Ever since the eurozone crisis broke out in late 2009, European leaders have sought to reconcile two mutually incompatible objectives : the need to restore market confidence in the zone’s indebted periphery ; and the unbending refusal of creditor countries in the core to turn the zone into a ’transfer union’. The solution they have come up with - a ’grand bargain’ announced to great fanfare at their summit in late March - attempts to square the circle. But it is far from certain that the deal will succeed in restoring confidence in the periphery. It could instead increase political and economic costs across the Eurozone further down the road.
The grand bargain was supposed to be a deal between the eurozone’s thrifty core and its indebted periphery. Germany, Finland, the Netherlands and other North Europeans assented to the creation of a permanent and enlarged financial assistance facility, the European Stability Mechanism (ESM), to replace the current European Financial Stability Fund. In return, eurozone members submitted to a raft of new rules and procedures - a strengthened Stability and Growth Pact, a Pact for the Euro, European semesters, and so on - designed to ensure that they reform their economies and consolidate their public finances.
In reality, the grand bargain was a German-inspired framework rather than a hard-won compromise between core and periphery. Germany and other likeminded countries were largely successful in limiting their taxpayers’ liability for debt in the periphery. They shot down proposals in late 2010 to mutualise sovereign risk by launching a common eurozone bond. They insisted that the ESM should only disburse loans (on which it will earn spreads) if all countries agree, and on the basis of strict IMF-style conditionality. And they made sure that ESM loans would enjoy ’preferred creditor status’ (junior only to IMF loans).
The price for the establishment of the ESM was the imposition of much tighter constraints on domestic economic policy - not just during crises, but in peacetime too. The Pact for the Euro will require member-states to make ’concrete commitments’ on microeconomic reform (which the Commission will monitor). It will also hardwire German policies into those of other countries. All Eurozone member-states, for example, will have to copy Germany by implementing the EU’s Stability and Growth Pact into a “binding and durable” domestic law. And countries will have to do all they can to make sure that wages do not grow faster than productivity.
The grand bargain raises two big questions. The first is whether the German medicine being prescribed will succeed economically and restore confidence to the currency zone’s indebted periphery. The official German narrative is that the peripheral countries sank into debt because they lost ’competitiveness’ ; and that the way out of the crisis is consequently for the peripherals to become more competitive. A more plausible story, however, is that the eurozone as a whole is in crisis because huge intra-zone imbalances resulted in an epic misallocation of capital in the periphery - for which creditor countries do not want to pick up the bill.
No sane observer disputes that the peripherals, particularly in Southern Europe, suffer from deep-rooted supply-side weaknesses that their governments must urgently address. But programmes of budgetary austerity and supply-side reforms are unlikely to restore these countries to debt sustainability. If anything, some countries could fall further into debt traps : the need to service their debt with falling incomes will force them to cut spending even further, resulting in further contractions of economic activity and ever-deteriorating public finances. The medicine prescribed could therefore inflict huge pain without restoring fiscal health.
The second question is whether the medicine will succeed politically. The grand bargain tries to shift the economic, and hence political, costs of adjustment almost entirely on to countries in the indebted periphery. The economic pain they are being asked to absorb is extreme (Ireland, whose economy has already contracted by 15 per cent from peak to trough, is in a depression). The risks in the periphery are that governments will struggle to bear the strain ; that much needed reforms come to be associated with economic stagnation (or worse) ; and that hostility will grow towards EU institutions and the creditor countries.
Given the asymmetric nature of the grand bargain, one might expect its political consequences to be more muted in the creditor countries. However, ever since the Greek government announced that its predecessors had repeatedly misled the rest of the EU about the true state of the public finances, the dominant mood in the creditor countries has been one of Wutburgertum - a form of collective anger among the media, taxpayers and politicians at having been taken for a ride by foreign spendthrifts. Seen from Hamburg, Helsinki or The Hague, citizens in the thrifty core are being forced to ’write cheques’ to bail out feckless deadbeats in the periphery.
So the eurozone’s grand bargain could give rise to the worst of all possible worlds : it may do little to mitigate the mood of self-righteous resentment in the core, while placing citizens in the indebted periphery on an economic torture rack. The irony is that current policies are unlikely to prevent the countries in most difficulty - Greece, Ireland and maybe Portugal - from defaulting on, or restructuring, their sovereign debt. At that point, taxpayers in the core will find out they have to bail out their banks (because of their exposures to peripheral debt), while citizens in the peripherals will ask why they were forced to endure such pain.
Defenders of the grand bargain will argue that politics is the art of the possible - and that nothing more could be expected, given the constraints on governments in the creditor countries. The trouble is that the political window of opportunity could become narrower than it already is. It would have been better if countries in the core had had the courage to admit that creditors are not sacrosanct ; and that banks and savers in the core should not expect to be bailed out by taxpayers in the periphery.