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Published January 7, 2020

Image description: Greek Prime Minister Alexis Tsipras, German Chancellor Angela Merkel, and then-French President François Hollande meet in 2015.

         In 2009, leaders within the European Union realized that they had a major problem. First came the crisis in Greece, during which investors were shocked to learn that Greece’s debt and budget deficit were much larger than originally anticipated. It turned out that the Greek government had been manipulating its financial statistics to downplay the severity of its fiscal situation. In response to this revelation, Greek borrowing costs soared and Greek bonds were eventually downgraded to junk status. Then came the contagion: Greece’s financial woes fueled investor concerns about public finances in several other eurozone economies, namely Italy, Ireland, Spain, Portugal and Cyprus. As investors became wary of debt issued by these five countries, borrowing costs for these countries soared as well. Suddenly, one-third of the eurozone’s member states found themselves in economic trouble. In response to the crisis at hand, European leaders agreed to create the European Financial Stability Facility as a temporary backstop for European countries in financial trouble. Eventually, European leaders rolled out a permanent backstop, known as the European Stability Mechanism (ESM).

The European Stability Mechanism (ESM) is an intermediate financial institution designed to help eurozone countries in severe economic distress. Countries that find themselves unable to tap the market for funds can go to the ESM and receive a loan, provided they implement certain macroeconomic reforms. The ESM has a comprehensive lending toolkit and has the capacity to make a wide range of interventions, from direct loans to countries to primary and secondary bond market purchases to the provision of funds for either direct or indirect recapitalization of financial institutions such as banks. Thus far, the ESM has made loans to Greece, Ireland, Portugal and Cyprus, and has assisted Spain with bank recapitalization.

The European Stability Mechanism also does not loan out any taxpayer money, instead funding loans with money raised on the market through bill and bond sales. The European Stability Mechanism has approximately €500 billion available for loans and manages €80 billion of capital that was contributed by euro area countries. The capital is used to show investors that the ESM is backed by the eurozone’s strongest economies, and this allows the ESM to borrow, and then lend, funds at very good rates. Given that many countries in crisis must typically borrow at very high rates due to their credit risk, a country that can borrow from the ESM rather than issuing its own sovereign debt can save a significant amount of money.

The European Stability Mechanism became a key player in the European Union’s response to the crisis and has become one of the organization’s most important tools for helping countries in distress. However, the creation of the ESM was also crucial in addressing some of the weaknesses in the euro area’s structure. The euro is the currency used by 19 of the European Union’s member states, just as the U.S. dollar is the currency used in the United States of America. Yet unlike the United States, the eurozone consists of 19 sovereign states, each with very different economic policy needs. Furthermore, the European Union has historically lacked any infrastructure that would allow it to help individual states that had fallen on hard times. Thus, when the euro crisis began, the European Union was far from prepared.

Since the 1960s, European leaders had discussed the implementation of a common currency. However, the common currency regime that was set up in Europe had two main drawbacks, and both of these issues have made countries within the currency union vulnerable to economic crises. First, by definition, a common currency means a common monetary policy; in the case of the eurozone, monetary policy is the responsibility of the European Central Bank (ECB). This means that individual countries within the common currency regime lose the ability to influence interest rates domestically, and cannot devalue their currency to boost export competitiveness should they find themselves in a recession. (Mody 3) Ultimately, the common monetary policy within the European Monetary Union has hindered the ability of eurozone economies to adapt to economic fluctuations. This became an issue in the lead-up to the euro crisis; as countries in southern Europe slid toward recession, the ECB kept interest rates high to accommodate the needs of northern European countries, for whom recession was not a concern. 

In addition, the European Monetary Union has historically lacked any type of framework for fiscal transfers. This stems from the fact that European countries historically haven’t been able to agree on a common budget; thus, this framework was never created. As Ashoka Mody notes in his book Eurotragedy: A Drama in Nine Acts, “…Europeans set about creating an “incomplete monetary union,” one that had a common monetary policy but lacked the fiscal safeguards to dampen booms and recessions.” (Mody 3-4) In other words, should a state using the euro find itself in economic distress, no organization within the European Union would be able to offer the state financial assistance.

 Instead of creating a common pool of funds, European leaders attempted to mandate fiscal moderation through the Maastricht Treaty and subsequent agreements. The Stability and Growth Pact was added at the request of Germany in 1997. The Pact requires eurozone member states to keep their budget deficits below 3 percent of GDP and to keep their debt-to-GDP ratios from exceeding 60 percent of GDP. In addition, the Maastricht Treaty also includes a “no-bailout clause” that prohibits member states from assuming the debts of any other member state. The general premises of both the Stability and Growth Pact and the “no-bailout clause” make sense–fiscal profligacy among eurozone member states could quickly spell trouble for the rest of the block. However, neither agreement has achieved the intended effect; the Pact, for example, has been heavily criticized for being too strict and uncompromising. (Mody 144). Furthermore, the Pact has been poorly enforced since its inception–France and Germany were the first to break it in the very early 2000s, and the European Commission decided not to enforce any fines. Although the Stability and Growth Pact was meant to promote fiscal discipline in the euro area, the fact that it was not enforced rendered it virtually useless. It did nothing to stop high levels of spending and the accumulation of debt in eurozone countries. The “no-bailout clause” also failed with the onset of the euro crisis and the first Greek bailout, under which Greece received €73 billion from the International Monetary Fund (IMF) and other countries in the eurozone. Even though the Maastricht Treaty assured countries that they could never be liable for one another’s debts, this provision could not be upheld when crisis struck. 

As the euro crisis developed, European leaders found themselves ill-equipped to deal with it. They needed a solution—and fast. A Greek default would have been disastrous for the euro area, setting a dangerous precedent regarding the stability of European debt. Greece has been the most fragile EU economy by far, but Spain, Portugal, Cyprus, Ireland and Italy have been on shaky ground as well. Furthermore, debt yields in economically troubled countries began to rise as the euro crisis unfolded, making it more and more expensive for these countries to secure funding on their own. The European Union was thus in need of an institution that could help countries in dire economic straits, offering both funding and an opportunity to refinance their debts and therefore avoid exceedingly high interest payments. This institution first came in the form of the European Financial Stability Facility, which was a temporary backstop created in 2010. In 2012, the European Stability Mechanism took over the European Financial Stability Facility, becoming the European Union’s permanent backstop.

 The European Financial Stability Facility has made loans to Ireland, Portugal, and Greece, but has not made any new loans since the creation of the European Stability Mechanism. During the crisis, Greece was part of three bailout programs: the Greek Loan Facility in 2010 (under which Greece received €73 billion from the IMF and other euro area countries), the European Financial Stability Facility in 2012, and the European Stability Mechanism in 2015. In 2012, Greece began a loan program with the European Financial Stability Facility under which it received €141.8 billion, much of which is still outstanding.

 In 2015, Greece began a bailout program with the European Stability Mechanism. Between 2015 and 2018, the European Stability Mechanism loaned €61.9 billion to Greece at an average rate of 1.62 percent, about €5 billion of which was used for bank recapitalization. In return for the funds from the European Stability Mechanism, the Greek government implemented multiple reforms, such as a revision of the income tax system, an overhaul of the pension system, as well as a 25 percent reduction in the public sector. In August of 2018, Greece received its last disbursement from the European Stability Mechanism, marking the official end of the program. However, Greece’s adherence to the aforementioned reforms will continue to be monitored by the European Commission and the European Stability Mechanism. Greece is expected to pay back its loans in full between 2034 and 2060.

 The European Stability Mechanism is still a new institution and has yet to exercise all its capabilities. However, refinancing through the ESM has helped several countries mitigate the costs of financing their debt; Greece, for example, saved between €3 billion and €10 billion per year between 2012 and 2016 while working with the institution and its predecessor. The European Stability Mechanism was created to rectify a problem in the eurozone that treaties and agreements alone could not solve. The loans disbursed by the European Stability Mechanism have played a key role in assisting in the recoveries of euro area countries plagued by crisis. In 2018, the Meseberg Declaration issued after a summit between German Chancellor Angela Merkel and French President Emmanuel Macron expressed support for strengthening the European Stability Mechanism in the future:

 “The ESM should have an enhanced role in designing and monitoring programmes in close cooperation with the Commission and in liaison with the ECB and based on a compromise to be found between the Commission and the ESM. It should have the capacity to assess the overall economic situation in the Member States, contributing to crisis prevention. This should be done without duplicating the Commission’s role and in full respect of the treaties.”

European leaders have sought to reform the ESM within the past few years, and on December 4, 2019, the eurogroup of eurozone finance ministers held a meeting in which they discussed the future of the ESM. They agreed to continue pursuing key reforms that will allow the ESM to work more closely with the Commission in times of crisis, just as the Meseberg Declaration suggested. If these reforms succeed, they will contribute to a stronger ESM and a more resilient eurozone, helping to prevent debilitating crises in the future.

 

Additional (Non-Electronic) Sources

Mody, Ashoka. EuroTragedy: A Drama in Nine Acts. Oxford University Press, 2018.

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