Bailing Out Greece is Just the Start

If anyone wondered why the Germans ignored President Obama when he flew to Europe to plead for countries like Germany, which is by far Europe’s biggest economy, to devote more money for economic stimulus, the answer is that they saw this day coming. Today, the Wall Street Journal reports, not surprisingly, that Germany is preparing to lead a bailout of Greece in order to stem the tsunami of speculation that the Greeks could default on their government debt. While every country is theoretically responsible for its own actions and the European Central Bank (ECB) is prohibited from bailing out anyone, the reality is that these protections and the laughably named “stability and growth pact” long ago failed. Germany must bail out the Greeks, if only because it is in their economic interest, however there are broader issues which the Germans and the European countries within the Euro-zone should use this crisis to address. If they do so, they could take this catastrophic and expensive step and turn it into an event that ultimately makes the monetary union stronger.

The structure of the European Monetary Union (EMU) makes “free riders” likely. Its creators knew this and took steps to attempt to prevent countries from riding on the coattails of others success without contributing. Initially, the European Union created the “stability and growth pact.” This agreement theoretically requires all of the countries in the common currency to maintain a budget deficit of no more than 3% of GDP or else be subjected to extremely heavy economic sanctions, namely enormous fines.

The pact hasn’t worked. The first country to exceed the 3% of the GDP mark set by the “stability and growth pact” was Portugal. Faced with the possibility of severe fines, Portugal slashed public spending to reduce its deficit, however in doing so; it further exacerbated the economic crisis by pushing up the already high unemployment figures. Later, both Germany and France would surpass the allowed 3%. In both cases, the powerful nations pressured their fellow members not to enforce the agreement and both countries got their way. Despite a European court of Justice (ECJ) ruling, “the stability and growth pact” might as well not exist as it is almost never enforced by the member nations.

The EMU also has a “no bailout clause” written into its rules which theoretically ban any eurozone country’s banks from bailing out another country. Despite the “ban on bailouts” in EMU rules, this is equally useless at preventing the free rider problem from manifesting itself.

The current situation involving Greece has shown all of these “rules” to be as good as non-existent. The structure of the EMU is flawed and it needs to be reformed. The EMU has a central bank but lacks a central treasury. It also lacks a supranational body to monitor national banking systems.

These flaws must be remedied. To preempt the future possibility that a country like Greece should have to be bailed out again, the EMU should create something like the IMF to deal specifically with its own member states. This would ensure that a country strapped for capital and facing insolvency could borrow at reasonable rates. There is also a pressing need for a supranational body to set fiscal policy. The member states have done an atrocious job of coordinating their fiscal policies and it has become clear that a central treasury to set fiscal policy will ultimately be needed. This will be a thorny issue, but full monetary union cannot be achieved without real fiscal policy coordination.

Rather than spelling the beginning of the end of the eurozone, the current economic crisis presents a real opportunity to undertake the serious reforms necessary to improve the arrangement. While countries will be reluctant to surrender control of fiscal policy to a supranational European institution, the lack of coordination must be addressed and the best way to do this is to create a Central European Treasury. If Europe’s leaders truly believe in the European Project and they believe that one day Europe will become fully politically integrated, then they recognize that this step will have to be taken at some point down the road. They would be well served to expedite the process and begin to take steps toward creating a central European Treasury.