June 22, 2010

Reforming the Eurozone

The debt crisis in Greece exposes serious fault lines in the Eurozone, says Olivia Albrecht ’11.


A dual-degree student at Columbia Business School and the School of International and Public Affairs, Olivia Albrecht ’11 was drawn to emerging markets first as an associate in corporate international business development at Lockheed Martin and now as an investor in frontier and emerging markets. Her recent coursework has focused on sovereign debt crises in emerging markets over the past century. “Sadly,” Albrecht says, “once you learn the mechanics of one crisis, you realize that they all end up looking pretty much the same — including the recent U.S. financial crisis.” Here, Albrecht draws on her experience and research to propose recommendations for reforming the Eurozone.

Some have argued that Greece is likely to leave the Eurozone in the next few years unless it can achieve major fiscal reform. What does the recent crisis reveal about the vulnerability of the region?

The debt crisis and subsequent contagion fears have exposed serious fault lines in the Eurozone — and have undermined the economic development strategy of Eurozone convergence. Without reform, the Eurozone may be yet another failed economic development strategy, leaving a wake of sovereign debt crises in the region.

Although the Maastricht Criteria [also known as the euro convergence criteria] for entry into the Eurozone were once hailed as the ‘solid ground’ upon which to build strong and lasting emerging markets, today’s results suggest otherwise: Eurozone accession has actually increased risk exposure for emerging countries. Economists today wonder anew whether the developed world can effectively ‘supervise’ emerging market success.

Coined in 1989 by economist John Williamson to describe ten economic policy prescriptions for crisis-wracked developing countries, the Washington Consensus included fiscal discipline, infrastructure development, priority spending on healthcare and education, competitive exchange rates and liberalizing interest rates. What role does the Washington Consensus play today in solving emerging-market sovereign crises?

Unfortunately, these reform strategies suffered from major shortcomings. Without a focus on institutional reform, social policy and capacity building, reforms were unevenly and often haphazardly implemented. These deficiencies led several Washington Consensus reformers including Argentina, Russia and Ecuador into crisis in the 1990s and 2000s.

Years later, the establishment of the European Union and the Eurozone provided an opportunity to address the shortcomings from these failed policies. However, the Eurozone criteria already show a desperate need for improvement — and not just in the form of an historical bailout.

The Maastricht Criteria — the criteria for European Union member states to enter the third stage of European Economic and Monetary Union (EMU) and adopt the euro as their currency — requires prospective Eurozone members to adopt such economic, institutional and political reforms as the establishment of an independent central bank. Why are these reforms insufficient?

By 2009 — and as suggested by the recent crisis in Greece — evidence revealed that existing and prospective Eurozone countries were hit harder by exogenous market shocks than were their non-Eurozone neighbors. The economic and institutional alignment undertaken in preparation for the Eurozone accession led to heightened vulnerability for these countries by increasing export dependency, the risk of capital flight, higher euro-denominated debt, reduced fiscal flexibility and the elimination of monetary policy as a viable tool for economic stabilization.

In the preliminary process of Eurozone accession, many non-members borrowed heavily in Euros to minimize currency risk. But investor uncertainty as well as uncertainty among the domestic population led to severe domestic currency run-offs that caused strong currency depreciation, rising interest rates and increased credit defaults.

Under normal circumstances, strict fiscal discipline is a precursor for sustained economic development. But in a crisis, governments are unable to react swiftly with stimulus packages; their hands are tied. In light of the bailout and stimulus strategies to alleviate the woes of the crisis, it is not surprising that all Eurozone members and candidates are in violation of the criteria with more than 3 percent government debt to GDP ratios. Unfortunately, without material consequences for breaching the Maastricht criteria and with uniform complicity across the Eurozone, scant punitive motives exist to encourage the adoption of austerity policies — aside from market punishment.

If Eurozone members are even more vulnerable since they relinquished their monetary autonomy, what can be done now to stabilize the region?

The recent financial crisis has certainly revealed that coveted Eurozone accession actually increases risk exposure for these countries and fails to provide safety nets or crisis management mechanisms to support them through transitions and exogenous market shocks.

Reform of the Eurozone is desperately needed and must include greater centralization, stronger monitoring systems and more credible enforcement mechanisms — significant malfunctions of the current Eurozone structure. Moreover, they must include ex-ante policies for crisis management within the entire EU and support for transition countries en route to officially enter the Eurozone. Without such reforms, the Maastricht Criteria may be yet another failed economic development strategy — and the Eurozone experiment may be dissolved.

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