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Eurozone crisis: light at the end of the tunnel?
At the fourth Eurozone summit in six months, on 8 December 2011, 26 governments of the European Union agreed on a strengthened regime of ex ante fiscal rules and decided to move some way towards joint fiscal governance in the Eurozone. The UK was not prepared go along. With their long-term focus, these measures could substantially alleviate concerns by some holders of European debt that the sovereign debt of some Eurozone member countries may be unsustainable.
The British government's decision to veto an amendment of the EU treaties at a time of acute peril for the Euro to pave the way for a revised fiscal framework raises several questions. First, what does this decision mean for the unity of European Union law? In particular, is it permissible to go outside the framework of the European treaties and achieve closer cooperation on a purely intergovernmental basis? What are limitations, if any, of such an approach? What role can the community institutions such as the Commission or the European Court of Justice, play in such an arrangement? Is the Schengen Agreement a model for the monetary and financial sphere? The final question is whether the British veto will fundamentally reshape the relationship between the UK and the European Union. Some commentators interpret this move as a precursor to a British exit from the European Union. Even short of the UK leaving the European Union, it is questionable for how long Eurozone governments will tolerate the financial capital of Europe to be located outside the Eurozone. Concerns of Eurozone countries would only grow should the UK decide to become an offshore financial centre vis-à-vis the Eurozone.
The political controversy following the British veto has obscured that, in the short-to-medium term, formidable challenges confront the Eurozone. First, many European banks remain undercapitalized, as highlighted in the latest round of stress tests by the European Banking Authority. No legal regime for cross-border burden sharing exists, both in terms of recapitalizing weak financial institutions and winding down failed institutions - long seen as one of the Achilles heels of the single market and European Monetary Union. Financial institutions operate on a European, or even global level, yet in death they remain national creatures. To negotiate ad hoc burden sharing ex post for large-scale failures of financial institutions does not appear to be a sustainable approach.
Liabilities resulting from risk-taking by European financial institutions in the formal and shadow financial sector from late 2008 onwards have migrated to public balance sheets - a primary cause of high levels of sovereign debt in countries such as Spain and Ireland. Risk-taking by private firms and households is the underlying reason for financial stress today. The Eurozone is experiencing a negative feedback loop, from sovereign debt back to private debt and back again to sovereign debt. This implies a need to break the potentially vicious circle in which the Eurozone is caught, and to restore investor confidence more generally with decisive, credible measures that enjoy broad public support.
Second, the European Central Bank has yet to give its unconditional backing to the Eurozone. At the latest ECB press conference following the meeting of the Governing Council on December 8 2011, President Draghi, in reply to a journalist's question about the possible demise of the Euro, gave only a guarded response. The ECB would be well advised to send an unmistakable signal to financial markets that it stands fully behind the single currency, and that it has further aces up its sleeves to shore up the Eurozone, without committing itself to large-scale purchases of sovereign debt. Investors would then think twice before entering into speculative bets on a break-up of the Eurozone, easing funding pressures on European sovereign and corporate borrowers and substantially reducing uncertainty.
Since mid-2010, the ECB has intervened with some regularity and in varying degrees through its Securities Market Programme (SMP) by buying sovereign debt of particularly affected states on the secondary market. The ECB's justification for such measure is that this intervention was necessary to safeguard the effectiveness of the monetary policy transmission mechanism in all Eurozone economies. The SMP is highly controversial, especially in Germany. Understandably, the ECB feels constrained by national sensitivities about the proper role of a central bank, maintaining its cherished independence vis-à-vis national governments. It is also keen to live up to its Statute, which rules out monetary financing of its member states. Finally, the ECB is concerned about debtor moral hazard. Countries that are facing increasing financing costs in international financial markets could relent in their efforts at structural reform should the ECB interfere in more substantial ways in sovereign debt markets.
Undoubtedly, more substantial intervention in the sovereign debt market would not sit well with the ECB’s mandate and potentially open the slippery slope towards monetary financing of governments. Abstract concerns about moral hazard should not, however, be the sole preoccupation of the ECB, condemning it to the role of a passive bystander in the Eurozone crisis. In certain circumstances, a doctor may need to administer a life-saving drug, even if it has potentially adverse long-term consequences that may be offset by other measures. The ECB cannot put the survival of the Eurozone (and its own) at risk on the altar of dogmatism. Central banks need to be pragmatic, especially in times of crises.
Third, sovereign debt markets of several Eurozone members remain fragile, despite the European Financial Stability Facility and increased IMF resources. Greece is an outlier, both in terms of the severity and the breadth of fiscal and debt challenges facing the country, its official financing need and the loss of international competitiveness. Yet the Eurozone so far has failed to draw a credible firewall around Greece. Debt volume in others members of the Eurozone do not compare unfavourably with other developed economies, such as Japan, the United Kingdom and the United States. The Eurozone's external position is sound, and there are no signs of a Euro currency crisis. Eurozone economies, taken together, are highly diversified.
However, questions about the durability of the European Union and the Eurozone hang like a Damocles-sword over the financing costs of two Eurozone governments - a point underscored by the decision of Standard & Poors to put a negative watch on all Eurozone sovereigns, including those six AAA countries at the beginning of December. Financial markets ask questions about the longevity of the Eurozone with increasing regularity. Eurozone policy makers, including the ECB, need to deliver a unified and clear message that their commitment to the Eurozone is unconditional, and end damaging speculation that the Eurozone is not here to stay.