Brussels came to the rescue yesterday. A summit of European Union leaders released a statement making it clear that they will stand in solidarity with Greece as that country comes to grips with its debt burden. This was the right thing for the EU to do economically, just as the recapitalisation of the banks was the right thing to do at the height of the 2008 credit crisis.
If Europe had stood aside as Greece defaulted, the panic would have spread to Spanish, Portuguese, perhaps even Italian, bonds. The entire eurozone could have unravelled. The debt markets reacted reasonably positively to yesterday's leaders' statement. The hope is that the interest rate on Greek debt will now come down, making it easier for Athens to manage its liabilities.
But it would be premature to declare the crisis over. The detail of EU aid for Greece will not be unveiled until European finance ministers meet next Monday. If investors feel the plan to be insufficient, the panic could yet restart. And if popular protests disrupt the Greek government's fiscal consolidation programme then all bets will be off. So what is the next challenge for Europe? Just as governments need to fix the banks that caused the credit meltdown, European governments need to address the imbalances in the eurozone that created the sovereign debt panic. The threat of bankruptcy did not constrain national government spending in the good times. A new version of the EU's Stability and Growth Pact is needed, this time with credible sanctions on national governments that do not fulfil their responsibilities.
But we must resist the assumption that this crisis is solely a result of fiscal profligacy by governments. It is true that Greece borrowed irresponsibly (and had deceived Brussels about the scale of its debts). But Spain and Ireland have come under pressure from investors too in recent months – and both had moderate public debt before the recession began.
In the decade after the formation of the single currency in 1999, the "PIGS" (Portugal, Ireland, Greece and Spain) experienced a boom fuelled by credit. Credit got out of hand because of relatively low European Central Bank interest rates and because international investors were prepared to lend freely to any eurozone country. The result was unbalanced growth across the continent. While inflation in Germany and France was subdued, there were considerable wage increases in Spain, Greece and Portugal. And their governments came to rely on bubble revenues from sectors such as property.
Then the credit bubble burst, leaving these same governments with massive revenue shortfalls and large deficits. They are also stranded with inflated labour costs, making their exports less competitive. And thanks to euro membership, they can no longer ease the necessary adjustment by allowing their currency to depreciate. Euro membership was a safe port in the storm of the banking crisis. But, as we are seeing, the pain was merely delayed.
Europe's leaders urgently need to turn their attention to promoting the integration of fiscal and labour markets across the continent. They need to grapple seriously with the question of how to deal with Germany's vast competitive advantage and a destabilising "one-size-fits-all" European interest rate. Otherwise, for the eurozone, this will merely prove a reckoning postponed.Reuse content