An External Stability Pact for Europe

BERLIN – The current economic crisis has exposed two fundamental problems in the design of the European Monetary Union. The first concerns the sustainability of public finances in a number of euro-zone member states. Second, inadequate macroeconomic policy coordination has resulted in divergences in the international competitiveness of euro-zone members, threatening the very existence of the euro.

Countries whose public finances seemed fundamentally sound as late as last year have come under severe fiscal pressure. Ireland’s government debt is expected to rise to almost 80% of GDP by 2010, whereas just a year ago the European Commission projected that Ireland’s government debt would be below 30% of GDP. Likewise, whereas Spain was expected to decrease its debt ratio, its debt-to-GDP ratio is now likely to double between 2007 and 2010, to more than 60%.

The EU’s fiscal surveillance mechanisms failed to predict these developments because they neglect a crucial variable: the dynamics of private-sector debt. Given the high economic costs of a banking crisis, governments are likely to take on the liabilities of their financial sector when a crisis hits – as recently occurred in the United Kingdom and Ireland, and in financial crises in Latin America and Asia in the 1990’s. The same is probably true when key business sectors near insolvency. A country with sound public finances can thus become a fiscal basket case practically overnight.

Given the increasingly close financial and economic linkages between euro-zone members, rising government debt in even one EMU country can have serious consequences for all members, because no member state will allow another to default. Thus, EMU members indirectly share the liability for fellow countries’ private-sector debt, which for this reason should be monitored within the EMU’s surveillance framework.