Fears that the European debt crisis might end up with Greece or other member states defaulting on their debt in a disorderly fashion have taken center stage in international financial markets a number of times over the past few years. These fears have triggered capital flight to what are perceived to be safer assets, e.g., US Treasuries, Japanese JGBs, and German bunds. As a result, long-term interest rates have dropped in major countries while corporate share prices have fallen around the globe along with commodities prices and sovereigns in emerging markets.
Every immediate crisis in the market has been contained by both central banks' actions and some political compromise between debtors and creditors. The central bank almost always steps in at a time of crisis by providing the financial system with liquidity. Central bankers during a financial crisis are something like fire fighters at the scene of a fire. While aware that their actions may create moral hazards, they cannot afford to sit on their hands as lenders of last resort. By providing ample liquidity, immediate crises can be contained or averted and the parties involved given time to make adjustments.
Both the market and the economy will nonetheless remain vulnerable to external shocks before adjustments to the fundamental disequilibrium underlying European economies have been carried out. You may associate a fundamental disequilibrium with the European debt situation, but I would like to emphasize the root cause of the financial crisis, which applies not only to Europe but also to the United States. In a nutshell, both Europe and the US are in a prolonged process of adjustment involving over-extended credit that fuelled housing bubbles in the US and southern Europe in the mid-2000s and then later burst. In this sense, the United Kingdom is part of Europe.
For one thing, the household sectors of these countries have lost a tremendous amount of wealth during the past five years. In addition, the large output gap darkens prospects for job and income growth. Superimposed on high unemployment is food price inflation, both of which have sparked anger amongst the poor in many countries around the world, from Arab Spring to a muggy summer/autumn in Europe, where people may take to the street again. Political instability tends to make necessary reforms politically unpalatable. In addition, people's anger is liable to create the political momentum to kill the animal spirit of entrepreneurs and bankers, which is in any case in short supply in a depressed economy.
Five years have passed since the credit bubbles burst, during which time large provisions and some write-downs have been made against non-performing assets. Yet sizable amounts of such assets remain on the balance sheets of financial institutions in Europe and the United States. The Japanese experience from the banking crisis of the 1990s tells us that as long as bad assets sit on banks' balance sheets, there is a significant degree of uncertainty over both cash-flows and profitability of banks, and as a consequence, banks tend to be cautious about extending credit. It is therefore a good idea to have banks dispose of their non-performing assets sooner than later in order to restore the functions of the banking system.
Not only the Japanese but Swedish and American episodes in the 1990s tell us, however, how painful this process can be. The negative feedback from asset sales, a decline in property prices, and an increase in non-performing assets have tended to create strong downward pressure on economic activity, which the then Fed Chairman Alan Greenspan referred to, at the time of S&L crisis, as a "fifty mile-per-hour headwind" to the economy. Given the present circumstances there is perhaps a hundred mile?per-hour headwind.
Compared to adjustment pressures in the financial system, the problem of European sovereign debt seems simpler. In recent years, many pundits have pointed to the single currency " the euro " as the cause for economic instability in the euro area. I don't deny the fact that the creation of the euro gave a wrong sense of the credit-worthiness of some European countries, thus feeding the credit bubbles that burst in 2007-2008. However, bubbles which had nothing to do with the euro also emerged in the US and UK during the same period. In my view, the hubris and complacency of central banks, amongst others, during the so-called Great Moderation period were the main factors behind the bubbles.
Leaving aside causality, some also argue that the euro leaves no room for exchange rate adjustments and that the gaps in productivity growth between Germany and southern Europe cannot be narrowed, so the system is thus unsustainable. I disagree! There are similarly wide gaps between Tokyo and rural regions of Japan within the single currency area of the Japanese yen and between California and, say, Louisiana in the US dollar area. The present instability of the euro area demonstrates not the lack of an adjustment process but the apparent weakness of political will to create a fiscal union.
If the euro area integrated its individual member governments' budgets, the aggregate budget deficit to GDP for the "Unites States of Europe" would be about two-thirds the deficit of the United States of America. The aggregate public debt to GDP is much lower in Europe than in America and the current-account balance of payments is virtually balanced for the entire euro area while America runs almost a $500 billion deficit per year.
A key question here is whether Germany and other creditor countries in the euro area are willing to transfer their tax revenue for spending in Greece and other debtor countries and also whether the latter countries are willing to accept the discipline that the former countries impose on their spending. In other words, it is the political will to go ahead with the idea of the United States of Europe, or what Jean-Claude Trichet called "quasi-federation," that will decide the sustainability of the euro system.
I believe there is a will to do so in Europe. Otherwise, the French would have voted for a more nationalistic president and the Greeks would have elected anti-euro leadership. A majority of Greeks still desire to stay in the euro area. Germans and Italians also seem to be determined to live with other Europeans, to say nothing of Benelux.
Reflecting such determination, some fundamental reforms are underway. In both Italy and Spain, labor laws have been revised for a more flexible labor market. In Greece, more than a hundred German tax officers are giving advice to Greek authorities. These efforts may not be enough to convince the jittery financial markets for the moment, but I am still hopeful of further such improvements to come.
Of course I am not so naive as to believe that any fiscal union will come about overnight. Rome was not built in a day! But an attempt for a partial fiscal union will, I hope, be made before too long. For example, European common bonds, or E-bonds, could be issued for the limited purpose of funding euro-area-wide expenditures such as infrastructure maintenance and EIB investment, for which 2 percentage points of VAT could be set aside every year. With such a small but clear step toward fiscal integration, the euro will begin to shine as the currency of a zone of stability.