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EU’s instability mechanism

by Hans-werner Sinn

MUNICH — By 2010, Europe was to be “the most competitive and dynamic knowledge- based society in the world.” This was the proclamation in 2000 by the European Commission in the “Lisbon Agenda.” Now, a decade after that bold pledge, it is official: Europe is the world’s growth laggard rather than its champion.

While current EU members grew by 14 percent over the past 10 years, North America grew by 18 percent, Latin America by 39 percent, Africa by 63 percent, the Middle East by 60 percent, Russia by 59 percent, Singapore, South Korea, Indonesia and Taiwan by 52 percent, India by 104 percent and China by 171 percent.

The Europeans wanted to achieve their goal through, among other means, further environmental protection and more social cohesion — desirable aims, but certainly not growth strategies. The Lisbon Agenda turned out to be a joke.

The European Stability and Growth Pact of 1995 has fared no better. EU countries agreed to limit their fiscal deficits to 3 percent of GDP to ensure debt discipline under the euro, so that no country could use the new currency to take its neighbors hostage and force them into bailout operations. In fact, the EU countries exceeded the 3 percent limit 97 times.

In 29 of these cases, the breaches were permissible under the pact’s original formulation, because the countries were in recession. In the remaining 68 cases, however, deficits above 3 percent of GDP were clear violations of the pact, and the European Council of Finance Ministers (ECOFIN) should have imposed sanctions. Yet not a single country was ever penalized.

The political debt constraints that the eurozone’s members had self-imposed were never taken seriously after that, because the sinners and the judges were one and the same. A subject worthy of Kafka and Moliere.

Indeed, this year, two countries, Greece and Ireland, were bailed out by the rest of the EU, even though Article 125 of the consolidated EU treaty stipulates that no member state is to stand in for the debt of another, a guarantee that Germany required as a condition for giving up its beloved Deutch mark. That doctrine of hard discipline was abolished in a coup in May 2010, when it was claimed that the world would collapse unless Germany opened its purse.

It is emblematic of the laxity with which the Stability and Growth Pact was pursued that Greece was able to join the euro through plain fraud, claiming that its deficit ratio was below the 3 percent-of-GDP threshold when it was, in fact, far above it. In view of Greece’s deceptive behavior, Eurostat, the EU’s statistical agency, declared that its Greek counterpart and the supreme Greek supervisory authority had “deliberately falsified” the data. But no matter, Greece was already in — and able to take its fellow EU members hostage.

Germany has now opened its purse, acting as Greece’s prime rescuer. Moreover, at their pre-Christmas summit, European heads of state agreed to amend the EU treaty by legitimizing the European Financial Stability Mechanism, now called the European Stability Mechanism (ESM), and making it a permanent institution.

Once back home, German Chancellor Angela Merkel, who had insisted for months that the facility had to be terminated, celebrated this as a victory over the rest of Europe. In fact, it was largely a necessary concession to Germany’s Constitutional Court, which had argued that the bailout measures lacked a proper legal basis. The participation of creditor banks, which had long been the condition sine qua non for Merkel, was downgraded to optional status.

The European Central Bank also lost its credibility. A year ago, it vowed to stop accepting BBB- rated government securities as collateral for its monetary operations. But that, too, went out the window in May, when it started buying even Greek junk bonds. Meanwhile, the ECB has announced that it will have to double its equity capital.

The EU’s maneuvers may stabilize Europe in the short run and help it to withstand better the current speculative attacks on some of the euro countries’ government bonds, but they risk long-term destabilization. While financial contagion today is limited to bank interaction, the EU’s measures have broadened the channels for contagion to include government budgets.

Indeed, the first step toward a potential chain of government insolvencies in Europe has been taken. The risk may be limited today, but it will become larger should the new ESM become full-coverage insurance against insolvency with no burden-sharing by creditors. In view of the foreseeable demographic risks from pension entitlements, a time bomb may now have been set ticking.

When politicians try to fight the iron laws of economics, they lose. This time is no different. But politicians are averse to academic advice. All too often, they prefer bad jokes — until the last laugh is on them.

Hans-Werner Sinn is a professor of economics and public finance at the University of Munich, and president of the Ifo Institute. © 2011 Project Syndicate