Rebuilding the Euro or Disassembling the Union? Implications of the March 24–25 EU Summit

Despite the fanfare at the time of its unveiling in 1999, the euro was a flawed monetary project of inharmonious fiscal policies and dissimilar economies void of fiscal unity. At the time, the euro’s systemic flaws were masked by German creditworthiness and exploited by profligate periphery states. A decade after the euro’s triumphant entrance onto the global currency stage, these flaws have been fully exposed. Europe now faces a growing economic rift dividing the relatively prosperous north from an economically struggling south and periphery. The stakes are very high at this week’s EU Summit where European leaders will attempt to establish a “comprehensive” and lasting response to the euro crisis. But with the collapse of the Portuguese government and the reluctance of AAA-credit-rated euro-zone members (namely Finland) to place their creditworthiness on the line, it remains to be seen how unified the European Union can really be.

Q1: How has Europe responded to its most significant economic crisis?

A1: European leaders have been trying to cobble together an emergency response to the crisis for the past year, with uneven results. In May 2010, the European Union, the European Central Bank (ECB), and the International Monetary Fund (IMF) bailed out Greece with a €110-billion ($146.2-billion) loan package, good through 2013 and contingent on the implementation of stringent austerity measures. A €750-billion ($1-trillion) crisis mechanism was also created for future euro-zone members that might succumb to the enveloping crisis, of which €440 billion ($350 billion) was made available via the European Financial Stability Facility (EFSF), a euro-zone-created lending mechanism. Although in actuality, due to reserve requirements, only €250 billion was made available through the EFSF.

Seven months later, Ireland did succumb (after initially denying that it needed bailout funds), and the EFSF, along with the European Union and IMF, provided Ireland with an €85-billion ($110-billion) bailout package. Now, all eyes are on Portugal as international intervention is seen as a foregone conclusion, with Portuguese borrowing rates exceeding 7 percent (and having reached an unsustainable 8 percent this week alone).

The €440-billion question now is will Greece and Ireland be returned quickly to fiscal health or will the prescribed austerity medicine “kill” the economic patient? So far, it doesn’t appear that the prescribed bitter medicine is working: Greek and Irish bonds, despite bailouts, have retained untenable interest rate levels, recorded at 11.4 percent and 9.1 percent respectively in February. And tough austerity measures—government pay cuts, pension reform, and tax reform—have caused governments to shake and ultimately collapse and have elicited a series of violent demonstrations. Backsliding has already begun less than a year after the bailout: Greece has requested and received an extension of its payback period (from 3 to 7½ years) with a reduction of its interest rate by 100 basis points or 1 percent. Less than two months after receiving its bailout package and due to electoral promises, the Irish government is seeking similar relief from its borrowing costs but has yet to receive a positive signal from European leaders. Portugal’s government has collapsed, even before a looming bailout package has been requested. Simply put, democracy and austerity are now in direct conflict.

Recognizing that future bailouts will be needed and hoping to send a strong message to the market that Europe is able both to control and to get ahead of this rapidly deteriorating situation, European leaders have laid plans, to be further discussed this week and approved by June, to increase the EFSF to its full €440-billion ($615-billion) lending capacity and to allow it to buy government bonds on the primary market for those countries that have entered a bailout agreement.

Q2: Can Europe ultimately resolve this crisis? What long-term reform plans will European leaders lay out at this week’s summit?

A2: European leaders fully recognize the magnitude of the crisis and the need for a permanent emergency fund. Resolving the crisis politically however is an entirely different matter. Europe is working on a two-phased approach to the problem. Phase one consists of increasing the EFSF to its full €440-billion lending capacity and allowing it to buy government bonds on the primary market. It is believed that the first phase would be able to satisfy future bailout requirements until the EFSF ends its mandate in 2013. Phase two is the creation of a successor to the EFSF after 2013. Here is where the proposed solution becomes a bit dicier. The 17 states that comprise the Euro Group have established a post-2013 permanent fund called the European Stabilization Mechanism (ESM). Euro-zone finance ministers have agreed that the ESM would have a €500-billion ($710-billion) effective lending capacity, based on a core fund of €80 billion and euro-zone member pledges of €620 billion, and would provide loans at a lower price than those offered now through the EFSF. However, two groups of European countries have concerns about this second phase: the first group, consisting of the newest members of the euro-zone with relatively small economies, believe that they are being asked to provide more funds than the larger euro-zone countries, on a per capita basis; the second group, consisting of the six AAA-credit-rated countries of the euro-zone members (led by Finland), do not wish to place their future creditworthiness on the line. It is unclear whether or not this point of contention for the ESM will be resolved during the summit.

The central issue of how to keep other euro-zone countries out of future crisis is the most significant long-term policy question left unanswered. In February, Germany and France put forth a Pact for Competitiveness, a six-point plan aimed at greater economic harmonization among member states and the establishment of a debt alert and response system for future debt crisis detection. Though the pact was seen as the price for continued German financial support for the euro, euro-zone leaders recently agreed to a watered-down variation and renamed it the Euro Pact. The Euro Pact is intended to improve public finance sustainability, competitiveness, and financial system strength, as well as automatize sanctions—that in the past remained at the discretion of European leaders and were never implemented. The Euro Pact is expected to be formally adopted at the summit, but whether this pact will have teeth will depend entirely on commitment and sanctions enforcement once enacted.

Hanging on the success or failure of Europe’s plan to curtail its sovereign debt crisis is the future of European banks. The recently created European Banking Authority has begun a new round of bank stress tests that will review 90 banks in the coming months, but the tests will not account for bank exposure to potentially insolvent state credit and, therefore, are unlikely to restore banking credibility.

So, where does this all leave Europe and what is it to do? For the past 12 months, European leaders have been able to implement a muddle-through strategy that has allowed them to take important steps toward resolving the crisis with some—but not severe—political costs. That time has now passed. The clash of the electoral politics of austerity and the budget crisis are on full display in Dublin, Lisbon, Helsinki, and in Berlin with Sunday’s upcoming and very important German regional election in Baden-Württemberg. It is unclear today whether there is sufficient European leadership and public will to agree to take the economic castor oil that Europe must swallow.

Heather A. Conley is a senior fellow and director of the Europe Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Lucy Moore is a research assistant with the CSIS Europe Program.

Critical Questions is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

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