The Union at Present
Motivation and description of bailout legislation and process
After years of planning and preparation, the euro party is in full swing and the currency recently celebrated its 10-year anniversary. While much pomp and circumstance ushered in the euro’s birth, the decade milestone passed quietly and the closest thing to fireworks last year was probably a Molotov cocktail at a protest. The drastic change in sentiment can be attributed to the ongoing euro zone sovereign debt crisis, which has dominated worldwide headlines for more than 5 years. Given the present situation, it is quite an interesting and unbelievable fact that initial Treaty legislation explicitly prohibited any form of shared debt burden or accompanying loan procedures.
Article 123 of the TFEU prohibits “overdraft facilities or any other type of credit facility with the ECB” while Article 125 further stipulates that the “Union shall not be liable for or assume the commitments of central governments… of any Member State.” This clause was intended to ensure that the “responsibility for repaying public debt remains national [and] thus encourage prudent fiscal policies at the national level” (Scheller 33). Meanwhile, Article 126 again reiterates that Member States must avoid “excessive government deficits.” Despite its founding principles, the EU eliminated these bailout prohibitions at the onset of the global financial crisis and established the European Financial Stability Facility, or EFSF, and the European Financial Stability Mechanism, or EFSM. Intended to be temporary, they may be superseded by the European Stability Mechanism, which would be a permanent addition to the Treaties, upon their expiration.
The sovereign debt crisis within the euro zone created the need for these various stability mechanisms. A currency union and the resultant subjugation of a nation’s monetary authority made the crisis inevitable because participating states did not simultaneously relinquish budgetary control. Members of the European monetary union “issue debt in a currency over which they have no control” (De Grauwe 7). Meanwhile, fiscal autonomy allows for variances among Member States in terms of taxation and social welfare, which creates a distinct conflict of interest when a State can exhibit blithe generosity towards its constituents without feeling cost restraint. This was an intrinsic flaw in the creation of the European monetary union, which has been exacerbated by ever-evolving and increasingly complex market transactions such as the securitization of longer-term government obligations like pension plans. Market instruments evolve with such rapidity that it is really shortsighted to believe they can be contained by legislation. Furthermore, this “implies that financial markets acquire the power to force default on these countries” (De Grauwe 7). The influence of financial markets is evident every time Moody’s, Standard & Poor’s, or Fitch downgrades the credit rating of a nation. The issues in the euro zone have been a near constant weight on the financial markets, but one must admire the creativity of market commentators in describing current conditions in the EU. Though it is essentially the same story of spending more than one earns, media outlets contrive new buzzwords such as contagion, market capitulation, and Grexit that typically undermine any fleeting positive sentiment in the market. By nearly forcing default on indebted nations in the euro zone, financial markets also influence political power as the region’s crisis has led to numerous leadership changes. This new leadership does not always take kindly to ECB intervention.
To understand how a country’s leadership specifically earns the ire of the Troika, another financially fashionable word that refers to the ECB, International Monetary Fund, or IMF, and European Commission, take the example of Cyprus. The small, scenic island was previously renowned for tourism and its tax haven status. Now it is known the world over for its banks taking depositors’ money and thereby a cautionary tale that exemplifies the need for the Treaty amendments related to bailout funds.
Case study: Cyprus
Cyprus joined the European Union in 2004 and the common currency area in 2008. The small island was already a prominent investment and corporate center of the world due to its low corporate tax rate and double taxation treaties with a number of other countries – notably with the former Soviet Union and current Russian Federation. Cyprus hoped to further capitalize on its position as an international business center by joining the common currency zone of Europe and it contributed a well-educated workforce with a high concentration of accountants and lawyers (Orphanides 2013).
Shortly following its union with the euro zone, presidential elections resulted in a communist victory with Demetris Christofias promising political unification of the island. It is important to note that his victory was not related to any economic policy.
The aforementioned rules that regulate admission and membership in the euro zone are not compatible with communist ideology and practice. The new Cypriot government essentially “took a country with excellent fiscal finances, a surplus in fiscal accounts, and a banking system that was in excellent health … [and] started overspending … [on] unproductive government expenditures. … [They also] raised implicit liabilities by raising pension promises and so forth” (Orphanides 2013). These excessive expenditures began to weather on international investor confidence, which culminated when Cyprus lost access to the international capital markets in May 2011 due to prohibitively high premiums on sovereign debt and an inability to borrow or raise capital. The island was in a precarious position because of the dominance of its banking sector and its high exposure to Greek debt. However, communist leadership declined to request aid from the ECB at this time because it did not want to make any accompanying structural adjustments.
In October 2011, the European Union Council decided to decrease the value of Greek bonds held by the private sector. All banks operating, and therefore holding debt, in Greece suffered. “For Cyprus, the write-down of Greek debt was between 4.5 and 5 billion euros,” which is substantial given that the entire country’s GDP in 2011 was $24.7 billion according to World Bank data (Orphanides 2013). Simultaneously, the European Banking Authority raised capital requirements. This caused severe liquidity issues, but again, Cypriot leadership declined ECB intervention in an attempt to avoid compromising its structural sovereignty. Furthermore, Cyprus still had no access to capital markets so the government could not raise public debt to compensate for the banks’ losses. Instead of attempting to aid the banks, leadership chose to attack the banks and blame them for the nation’s economic woes ahead of another election in 2013.
Athanasios Orphanides, governor of the Central Bank of Cyprus from 2007 to 2012, said propaganda ahead of the 2013 election claimed Cypriot banks needed as much as 10 billion euros. Though he believed this figure to be inflated, it nonetheless raised substantial concerns over Cyprus’s debt sustainability. The growing amount of debt led all three, major ratings agencies to downgrade Cypriot sovereign debt below investment grade in June 2012, which, according to ECB rules, “made the government debt not eligible as collateral for borrowing from the euro system, unless the ECB suspended the rules, as it had done for the cases of Greece, Portugal and Ireland” (Orphanides 2013).
Theoretically, the ECB could have simply suspended the eligibility rules again, but it chose instead to press the government into negotiations to determine a debt reduction program. Yet again, the stubborn communists refused to adopt outside influence so it took 9 months and another change in Cypriot leadership for the ECB and the island government to finally reach an agreement. Here, the Cyprus saga really starts to sound like a soap opera. At this point, the island had started to implement some of the required structural adjustments such as the privatization of wholly or partially state-owned enterprises and limiting public spending. However, as previously noted, Russian capital comprised a substantial portion of the deposits in Cypriot banks so negotiations with the ECB turned highly political. In Orphanides view, Germany’s leadership was motivated by upcoming elections and no politician wanted to be associated with an ECB bailout of the “Russian oligarchs” (Orphanides 2013). Consequently, Cyprus was essentially threatened or bullied into accepting the depositor ‘haircut’ that subsequently garnered so much media attention and sparked social upheaval on the island.
Cyprus sheds light on the numerous, inherent flaws in a monetary union comprised of sovereign nations. First and foremost is the misalignment of monetary and budgetary policy and the inevitable conflict of interest produced by this separation of powers. From an economic theory standpoint, the evolving bailout process of the euro zone has also allowed two troubling issues to develop: 1) moral hazard due to the failure of regulation, and 2) the principle of the tragedy of the commons.
Moral hazard is a byproduct of the bailout system as the ECB can be viewed as a lender of last resort. This has parallels to the banking crisis in the United States as the large banks came to be considered as ‘too big to fail.’ When the banks have the comfort of knowing that the Federal Reserve will not allow them to become insolvent and shut their doors, it creates an environment that encourages them to take on additional risks in their investment. There is a common saying that one must ‘risk big, to win big’ and of course an investment bank would do just that if it has nothing to lose in terms of capital or its ability to continue operations. As in communist Cyprus’s case, the conditionality of IMF and ECB loans is probably the only factor mitigating the moral hazard of the indebted nations in the euro zone.
Secondly, the tragedy of the commons is an economic scenario in which free access to a resource will inevitably and rather quickly lead to its depletion. When multiple parties have access to a shared resource, each acts in their best interest and thus maximizes their share of the resource with disregard for the resource’s efficient and sustainable allocation. In a way, this inadvertently occurs with ECB capital available for lending and exacerbates any notions of voracity an indebted Member State may possess. The ECB previously suspended its eligibility rules for Greece, Ireland, and Portugal, so it would almost be reasonable for Cyprus to expect similar treatment. Orphanides noted in his interview that Spain requested additional capital from the ECB on the same day that Cyprus finally asked for Troika assistance in June of 2012. With so many hands in the cookie jar, one is bound to come out hungry.
Related to these two concepts, is the fundamental economic assumption that an individual or entity always acts in its best interest. Every sovereign, democratic nation has the implicit obligation to serve its constituents to the best of its ability. For an example, a German politician elected by the German people obviously has the duty to serve Germany’s interests. Therefore, a successful union of any sort must be accompanied by a transition in mentality. Until said politician considers himself European first and German second, there is absolutely no chance for objective management of the European monetary union. Regardless of the complex system concocted for voting in the ECB’s Governing Council, it always boils down to the money in a capitalistic mentality. These tensions are evident in, and likely exacerbated by, media reports, which, for example, may depict a fat Greek relaxing on a beach while the dedicated automaker in Germany slaves away to support his lazy counterpart. Understandably, there was a plethora of economic analysis surrounding the creation of the euro zone, but perhaps analyses drastically underestimated the psychological impact of independent nations sharing a single currency. Nevertheless, currency union obviously happened and the only direction to move is to find a way forward.