Expectations about this weekend’s EU summit are low, but the issues on the table are momentous: How to support Central and Eastern European economies under stress; how to react in case of a crisis in a eurozone member; whether to launch joint government bond issuance; whether to allow rapid ERM2 entry of CEE countries. These issues will not be resolved by Sunday night, but we could get a signal of what progress we can realistically expect in the coming months. The financial and economic crisis is posing a powerful challenge to EU policymakers, exposing as inadequate several of the Union’s institutional features and rules. Commissioner Almunia noted that Europe is likely to suffer a longer recession than the US largely because of the lack of coordination in the policy response. This is tremendously embarrassing for EU policymakers who spent the first twelve months of the crisis congratulating themselves on the supposed greater resilience of their economies. This is a coming of age crisis for the EU.
The CEE region remains at the top of the agenda, and today’s announcement of a EUR24.5bn lending package by the World Bank, the EBRD and the EIB confirms that European institutions are firmly committed to supporting financial stability in the region. The money will go to finance banks, small and medium-sized businesses, infrastructure projects and trade finance. Hungary has already upped the antes, calling for a much larger financial aid plan, and the EU remains under pressure to offer a commitment substantial enough to allay concerns about the region’s external financing needs. It seems unlikely that we will see a concrete announcement of a wider financial support plan already this weekend, but the trend will remain towards a reduction of perceived systemic risk, in line with the arguments I outlined last week.
Markets will also be looking for clarifications on whether or not eurozone members would stand ready to bail out one of their own in case of need. While a default scenario for a eurozone member remains in my view extremely unlikely, the sharp widening of CDS and sovereign bond spreads have forced the issue on the agenda, triggering a series of contradictory statements by EU policymakers: German Finance Minister Steinbrück hinted that a sovereign bailout, if necessary, would take place, while ECB’s Stark countered that the no-bail out clause should be upheld.
Should a eurozone country run into financing difficulties, it would almost certainly be bailed out by the rest of the area rather than left at the mercy of the IMF—as recently indicated by German Prime Minister Angela Merkel. The process however would not be painless. With unemployment rising across the board, taxpayers in low-debt countries would be extremely unhappy to foot the bill for rescuing their profligate neighbors. At the very least, the rescue should be tied to policy conditionality aimed at restoring long-term fiscal sustainability. It seems unlikely, however, that this conditionality could involve immediate spending cuts or tax hikes, as such pro-cyclical tightening of fiscal policy would be counterproductive in the midst of a recession. But if the conditionality relies on future adjustment measures, I have serious doubts that it would then be enforced.
