The European Debt and Financial Crisis: Origins, Options

by Nicolas Veron


Peterson Institute for International Economics
Congressional testimony submitted to the US Senate Committee on Banking, Housing, and Urban Affairs: Subcommittee on Security and International Trade and Finance
September 22, 2011

Thank you Chairman Warner, Ranking Member Johanns, and distinguished members of the Subcommittee for the invitation to appear at today's hearing. The European crisis is entering a critical phase as policy initiatives undertaken so far have not prevented systemic contagion. I will concentrate my remarks on the role of Europe's banking system in the crisis, the steps needed at the European level for the crisis to be resolved, and the short-term outlook.

I currently work both at Bruegel and the Peterson Institute, on a half-time basis in each organization, and divide my working time between Europe and the United States. Bruegel is a nonpartisan policy research institution that started operations in Brussels in 2005 and aims to contribute to the quality of economic policymaking in Europe through open, fact-based and policy-relevant research, analysis, and discussion. The Peter G. Peterson Institute for International Economics is a private, nonprofit, nonpartisan research institution devoted to the study of international economic policy. The views expressed here are my own and not those of the Peterson Institute or Bruegel. I have no financial or commercial interest that would create a bias or conflict in expressing these views.

The key points of my statement are the following:

• First, Europe's banking system has been in a continuous stage of systemic fragility since 2007-08, in contrast with the United States, where banking crisis resolution was swifter and was essentially completed in 2009. The inability of European policymakers to resolve their banking crisis so far can be explained by deeply-embedded features of their respective countries' financial systems and political economy structures.
• Second, the current phase, which is often described as a sovereign debt crisis, is really a sequence of interactions between sovereign problems and banking problems. Had Western Europe's banks been in a better shape a year and a half ago, the policy approach to the Greek debt crisis would have been entirely different, possibly allowing for a much earlier sovereign debt restructuring. So the situation is best described as twin sovereign and banking crises that mutually feed each other. The result of this interaction is a gradual contagion to more countries and more asset classes.
• Third, the crisis has exposed a major deficit of executive decision-making capability in the EU and euro area institutional framework, which helps to explain the insufficient policy response. It can thus be said that the banking and sovereign crises are compounded by a crisis of the EU institutions themselves. Specialized European bodies, primarily the European Central Bank (ECB), have partly bridged this gap with policy initiatives that go beyond a narrow reading of their mandate, but they could do so only to a limited extent that has not been sufficient to stop the contagion.
• Fourth, a successful crisis resolution will need to include at least four components at the European level, in addition to steps to be taken by individual countries: (a) fiscal federalism, i.e., mechanisms that ensure that fiscal policies in the euro area are partly centralized with shared backing across countries so as to meet the requirements of monetary union; (b) banking federalism, i.e., a framework for banking policy at the European level that credibly supports the vision of a single European market for financial services; (c) an overhaul of EU/euro area institutions that would enable fiscal and banking federalism to be sustainable, by allowing centralized executive decision-making to the extent necessary and by guaranteeing democratic accountability; and (d) short-term arrangements that chart a path towards the completion of the previous three points, which is bound to take some time. These should involve expanded instruments to intervene in the banking sector and to provide interim funding to struggling euro area governments, taking into account the possibility of insolvent member states having to undergo debt restructuring.
• Fifth, these requirements for crisis resolution cannot be met unless political conditions change sharply in their favor. This leaves the United States exposed to a risk of financial contagion, which it can partly mitigate with adequate contingency planning and proportionate precautionary measures. The United States can and should also continue to play a constructive role by providing advice to its European partners, and thus helping them rise to the momentous challenges they face. However, only the Europeans themselves can solve their current predicament.

I would not want these remarks to sound unduly pessimistic. In the US public debate, one frequently hears the euro area described as an inherently unsustainable experiment, and European nations as incapable of reform. Such dark depictions of the European situation are unhelpful and misleading. European monetary union is certainly an experiment, but it is not doomed to fail: Euro area countries have shown and are showing an extraordinary degree of political commitment to perpetuate their currency union. They have already taken very significant institutional steps towards more centralized economic and financial management since the beginning of the crisis, and are gradually accepting the need for further steps, even though the process is not as swift as external observers might wish it to be. Most euro area periphery countries have taken very serious and painful initiatives to reform and place themselves back on a sustainable economic track. And elections in many European countries since the start of the crisis have shown that the vast majority of citizens resist the temptation of populism and are willing to embrace the needed adjustment policies.

I personally believe that the integrity of the euro area will be defended in this crisis and that the European Union will eventually emerge from it with a stronger, more resilient economic and financial policy framework. But I also expect the road to be very bumpy, and that the Europeans will pay a high economic price for the inadequacies of their collective decision-making processes.


More