Gianpaolo Rossini - 03/ 2011

At the start of March 2011, ECB president Trichet announced a possible rise in interest rates in April. Less than a week later, Moody's, the American rating agency, downgraded public debt of Greece by three levels and in Spain by one level. On March 16, it was Portugal's turn to be downgraded by two levels to A3, with the likelihood of being further relegated to category B. Moody's is unpredictable, as the name suggests. But all it does is to calculate the impact of the announced interest rate increases on financial sustainability. Yet, only a few days earlier, the IMF issued a warning to the ECB to proceed with caution. The economic and financial outlook of the entire Western world, including Japan, do not allow reductions of the abundant liquidity provided by the central banks. However, ECB anxieties and Moody's bullets are taking their toll on the rates that Portugal, Greece and Euroland's ailing members are called upon to pay, making their financial exposure unsustainable. To make matters worse, this has prompted Standard and Poor's to downgrade Portugal's sovereign debt rating to triple B. That is a series of disproportionate responses leading to a self-generating spiral. Such is the scene surrounding the stipulation of new financial rules by Euroland members on the basis of agreements reached on March 12 and during the last weekend of March 2011.

A new pact for Euroland?
The deal struck on 25 March has a name: it is called the Euro Pact, a name which is designed to underscore the fact that the central problem is monetary union. The Pact established in March 2011 introduces a new set of rules and something like a European monetary fund, which will be called, somewhat cryptically, the ESM (European Stability Mechanism). The decade of the Stability and Development Pact thus comes to an end, and the Maastricht criteria are finally consigned to economic history. The Pact and related agreements focus on four areas.

New conditions for Greece
The first concerns the conditions attached to the loans to Greece and Ireland. The EFSF (European Financial Stability Fund), the sovereign debt bail-out fund set up by ECOFIN in the summer of 2010 and which will remain operational until 2013, has reduced the rate for Greece by 100 basis points (1%). The deadline for repayment has been extended to seven-and-a-half years. These measures, which were adopted as a result of the agreement, bring European intervention back into line with IMF conditions and prices. Conditionality requires the privatisation of real and financial activities of the Greek state of some 50 billion euros (around 45% of GDP). This represents a  degree of rigidity and invasiveness higher than that employed by the IMF in similar circumstances. Europe struggles to speak with one voice on a wide range of issues: when it succeeds it always overdoes things. Ireland sought better conditions. It was denied a discount because it refused to raise corporate tax now at 12.5%. Ireland's corporate burden is at tax-haven levels, which is unsustainable for a union. A gradual increase would do no harm, and Ireland itself would gain in financial stability and transparency, obtaining discounts and fewer sacrifices for its citizens, who are now burdened with the rescue of a comatose banking system. Just as the Netherlands changed its course on the free sale of light drugs, which turned the country into a hub for drugs' trafficking, Ireland would do well to gradually raise its corporation tax. It would benefit the quality and stability of the financial systems of both Ireland and Europe. But, unfortunately, we face an impasse.

Rules for public and private finances
The second area which is central to the Pact concerns the public finances of Euroland members. It comes as a surprise that fiscal policy continues to be the scapegoat for the problems that emerged in 2010 with the crisis in Greece and Ireland. There is a stubborn resistance to recognize that Ireland's crisis bears no relation to public finances, having been caused by the collapse of the banking system and the country's international exposure. Europe fails to shine even when it comes to interpreting events. The Euro Pact set an annual reduction grid of public debt. For the part in excess of 60% of GDP, public debt must be cut by 1/20 as of 2012. Substantial penalties shall be applied automatically by the Commission for those who fail to comply. For instance, a country with a public debt equivalent to 100% of GDP and a 4% nominal growth rate (2% real + 2% inflation) should have a public deficit of less than 2% of GDP. A country like Italy, with public debt running at 119%, can have a deficit of little over 1% as of 2012. Greece will need a public surplus. There is, however, one piece of good news. The EU Commission can take other parameters into consideration. Levels of private debt and foreign trade imbalances are two key factors in determining a country's financial sustainability. Where favourable to the country in question, these variables may mitigate the automatic sanctions imposed on the basis of the new pact. The decision will be made by the EU Commission. The fine consists of a non-interest bearing deposit equivalent to 0.2% of GDP, which is to be paid into the new ESM fund. The downside is that it amounts to international sanctions levied against a country by its closest partners. The seriousness of international sanctions is not to be underestimated. They cause conflict and international tension, and they undermine alliances. In a union which was created specifically for the purpose of saying "never again" to conflicts on European soil, it would appear to be out of place and fraught with risk. On a political front, they erode the Union's cohesion; economically, when applied, they complicate matters for countries which have already fallen victim to  financial distress. The spirit of Maastricht is still to be heard over the EU uttering a sad and unacceptable refrain. Why does the EU compulsively evoke sanctions, while the IMF never does? Unlike the IMF, Europe has recourse to regional funds. Reductions for countries that repeatedly violate the rules may be the way forward. But this must also be pursued with caution, because countries in dire financial straits cannot be flogged. Given its level of financial integration, the echo (contagion) of the blows would be felt even by the "healthy" partners. The positive aspect of the new regulation is the greater number of indicators required to determine a country's financial solvency. It is a partial measure, as it fails to specify precisely the weight of the indicators when applying sanctions to countries that fail to comply with the guidelines for public debt reduction. They acknowledge, albeit too late, the fact that public finances are only one part of the economic system of a country. The state of private finance is at least as important, if not more so, than that of public finance. The countries most deeply affected by the crisis over the past three years are suffering primarily from a condition of extreme weakness of private finance, namely the banking system and households. This is the case in USA, Great Britain, Iceland, Ireland, Portugal and Spain, all fiscally virtuous until three years ago, but exposed internationally owing to indebtedness in the private sector which was not compensated by virtue in the public sector. The new pact has finally taken all this into account, leaving behind the trite philosophy of Maastricht, which viewed the public sector as the only source of financial instability. It is to be hoped that this new perspective will be genuinely applied in the offices of the Commission.

THE ESM
The third area in the Pact has to do with the creation of the ESM, a financial institution akin to the IMF, with capital provided by Euroland members according to quotas that reflect those of ECB capital. It is a bail-out fund which puts an end to Maastricht's prohibition on saving countries. It will finance itself by issuing triple-A rated bonds, thereby indirectly satisfying the Tremonti-Juncker proposals for eurobonds. The fund may, for the time being, purchase  member state sovereign bonds only on primary markets, namely at auction. It cannot operate on the secondary market. This limitation is opposed by the ECB, which would prefer to trust on it in the event of countries running into sudden difficulties on the financial markets. The limitation will most likely be swept aside by events, like so many other cumbersome and pointless devices. The establishment of the fund set for 2013 marks a significant step forward for global financial stability. Its downside is that its bonds will end up marginalising the government bonds of the weaker economies, which will be overshadowed also by the seniority of ESM bonds. This may, however, lead to the fund acquiring greater scope and fully embodying the mandate envisaged by Tremonti and Juncker with the creation of European bonds.

Competition and the single market
The fourth area concerns competitiveness, especially that of countries at risk. A new chapter, therefore, but one that is also old and deserves to be opened with determination. Old because it furthers the development of the common market, which was established in 1993, but remains latent in certain sectors. The opening of Europe's internal borders is in fact a condition for all members to benefit from integration. The smaller countries are the first to suffer from even minor closures in the markets of the bigger countries. A small country is on an equal footing with a big country if it has equal access to the common market. If this does not happen, the temptations of fiscal free-riding are strong and reduce the financial stability of the whole of Europe. The novelty of the pact consists in the monitoring of competition policies by the Commission, since the weaker countries have ongoing deficits on the current account of the balance of payments, a clear sign of reduced competitiveness. The EU commission will keep an eye on salaries, investment in research and development, infrastructure, the liberalisation of markets that are still closed and public administration. It is one positive aspect of the pact, albeit largely the result of delays in completing a common market which is now twenty years old and suffering as a result of behaviour during the past three years of profound crisis which has very little to do with integration.  

Prospects
The Pact establishes new rules. They are neither simple nor pleasant. They are however the result of a less Manichaean view of the financial markets. They lay the foundations for Europe to make a significant leap forward, despite not being the best that might have been expected of the European authorities. There will be resistance in the more virtuous countries, where the media and political debate rarely, if ever, help the citizens to understand the extent to which Europe's countries are interdependent. Only when this is made clear and is reflected in the rules of cooperation will Europe become immune to the vagaries of citizen consultations, which are constantly being held from Lisbon to Vilnius and from Roma to Helsinki.

Gianpaolo Rossini (University of Bologna)