change ECB's president requires amending the European treaty, and that is a piece of work to do that takes forever. This seems comprehensible as an argument, but this is not a reasonable way to hold accountable the ECB by making it more dependable on politician's influence. As far as it can go, might take place a situation like in US, when congressman want to audit the Fed, make it more dependable on congress, or even abolish it.

The central bank is and should be an extremely technical institution. It has delegated power by politicians, however, this is one case, which politicians should not have much control over the power they delegate, for the best of the system and society is better to keep frequent political madness away.

Lastly, European monetary policy one size fits all is not working out to some extents. In order for such policy not to be frustrating, further integration is needed. Individually, countries have different monetary needs. This does not come just from different economic growth paces but also from the heterogeneity of continent's economies. For example, countries that have considerable output gaps are facing inflationary down pressures, which increases the real interest rates thus 131

snagging growth tendencies. In order for the monetary union to work real integration is needed and more harmonization of European economies.

4.3.

The Political Factor

The XXI century gave a meaning to globalization and made it essential to the system as a whole, and to localities as sub-systems. Nonetheless, as everything else, this process came with its positives and opportunities, but also with its negatives, risks and costs. The wider the influence, the wider the scope of action, hence greater the risk. In this case, not only the amplitude of the risk is higher but also its complexity. Globalization is an important element when it comes to the increase in dependence of peoples on governments. As said, bigger markets are associated with higher risks and higher instability. Moreover, the inequality gap in wealth is more and more problematic not only in Europe, but almost among all industrialized countries. Hence, the role of government as redistributor is even more important.

Well, the XXI century did not only gave meaning to globalization and made it mainstream, but associated with that came also a new modernist era that changed many ideas and put in question many concepts. With the new wind that made everything more mobile and liquid in conception is hard to define what values are. It is more difficult today to argue for a cause, because another doubts the objectivity of what is a cause. An example, not much related with the paper, is the climate change, or the green energy. Before a while, both were superlatives of policy makers, now both are dilemmas among policy makers. Maybe, policy makers are not a standard for comparing the phenomena due to their characteristic shortsightedness.

While at decision makers, it is worth emphasizing that this crisis, as any other crisis, is a straight result of bad decision-making. This might sound like tautology, but often-obvious things are missed because people look for answers in the sky while they can find them in the ground.

Not only the crisis is a result of bad decision-making, but also its deterioration. The illustration for it, is the ongoing crisis with politicians playing the 'game of summits'. At least the last two years have been not only a drama for the real economy and people suffering from these consequences, but also a theatre showing lack of leadership, absence of visions, shortage of 132

ideas, and a typical European indecisiveness due to complexes related with pride, individualism and egoism. Countries individually were more than satisfied when taking advantage from the monetary union. Greater market, cheap money flowing, more opportunities made them cheer in unison about the common project. However, when it comes to sharing the costs of risks countries seem reluctant to do so.

This crisis has many aspects. Nonetheless, one thing is sure, it is not only a debt crisis. It is more than debt in it, because the fiscal deterioration that took place in few countries was not present among others swept by the actual crisis, also the degeneration that took place in fiscal positions was limited to one country only. A deterioration in public finances, exactly, the escalation of the public debt is not a debt crisis per se. There are two main reasons why public debt explodes. First and the main one related with the point in discussion, is when charlatan politicians take decisions based on personal or political pragmatic interest. Second, and the most economically justifiable, is because of financial crises transferring the burden to the public. Here are included the costs of 'modern' techniques such as bailout-s, and the cost of automatic stabilizers of fiscal policy.

Europe, at the time speaking is in the middle of a crisis; the problem is that it has been in the middle for more than two years now. Greece that was the most extreme case, de facto defaulted on its debt, and to be called a technical default we will have to wait some time, taking in consideration the numbers that seem impossible to match the reality. Other countries like Spain and Portugal are on the verge of default.

The risk of default of a country depends on different factors. Some of them are the level of indebtedness, the quality of country governance, which is regarded here as the political factor, market concerns for fiscal positions, and other factors outside government competences.

Until now, we have seen markets doing their own, and for that they took a hefty price, a more that 70 percent haircut from the Greek bonds. If markets, speculators included, would not have pushed that far, they could have had back their investments in full, as previously said it is difficult to reason in panic. On the other side, fiscal position deteriorated, and the reasons for that were presented earlier. To come down from those levels of debt is politically a Sisyphean work to do, because reducing government spending now risks turning politics against politicians.

Therefore, we turn again to the political factor, the decision makers.

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Politics has an essential role, and sometimes the most important. In Europe's case, the political problem is exacerbated by a non-consolidated institutional structure, or better a non-consolidated identity structure. Slow decision-making, even those decisions taken were vague enough to tranquilize markets, and absence of coordination seems to be the problem of this European political identity. Moreover, this structural problem is reflected in differences of opinions between the high-end decision makers and the people they theoretically represent.

As early mentioned, politicians were forced out during the crisis, and for these outings markets were credited. The answer to markets was naming technocrats on top of governments, that way the heavy burden of reform could fall on them, taking also in consideration that they are designated to be temporarily and consensual, hence bare no political cost whatsoever. Even these consensual installed heads of governments have found it hard to introduce the so much needed reforms in their respective countries, even though that there is a wide acceptance of the problems that have plunged the economies and of aspects of the economy that have to be reformed. The responsibility of politicians is to return social expectations among European countries, that way would be sounder economically to face the multilateral crisis that the continent is facing.

Social unrest is justifiable to a certain extent, even though it is different among countries. In Greece, politicians are to be held accountable for what they did to a country, and consequently to Europe. However, in Greece the biased political, social and economic structure was widespread among the population. Corruption was a way of living, thus protesting now at such levels is not socially justifiable for Greece, It would have been if Greek society would have paid taxes, would not have made fiscal evasion and lastly, would have been productive economically. Meanwhile, in Ireland, it is a diametrically different situation. The social unrest might be justifiable because the robust, productive and innovative economy of Ireland was put i arrears by an arbitrary decision taken by the government. Moreover, the decision included one of the greatest controversies being discussed in economy, bailing out failed banks.

A bad reform is better than no reform at all. The political deadlock in Europe is one thing, the absence of political will is another. Reforming is always difficult, the status quo is always challenging, even when considering the European disorganized political environment and conflicting interests. Resistance to reform is not only met in developing countries but also in industrialized ones.

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To illustrate the decision-making problem (political factor) let us take for example the OECD report, 'Going for Growth'. The OECD organization comes with this report yearly. In 2005, the organization had identified five policy reform priorities. Those priorities were reassessed again in different years. Yet in 2011, the report had the same priorities, they remained actual to be firmly reassessed by the organization. Taking in consideration how much the world has changed and the urgent need for reform since 2005, those priorities must have been different by the time speaking. From another perspective, which proves the point in discussion, it shows that experts have done a good job identifying systemic problems, meanwhile politicians a bad job by stagnating on vital reform and helping the world economy. However, assessing the political factor one should not always bias politicians. In a way or another, they can prove the point made before to be wrong. An illustration in this case is Brazil. In 2002, investors feared a pivotal change from changes in political leadership. The biased populist Luiz Inacio Lula da Silva, demonstrated that he was more macro economically prudential than investors thought to be.

In addition, the political will is the other side of the medal. When the US was swept by the crisis, the political will was decisive in its resolution. No matter how debatable are those decisions, important that politicians responded to an unprecedented crisis with unprecedented measures. In Europe, politicians during the first two years refused to recognize the crisis at all. From one point of view, Europe is where it is today because of its apathetic political action. Yet, the same behavior characterizes EU governing bodies. Willingness no to take measures in order to avoid political costs and waiting for the situation to selfheal, shows the small-minded mentality and a shortage of visionaries.

While the importance of Germany, and then France, for the union cannot be faded, the importance of other countries is also relevant. When Germany and France are presented at the European summits with pre-arranged conditions or a bilaterally pre negotiated resolution, do not expect other countries to bind that resolution. First, not because it is a lack of political respect, but because it does not show any sign of trust among members. Second, if resolutions are negotiated bilaterally or trilaterally, the interest taken in consideration there is only of parties involved in negotiations. Bypassing collegial decision-making institutions in Europe, especially by those that have the most interest in the union existence, is a political gaffe that could prove to be very expensive in the future. From a certain aspect, the two main initiators of the European 135

Union forget why the union was created in the first place, forget that initially the motivation was halve reason and halve fear.

Another interpretation, why the two European heavy weights skip collegial decision making is the idea of a two tier Europe, or two ‘gear’ Europe, which lately came in the political market as a French export. The idea that France tries to promote now, the idea of a two tier Europe, or one part more federalized and another part made of peripheral states, which will be the second gear of Europe, is not as new as it came shocking for some. This would be a disastrous political project and another dysfunctional idea that comes from supremacy roots. However, for such thing, there was a warning several years ago by a European renegade, exactly 17 years ago, when the EMU project just started to take life46.

Whatever the reasons behind this project are, t this will always be a virtual project. Nonetheless, if it is tried in practice it will be the end of Europe as we know it. Countries with their characteristic pride, in this case is fully justified, will chose abandon the project because it is impossible for them to cede sovereignty under such conditions. Tentatives to monitor countries fiscally are facing harsh objections by other countries, and this comes under the argument of losing sovereignty, imagine a union with mother France and father Germany and the rest abiding in row, it seems more like vassal relation than a two core Europe.

History tells us that during default scenarios countries have lost their sovereignty, as happened with Egypt when became a British protectorate or with Newfoundland when became a Canadian province. Today this fear seems vaguer, but still, it is a slight probability of speaking German for some EU countries, at least not literally.

46

Bernard Connolly, “The rotten heart of Europe, The Dirty War for Europe’s money”, Faber and Faber, England, London, 1996

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4.4.

Reforming The System and Further Implications

Reform is not a matter of regulation; it is a matter of common sense. For every year that Mr. G.W. Bush was president of the US, a thousand pages of regulation was added, for eight years it rounds to eight thousand pages, yet after that the worst of economic crises happened. Moreover, the problem is that even common sense is hard to find nowadays, and this for the same reason mentioned earlier, that it is difficult today statically defining values with this mobile world of fluid interests and concepts.

Whether to reform or not, in economics it has a vague meaning. Better would be to adapt after market evolutions. Whether reforming or adapting the system is not going to resolve anything without the common sense. There is not such thing as a bad system, there is only a system used badly. That saying, explains more what went wrong with Europe during last decade. Obviously, there is an urgent need to tackle several problems within the existing European structure.

As it would be the most normal way, to tackle those problems, first, one needs to identify them.

In reality seems to be a fallacy with identifying these problems. All know where the issues are, know what is to be done, however there is no concrete action.

Often the fallacy lies between the distinction of virtual economy and the real economy.

Economists know that the real economy is the one going to bare the main share of the costs and ultimately the tax payer, which in the case happens to be the same entity. Governments, as it happened, infuse cash in different ways into banks and other financial institutions, thinking that that is going to jump-start the economy. Here is the fallacy, maybe intentional, of identifying the problem. History, even the recent one, proved that giving money away free to banks would not help the economy, at least for as long as they do not pass it over. In both recent cases, in US and Europe, beside the fact that banks made lucrative profits thanks to cheap money, they were forced to massively buy government bonds.

In US, this was done timely and the government poured the money back into the market without suffocating it through big spending packages. Whether it is right or wrong, it is another discussion. It is better a bad action, than no action at all. The economies needed hope, and at least in US the economy was helped with some.

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Meanwhile in Europe, it was done in the worst way possible. Bureaucrats woke up when the Greek issue had already taken the runaway. Banks were forced to buy bonds when the Greek illness had contaminated the whole continent, and what is more problematic, that European governments are pushing with austerity measures in most countries, thus suffocating the economy and sucking up the liquidity out of it.

Another example of wrongly identifying the problem, and sometimes this is fully explainable, is the late attack on the ECB. Almost none of the problems that EU is experiencing now is not related with monetary policy directly or with the role of the ECB in the system. Yet, this is the most attack institution. At this point, it is worth emphasizing once more, that currency devaluation is not an option under a monetary union, thus it cannot be discussed as a potential tool to get out of the crisis without reforming or adapting. The argument continues with the same logic as previously elaborated.

In the first chapter, there was a discussion about the rising tendency of debt, and not only government debt but also privet debt. Data shows that historical government expansion has made it a more important entity economically than other entities participating in the market, and sometimes government is the market under certain circumstances. This expansion of government expressed through raising debt levels complicates the whole market functioning. First, government as a substantial market operator, manipulates markets balance, hence there is no justification to blame markets for whatever kind of occurrence happening inconsistently in the system. Second, this austerity logic puts governments in a paradoxical position; because governments restrain their spending now money is needed the most by markets. Note that here is an element of procyclicality, governments amplifying or accelerating market developments.

In addition, there is another complication with debt as a notion related with financial crises. A lately surfaced debate among economists, which represents the post-Keynesian economics by Steve Keen, criticizes both views, neoclassical and Marxian economics. The theory builds on two well-known previous theories; the debt deflation of Irving Fisher and the previously mentioned Minsky hypothesis of financial instability. Actually, the view emphasizes more the role that private debt has in developing financial crises, and it argues that debt is the main reason of crises. Data significantly seem to support such claims, even though that the discussion is still at its initial phase. Nonetheless, this view presses more on private debt rather than public debt.

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Actually, if keeping in mind the two reasons mentioned earlier why public debt explodes, removing from the equation the fact that it could be a result of political abuses, we can derive that public debt is a corollary of crises caused by private debt. That said, identifying the real problem remains a hard task to do, yet, provided that relations and theories mentioned here are true, there is another problem wrongly attacked.

Nevertheless, the debt problem in Western Europe, or mainly in developed countries, is not just a result of the Great Moderation. The debt problem is also a reflection of a change in economic philosophy. During years government spending, and as a matter of fact intervention in the market, has seen a sizeable and obvious rise in prominence. Government influence has expanded significantly, at least after WWII. For example, The Economist calculates that the average government spending (as percentage of GDP) in 1870 was only 10.4 percent. In 1920, it reached 18.4 percent, and 1960 it was 28.4 percent. However, only two decades later, in 1980, it almost doubled reaching 43.8 percent of GDP, to reach in 2009, 47.7 percent. The actual situation in Europe that countries are demanded to implement austerity measures is somehow paradoxical, because it does not comply with the spending spirit, even more in such needy times.

Albeit, with such involvement, the influence is greater and the risks are higher, thus we can say that markets are not working on proper conditions. The issue that rises here, is what proper conditions are? An optimal market would be one that is not (cannot be) controlled by any entity or constituency, but only by its internal systemic energy. The influence exercised on it by different parties shall be minimal.

However, when the government practices its influence in the market, it automatically loses its internal balance, hence its function as a regulating medium. The same bias is created when the market is controlled by a handful of big firms that have enough power, comparable with the government, to ruin market balances. It should not be a justification that the government is a market operator as any other, because governments do not compete, and that is enough to disqualify them from the imperative above.

When government spending has risen in such level as described above, it takes a monopoly position in the market. Therefore, the market is only a government extension, whereas it is supposed to be otherwise. The main suggestion that would come out of this reasoning would be 139

for the government to shrink its spending and contract its influence on markets in order to let it breathe and operate based on the synergy of its subsystems.

That said in a more global sense; let us turn to the European Union discussion, which is the subject of this paper. First, every kind of reform should bare a local perspective, by local here means in a national level. The EU should serve only as a coordinator and framework provider.

The European Union is too heterogeneous to implement one size fits all regulation. Second, any kind of reform must have one very important characteristic; it should be more technical than a perquisite of certain conditions to be met. This means that potential new rules for EU governance, should be left on political hands as less as possible.

However, is it possible to have a union where each country has responsibility for its own finances and the union as a whole bares responsibility for the monetary policy, in other words, individual fiscal policy and common monetary policy? Do these policies have to converge?

Sometimes they have to, but not always. Having a common monetary policy, lead through an independent central bank, means that at least the institution is hard to take politically influenced decisions. First, because the ECB has to take in consideration the monetary area as a policy meter, and second it is more difficult to bend to one country wishes when in reality the institution is held accountable to a union of countries. Besides that, the ECB is well structured in order to represent interests of all countries included in the matter.

Some experts claim that a set of traditional monetary policy combined with ordinary financial regulation were not an effective way to prevent the crisis that shook the system. That is not totally true, because in some cases it was not even a fiscal problem, the more a monetary problem.

In addition, beside the first two characteristics mentioned above, should be taken in consideration also the shortsightedness problem, which means that political decisions are not based on grounded economic rules. Additionally important in the case of European Union, is the common pool problem, in the sense of moral hazard.

First, the EU needs to put in order its fiscal house. It does not mean that the only way to do it is for countries to cede sovereignty. Under globalization terms, such pretenses should not even be mentioned, however, some trade ins are to be made while under a union. When it comes to 140

benefits from the monetary union and the wide opened market, countries comply, but when it comes to contributions, complying then becomes a breach in their national sovereignty.

Before mentioning some measures that according to this paper should work for future EU, it is better to mention some ideas that are circulating and in the view of this paper are not appropriate.

First, there is the idea of a European Monetary Fund. Such fund bares no value added for the system because would be a small IMF replica governed by EU, and there is no economic wisdom for the continent contributing in both funds or having two of the same. Besides that, the EU does not need a fund, because this is not the answer to its problems, again here the fallacy of identifying the problem.

If since from the beginning EU authorities had made clear, which countries had problems with liquidity and which with insolvency the outcome would have been different and easier. Countries like Greece that were obviously insolvent, should have been let to IMF standard procedure. This way, the union would not have been compromised, and it would have sent a clear signal that the no bail out clause is as firm as it can be. It turns out that it is not enough to have a no bail out clause. Politics always ruins even the best of economic balances. In this case, the intentional no bail out clause in the European treaty was made less credible by respecting political sakes.

On the other side, with countries that had liquidity problems, or others that risked contamination from deteriorating market conditions the EU should have set up a firewall in order to stop the dominos falling, in the same time urging countries to improve their structural fiscal positions in order to gain market authority. Procrastinating on such issues and politically vegetating brought the situation at this point.

The other non-compelling idea is issuing common euro bonds. This, yet again, fails to identify the problem. Issuing common euro bonds would just cover up the profligacy of some countries and would build up more moral hazard. Why should well-behaved and fiscally consolidated countries have to pay for reckless ones? Additionally, issuing common bonds would be another add up to internal imbalances. The European Union structure is not that integrated in the aspect of reliability and after that accountability. This measure practically says that irresponsibility is rewarded by poling it with responsibility and not paying the fair share for it.

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Hesitation and willingness not to risk politically during the crisis, made that some of the decisions taken to be at the best pragmatic and at the worst immature. The rescue fund created, which firstly set to be temporary, created even more bad market incentives. After bailing out Greece, Ireland, and Portugal using that mechanism markets were demanding even more on that direction. Markets were looking for Spain and Italy to go for the same way. Soon after, were brought up claims that the fund was too small because it could not withstand a total bailout of Spain and Italy.

The absurdity here lies in the fact that such pretenses are irrational. First, why should such fund be the same amount of the sum of Spanish and Italian debt? In an extreme case, if countries both default on their debt, there is no need for a fund at all. Second, if both countries restructure or reschedule their debt, somehow like Greece did, markets would most probably get another haircut for their own mistake, and what is most important still the amount of the fund would not have to be as the outstanding amount of debt of both countries. Therefore, claims that the fund is not enough to withstand Spain and Italy are nothing more than journalistic waffle. However, the worst was not done yet. It was achieved when it was announced that the fund would have to be made permanent, in other words acknowledging that in the future would be more similar scenarios no matter what we do today.

Another thing to avoid before going to concrete proposals is creating new institutions while the ones that failed continue to exist. In such cases, there is a political habit to create new national institutions or pan European institutions. In any case, there is absolutely no need for bigger government, or more bureaucrats to make it a Kafkian union.

But what has to be done? This paper modestly emphasizes on some suggestions that are being publicly debated and one that is not. As previously noted, European countries are trying to implements austerity measures. Austerity measures are not problematic because they are difficult to implement, they are problematic because of their endorsement to the public. The difficulty appears when there is no political consensus to bear the share and push the burden of the measures.

History shows that countries that have undertaken measures to bring their fiscal house in order have been well rewarded. After the lost decade of the Latin American financial crisis, some 142

countries followed a certain road with the IMF as a protĂŠgĂŠ. Meanwhile, others took the reform way, and Chile was one of them. Chile reformed the system, privatized what was nationalized before, brought inflation to sustainable levels, cut the budget deficits and employed free market reform. These measures were not only to serve to the health of domestic economy but also restored foreign investorsâ&#x20AC;&#x2122; confidence.

Chile, is not the only example, a fresh one is Ireland. Ireland also approached the situation in a stoic way, even though it is still discussable the morale of all this. Chile then, and Baltic countries today, are the perfect example that austerity measures cannot rescue an economy without two important imperatives: reform and political will to support it. Another problem with austerity, is that it tends to be procyclical, and this is an additional issue to tackle. The procyclicality is observable when comparing US economy turn out from the crisis, and the prolonged European economic sluggishness.

Nevertheless, austerity has two parts. The first one is the adjusting economy, which means adjusting wages, competitiveness, market conditions, and social expectations. Second, is fiscal consolidation. Starting from the late one, the IMF finds that fiscal consolidation, at least in the short term, raises unemployment. This is not a problem in crisis, because the effect was already done by the economic downturn. Theory also suggests that fiscal consolidation has a positive effect on national savings; hence, the effect would be also positive for the current account balance. However, in practice it is different.

Regardless, fiscally, countries have to bring debt to GDP ratios down to sustainable levels, and also public deficits. As long as it is done, there is no need for other steps, at least fiscally. To bring down these levels and to keep them in the long run, are two different things. Here would be very helpful independent fiscal bodies that would monitor fiscal policy from it conceivement, public budgets, and the implementation of policies. Such governing instance should not predetermine governments fiscal policy or their programs, it has only to make sure that governments exercise their activity within the rules previously set by the EU in the stability and growth pact. In order to avert potential internal conflicts among institutions, would have been optimal that such fiscal monitoring institution or council, to be set up in Union level and not nationally.

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Beside technical suggestions, for example on taxes, fiscal evasion, government efficiency, etc., which are important policy findings in different IMF, OECD, or any other research organization, this paper suggests a mechanism based on a theory not much elaborated.

The approach of balance sheet recession, which explains in comprehensibly the ongoing European crisis paves the way for a proposition on a crisis resolution. In a late paper47, Richard Koo, explains the mechanism of the crisis and his resolution to the problem according to his view. The idea is that when the crisis hit Europe, asset prices plummeted but the debt that had to be paid did not vanish. Now European countries are deleveraging, they are not spending or investing but are paying back their debts. In this condition, when all are saving, the money is not directed to the 'income stream' thus triggering a deflationary spiral, hence the balance sheet recession.

According to theory, monetary policy is not a solution, even with zero interest rates. This is understandable, first it is difficult to find lenders in a recession, and second, people and companies that are trying hard to get rid of high debt levels would not borrow any more. The only solution remained according to Koo, is for the government to step in and borrow the savings accumulated and to spend it in order to offset the effects of the balance sheet recession.

However, in the European case seems to be a problem, because it is more specific. The monetary union makes it more difficult for the process to take place automatically. Again, according to Koo, when fund managers are looking to allocate the money saved, in US case they would buy treasuries in order to avoid currency risks or any other added risk, but in Europe case it is not as easy. Fund managers from, say, Spain and Portugal would buy German bonds, or any other country that is a safe heaven, this way leaving the government without the much needed funds to spend in order to stabilize the economy. Lastly, his proposal is to restrain who buys the bonds of a certain country. For example, Portuguese should buy only Portugal government bonds. The proposal has it flaws but discussing them is not the scope of the paper.

From the above exposition, let us take it from the point where it becomes specific for the European Union. The proposition of this paper based on the framework represented above, would be a creation of a mechanism that would offset the effects of outflows from some 47

R.C. Koo, â&#x20AC;&#x153;Revitalizing the Eurozone without Fiscal Unionâ&#x20AC;?, Nomura Research Institute, March 2012.

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countries to others within the union. First, the notoriously named bailout fund should be abolished. Second, the mechanism created should not have fiscal character, but should be constructed as a structure to maintain equilibrium of inflows and outflows in the explained cases.

The funds directed back, say to Spain, should not be assigned by an arbitrary amount. The amount should be calculated based on outflows from a certain country, in this case Spain. This way the mechanism makes sure that no overflow of funds pour in, because that would be basis for overspending or returning to imbalance at the first place. The aim of the mechanism is to correct imbalances through regulating the relation of domestic savings with domestic investments within a monetary union and in national level too.

The structure should work automatically, balancing outflows from countries regarded as in difficult conditions, to countries that are stable. The mechanism can be permanent, but active only in times of economic crisis. It is not a fiscal transfer of funds, the money to fund the in and out flows can come from a European Union common pool. An additional advantage of the mechanism is that would lower the chances of a debt crisis like the ongoing one. More demand will be for bonds of respective countries, thus the price higher and yields would go down.

However, it would have to work under the limits of government spending set by the SPG pact. In times of crisis, for example, the 3 percent to GDP limit of public deficit can be waived and related more with the rate of national savings of a certain country. In addition to fiscal reform, the EU should oversee the cycle in the European level, that way to prevent boom and bust cycles from happening, even though, that such prevention is easier said than done.

In order for this mechanism to work, the economies of Europe have to reform other aspects lagging behind. Two main aspects that have urgent need for reform are the labor market and institutional functioning of the EU. However, before discussing the two, it is worth emphasizing an important point related with the ECB and its role.

As previously said, the only positive comment goes for monetary policy and the institution that is responsible for that, the ECB. Even though it had its own drawbacks, yet the ECB remains the most authoritative institution and the one with the greatest influence in the market. Claims related with it have to do with its role as a lender of last resort. There is a deep misinterpretation of this function. Latest pretenses, as previously mentioned, want the ECB to be a lender of last resort for governments of the Eurozone. Yet again, the proposition fails to properly identify the 145

problem. A central bank is a lender of last resort only for financial institutions, and mainly for banks, and not for governments. This is also an argument for why governments should not bail out banks.

Beside the huge risk of moral hazard that such action could cause, it would be the capitulation of such institution. It is not only for the risk of inflation, but for one main factor that keeps authoritative central banks is independency from governments. Concertedly, the fact that they are not the bank of government, and do not serve to finance political failures. In this context, the ECB should not engage in any bond buying under any circumstances.

The European Union, even because of its specificity, has an almost chronic problem with labor markets. First, the elasticity of European labor market lags behind, and here the benchmark is the US market as mentioned earlier. Europe needs consolidation, and the main factor of consolidation is not fiscal policy but with labor markets. In absence of monetary elasticities in case of shocks, the labor market is the only one that must absorb shocks, be symmetric or asymmetric. The EU labor market is rigid, not mobile and not easily adjustable. The labor market is crucial in EU's case because it is the device to be used for depreciation instead of currency depreciation.

Increasing competitiveness, freeing over regulated markets, reducing collective bargaining, reducing reliance on government, and introducing new laws that can allow companies to fire people easier and not to bind companies with their workers in a forceful marriage. Measures also should be taken when it comes to pension reforms. Taking in consideration life expectancy, life conditions and working conditions, retiring in mid 50s and working 7 hours per day is clearly not helping the society. Adding the fact that after retirement benefits are so generous, it turns out that it is better of retiring than working, especially in Greece. Meanwhile pension reform, as a part of labor market reform, would have to work in two fronts. First, enhancing labor utilization and second, taking in consideration the huge fiscal burden that the future has reserved for such government promises. Lastly, a pan European coordination of the tax code on wages would have been helpful in order to get rid of discrepancies created from national interventions that affect the labor market.

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Lastly, institutional reform includes a set of different issues within it. It includes political integration, market related reform, and the much-debated rating agencies. At union level is being created a gap between rules and obedience to them that is filled by moral hazard. Saying that, EU should not develop new rules or super-regulators that tend to overregulate, but new mechanisms that will work properly. Mechanisms to oversee fiscal issues, financial markets issues, and coordination among EU countries.

The absence of a fiscal mechanism has led the ECB to mix monetary policy with fiscal policy, even though it happened after unprecedented pressure. The problem with the EU institutional structure is that, EU lacks common goals and political unity. The union has an identity crisis that causes reluctance in decision-making. There is no will whether to integrate further, to go for a fiscal union, or stay still and improve the existing framework. The lack of leadership and vision causes a shortage in institutionalism.

However, with all imperfections markets have played a leading role in all developments. Beside speculation, markets have sent strong economic and political signals to bureaucrats in Europe.

There is no stronger signal than raising government debt rates three fold or more, and probably no such fiscal authority would have made something or at least created such urgency, or even toppled heads of governments.

To a certain extent, European bureaucracy has worked only in tranquilizing the market frenzy.

What is the best way to calm markets? If quenching liquidity thirst by ECB doesnâ&#x20AC;&#x2122;t work, and political assurance has the same effect, what to do else? It is almost five years now since the financial crisis started, and more than two since the debt crisis. Market unsustainability still prevails, but it is as frenzy as it was. At a certain point, the market reaction reached absurd levels, maybe it was intentional behavior, but the answer from EU politicians was somehow the same. Markets were waiting for a 'Godot', and EU officials promised one, either just to calm markets down, or to let of steam from the momentum that the frenzy had gained. For a good couple of years officials kept talking, kept gathering in summits and releasing press announcements, but they never delivered what markets were expecting, Godot never came. The medal always has two sides.

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Lastly, a very urgent and important need for reform is needed for rating agencies, and concertedly their business model and the role that they have in the system. The first and foremost problem is that rating agencies systemic power is mostly a result of regulation on banking, specifically of Basel II banking regulations. Unfortunately, banks, pension funds and other institutional investors are obliged to rely on their services because that is a necessity of doing business.

Credit rating agencies have a plethora of issues. The financial crisis proved that their rating methodology was deeply flawed. Such institutions not only wrongly rated financial instruments but also failed to timely correct their ratings. Then it came the debt crisis, which proved again that rating agencies not only were not rating but were caught off guard again. After their position in the business model was being questioned and their authority was tarnished, they woke up and started a business of witch hunting. After the wakeup call that came from Dubai, they deteriorated market perceptions with a series of rating downgrades in several European countries, contributing so to the frenzy that was building up. In a timeframe of five years this element of the financial architecture, failed systemically twice.

Another problem related with such agencies is their business model. Not only the fact that a handful of agencies control the whole world, but more importantly the fact that these agencies are paid by the same institutions that they rate. In other words, if you say to me that I am beautiful, I will give you $100.

What is more miserable with such agencies is the procyclicality that they create. During the financial crisis, accounting rules were blamed for the effect of 'rapid-fire sales' of assets that created downward spirals hence exacerbating the crisis. Actually, rating agencies did this during the ongoing public debt crisis, not only raising the panic related with sovereigns, but also with the European banking system. Their behavior is also unclear, when they have to do a downgrade and how. For example, Moody's investor service, declared that would delay by more than a month a decision whether to downgrade or not 114 European banks. The argument for this was that banks were operating in weak conditions and financing difficulties. The absurdity here is that it keeps on hold a decision that deeply affects bank's businesses and the Eurozone as a whole, while making public the outcome of that decision earlier. Again, in other words, we would have downgraded you, but we did not because we are sorry.

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However, when judging the rating agencies some, arguing for them, complain that shooting the messenger would not resolve the problem. Well, beside the fact that is plenty of evidence out there to prove that rating agencies might be whatever, but messengers. The only case that the justification of donâ&#x20AC;&#x2122;t blame the messenger can work is when judging speculators, and even in this case partly justifying their role. These institutions missed financial crisis, currency crisis, debt crisis, and Enron like crises, and these are disqualifying conditions of being a messenger. On the other hand, one cannot blame rating agencies for not predicting such crisis, because doing so would have been very unrealistic and economically absurd.

Rating agencies have an unjustifiable position within the system; additionally they have tarnished their own business model. The public does not believe in them anymore, and it is a low probability that governments are going to rely on them anymore, at least not the same way they used to. Strange enough is the fact that the complaint against such institutions is almost in unison, however the slightest action is taken against them.

In the view of this paper, their role in the system is exaggerated, not to say that is irrelevant at all. They absolutely should not replace the due diligence job that banks or investors should do prior to take decisions. As his or her failure proved, no one, or institution can look after the interest of the one concerned in the matter better than he or she can. In a worst-case scenario, such agencies should be as less relevant as possible, and in a best-case scenario, they should be out of business as long as they represent no benefit to the system. Until now, they have proved that do not make the system better off.

In conclusion, the imperative of all is political will. The creation of an identity for the European Union, that depends on where this group of countries is headed. The direction will deeply depend on visions that have to be drawn by a clear leadership that until now in Europe has not surfaced.

If such imperatives are to be set, the way for reform is paved and the common goal should always be sustainable growth and prosperity among European peoples.

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Conlcusions The research on this paper was carried out mainly in three different aspects. First, was identifying past financial, debt, and banking crisis, and analyze their causing factors, in order to determine if the ongoing European crisis was different at all from past crises or they had many similarities. Second, the research focused on European Union economic situation and the path that it followed since its creation, especially for some selected countries that evidentially indicate most of the symptoms of the disease. The third focal point was a treatment of the ongoing crisis from a political standpoint.

In relation with the first point, financial crisis history shows that crises are always a decisionmaking problem. In some cases, a mob decision making or a mass hysteria. Moreover, history also shows that whatever the bubble is, it is never related with the real economy. It is always related with a perceptional value of the economy or not even that in some cases. After fulfilling a sort of cycle, the crisis then affects the real sector, fact that is not fare and always not avoidable.

In relation with the second part of the research, the argument is build up on a well-known and heavily media used division of the European countries, which is the wealthy North and the troubled south. Evidentially, economic differences between wealthy North Europe and troubled South Europe are results of different political backgrounds. The south is teetering politically, where governments are incompetent to go through with reform and the social cohesion is put in question with frustrated people that vote every time more for extremist and populist irresponsible politicians.

In the picture that grasps the south part of the European horizon, Spain looks different, this maybe because of the fact that people gave the government a clear majority that made that able to take a full front war to existing economic conditions. The actual Spanish government has shown the right will to undergo this painful process. On the same front there is Greece, of which according to a late research among all European countries regard themselves as the most hardworking people of Europe, which is probably going to leave the Euro zone. On the other hand, there is North Europe, which in this case is represented by Germany, Austria and Netherland, and seems to weather the crisis very well in comparison with the rest of their European peers.

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Lastly, the third part of this research tries to make some points in relation with approaches taken and those to be taken. It argues that most of all this was a failure of values. Moreover, that because one can track failure from government, regulators, rating agencies, corporate governance, to banks orchestrating all this. It was as if the system was lubricated with greed.

Some claim that the system has a tendency to slide from equilibrium to unjustified booms or speculation.

Additionally, blaming the system does not make anything but tries to hide the effects of bad decision making and those accountable for that. Politics might be a 'dirtier' notion than economics, but in European Union case it has proved to be more effective because the number of governments toppled reached eight. If the same number had been true for bank CEO-s and regulators during the Great Recession all over countries, at least some moral results would have been visible.

Lastly in this point, the plain wrong approach is when asking from European wealthy countries to bare more and more of the troubles of their weaker peers. Meanwhile, after years in crisis, troubled countries find it impossible to reform the right way. Nevertheless, they find it morally right pushing for hazardous and parasitic measures that leave aside their responsibility and accountability.

To conclude, this paper challenges the view that the problem with Europe now is economic. If not all, most of it, is a political issue that bares European typicalities and expresses its divergences. In addition, the significance of this paper relies on the opinions put forward in it, and in authorâ&#x20AC;&#x2122;s knowledge, the different view on the topics discussed.

Summing up, the wrongdoing is blaming the system while at the end all remains human, all too human.

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