A Post-Mortem of the Euro Crisis

On a global level, the past year will be recalled as the year when the world economy began to recover from the crisis. Output and trade bounced back, unemployment stopped deteriorating and capital flows to the emerging economies resumed. Inflation also made a come-back, not least in China.

But 2010 will also be remembered as the year when the European crisis erupted. It started early in the year with emerging tensions on the Greek government bond market. By late spring, after a long sequence of disagreements, hesitations and half-backed responses, Greece was granted financial assistance by the EU and the IMF. Tension abated for a few months, only to resume in the autumn. In November, Ireland was the second country to file for assistance. As the year came to a close, spreads on Portuguese and Spanish bonds indicated persistent market concerns over the ability of Southern European countries to meet their obligations.

Throughout the year, policymakers in the rest of the world have reacted with increasing concerns to developments in Europe. While indicating support – sometimes, as for China, through actual bond purchases – they became more and more concerned about consequences for growth and repercussions on the other sovereigns' borrowing conditions. Furthermore, they wondered more and more about the medium-term international repercussions of the euro crisis.

It is too early to figure out what effects a yet-unfinished crisis will have. But a few consequences are already visible, or at least likely. I can count seven, which I will list in decreasing order of probability. 

1. Sovereign crises are not the privilege of developing economies. Since 1976, when the UK was forced to turn to the IMF, no advanced country had borrowed from the Fund. Initially conceived as a cooperative, it had become the rich countries' instrument to assist poorer ones (and lead them to introduce policy reforms). The programmes in Greece and Ireland bring us back to the basics. The IMF is, potentially at least, for all.
 
2. All government bonds carry risk. No advanced country has defaulted on its sovereign debt since World War II. The false assumption that securities issued by governments from this group of country were safe was made part of a series of regulations, including the banks' capital adequacy ratios. The truth however is that there is no such thing as a 100 per cent safe financial asset. Whether or not sovereign defaults will occur in Europe remains to be seen, but whatever happens, what the crisis has taught investors should price the corresponding risk.

3. There is now a template for combining regional and multilateral assistance. At the time of the Asian crisis, the G7 (that is, the U.S. and the main European countries) refused to let Asian countries create their own “Asian Monetary Fund” and insisted that any financial assistance be provided by the multilateral institutions. Asia was therefore looking at the European situation with interest (and a zest of irony): which standard would the Europeans choose for themselves? It did not happen without controversy, but in the end a clear choice was made. The IMF will be systematically involved in all future euro-area assistance to countries in trouble. The pattern of financing has also been set: one-third of the assistance will come from the IMF and two-thirds from European partners. This agreement provides a basis for defining similar arrangements in other regions of the world. 

4. For some time, the EU will again be forced to be more inward-looking. In 2011, the entry into force of a new EU treaty was supposed to close the twenty-five-years European integration cycle initiated in the mid-1980s. Consequently, the EU was supposed to become a more assertive and more effective international player. The euro crisis once again forces policymakers to turn inwards and to focus on domestic reforms. Beyond the current priorities for crisis management and governance reform (which are far from over), this is likely to apply to the next phase of economic and budgetary adjustment.

5. Economic policies in the U.S. and Europe are diverging. The crisis was a high mark of transatlantic cooperation within the framework of the G20, but divisions emerged already in late 2009-early 2010 on the strategy for exit. There are good economic reasons why the U.S. and Europe have different economic priorities going forward and this should not be interpreted as indicating refusal to cooperate. But the trauma of sovereign debt crisis has strengthened the European's resolve to enforce fiscal discipline at the same time the U.S. is launching a new stimulus package. The resulting policy divergence in policy philosophies is likely to complicate coordination at a time it is still needed.
    
6. Europe in the years to come will be more divided. The euro was meant to be a unifying factor. But the crisis implies that euro area enlargement will be slower. There is still momentum towards it, as indicated by the fact that Estonia is joining on first January 2011. But it will be slower, both because applicants are more cautious and because current members are less enthusiastic. There will also be in the years to come heightened economic disparities within the euro area. The Southern European members and Ireland have to struggle to restore budgetary sustainability and regain competitiveness vis-à-vis Northern European members. This is bound to be a protracted, painful, and politically divisive process.
  
7. The euro will be weaker in the short term, but there is potential for a stronger euro area eventually. In the short run the euro is paying the price of renewed doubts about its undeRPInnings and its future. Investors were shocked to discover how weak its surveillance system was, how uncertain provision for crisis management were, how much disagreement discussions about reform could elicit. They will for several years take the future of the European currency as less certain than previously thought. This will affect the potential for developing the euro as an international reserve and investment currency, with consequences for the composition of international reserves, portfolio allocation and exchange rates. Eventually, however, reforms in the euro area, if successful, are likely to have the opposite effect. Having successfully passed a major hurdle, the euro will be perceived as more solid.   

Jean Pisani-Ferry is the director of Bruegel, the Brussels-based economic think tank