By Gu Bon-sung

After the bailout of Greece in 2010 the whole of Europe fell into turmoil with a series of bailouts and fiscal crises. Even in June 2012 the bailout of Spain amounting to around 100 billion euro caused concern about further contagion to major member states of the European Union.

The EU system formed through the Maastricht Treaty in 1992, had exhibited economic prosperity through implementing several measures targeted for economic growth, market integration and financial reforms before the global financial crisis in 2008. In particular, the Euro currency introduced in 1999 even rose to about 1.6 against the US dollar with expectations of the new hard currency high among the global financial community.

So, where did all those crises like those in the Euro system, the European Union and the fiscal crises of member states stem from? And will the Eurozone overcome the current crisis through ongoing efforts conducted in many ways, even unprecedented ways? Otherwise how will the EU find innovative alternatives to the current system? It may be the right time for us to review those actions already taken, currently discussed and that to be implemented in the future.

The Eurozone crisis is deeply rooted in three factors: macro-economic and international economics, the European internal market system and vulnerabilities in the financial market. First of all, the macro-economic factors hinge on the high levels of government debt ratio GDP and continued government deficit. The cumulative and, sometimes, chronic deficits at the government level could well cause a vicious circle sharply increasing levels of debt by requiring consecutive issuances of government debt. Especially, the fiscal deficits of the European countries are mostly related to discretionary expenditures such as medical services, pension benefits and educational subsidies, which caused heated debate over the cost of welfare and fiscal soundness in other countries.

Secondly, the internal market issue is largely due to the difference or the gaps in competitiveness, industry structure, and trade relationships with other member states. With higher trade exposure among member states, it would provide greater incentive for maintaining the current system and achieving stability in the currency system. Also at an institutional level, the EU has attempted to integrate all the market mechanisms through harmonizing competition, financial supervision and the labor market. In this respect, the degree of integration among the member states of the EU is still at a medium level and requires further effort in other aspects. The current fiscal crisis may require much harder and much more critical levels of integration since it may need both fiscal and financial arrangements such as fiscal consolidation, a capped ratio of government debt and stability of the government debt market. In other words, the current crisis in the EU may require determination and integrity from both social and political perspectives.

Thirdly, the financial requirements have evolved as the integration of the European government debt market and the inter-linkage of inter-bank funding markets were quickly formed, comprehensively and broadly. For instance, the interest rates of the government debt issued by the member states of the EU quickly converged and lowered, and that the holdings of government debts by the member states’ financial institutions sharply rose as well. The fast and sweeping integration of the government debt markets may require considerably more fundamental and long-term adjustment in terms of market structure and systemic stability through policy coordination at the global level including the United States and the International Monetary Fund (IMF). Yet, the financial requirements have driven policymakers to minimize short-term volatility and to protect the stability of the financial system first of all.

That is, the responses of the European policymakers to the crisis up until now mostly focused on financial assistance in terms of providing liquidity and imposing the conditionality tailored to the economic situation of the member state(s). The liquidity provision has been mainly made by the European Central Bank (ECB) through both short term-and long-term RP operations (LTRO) and purchases of government securities through the securities market programs (SMP). Also the bailout by the IMF imposed tight structural reforms so as to rationalize government expenditure. The reduction of government expenditure may drive down private consumption and lead to a further contraction of the whole economy which may worsen the future tax revenue and aggravate government deficit. Some worry that the tightening of government expenditure may lead to a region wide recession caused by sharp deleverage in the public sector. However, Germany and the Nordic countries including Holland persistently argue that the policy should focus on improving productivity and competitiveness in stricken member states through maintaining structural reforms.

Also, very recently there have been several new ideas to remedy the table such as bank unions, redemption funds, Eurobonds and a growth pact. The bank union consists of integrating bank supervisory agencies, a single deposit insurance corporation, or a resolution trust at the European level. The redemption fund is intended for issuing safe bonds up to a certain level of government debt to gross domestic product (GDP) ― say 60 percent ― and over that ratio the individual member states should finance their fiscal requirements. The scheme itself is intended to reduce the interest rate and to centralize government debt up to a certain level in order to maintain sustainability and confidence in the fiscal soundness of member states. The Eurobond is similar to the idea of the redemption fund since the former is issued as a form of common guarantee or bilateral guarantee among member states. All three schemes are basically intended for providing monetary subsidies in terms of the cost of interest and credit ratings. On the other hand, the growth pact focused on the expansion of the infrastructure investment, improving the tax bases and opening the labor market in order to improve competitiveness in the public sector and to strengthen internal structural reforms for a sustainable recovery. Ideas for structural reforms are in the same vein as the existing market reforms.

Could those new ideas focused on financial assistance and the European level approaches resolve the current crisis? It is somehow clear that short term assistance and the liquidity provision to the government bond market will be effective in stabilizing the short-term financial market. But the fundamental issues that the EU system has been facing are to stabilize long-term government deficit and to lower the government debt ratio to GDP, which will require long-term adjustment and reformulations. Until now, the crisis responses were too sweet to draw the incentives for structural reforms but from now on, they should focus on long-term structural improvement and long-term sustainability which require painful adjustment at least in the short term. Remaining uncertainty that the Euro system will encounter is whether or not there is willingness within member states to undertake costly reforms, without which the EU system may not last so long. If the internal structural reforms can proceed in the coming years, the EU system will be able to be more integrated and resilient and, hopefully, resume its intended role as a new hard currency zone.

Gu Bon-sung is a senior research fellow at Korea Institute of Finance (KIF).