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Another euro summit, but are things different this time?

Last Friday the European Union concluded its 19th summit meeting since the beginning of the euro-zone crisis more than three years ago.



The last meeting follows fast on the heels of 18 previous disappointing summits.

Before the summit, most economists and financial analysts had low expectations about what this summit could achieve. But they were surprised by the agreed package of policy measures from Brussels. The newly elected French President Francois Hollande told reporters, "We now have a coherent framework: a growth and job pact, banking union, budgetary union, a support mechanism, a will to extend economic and monetary union."

The market appears to share President Hollande's optimism, at least for the time being, that, for once, the European leaders have exceeded (admittedly low) expectations. Wall Street and major European stock markets surged and sustained levels following the meeting. The euro appreciated nearly 2 per cent against the dollar. Spanish and Italian long-term bond yields (borrowing cost), which edged towards 7 per cent before the summit, dropped sharply to 6.43 and 5.83 per cent respectively. The Asian markets had already closed when the announcement became public.

Will the policy agreement reached at the summit this time make a difference in terms of responding to the euro crisis? The short answer is a qualified yes. There is a change in policy direction - a new approach or breakthrough, as European Council President Herman Van Rompuy called it.

The policy debate among the leaders has been about two possible approaches: should policy-makers take short-term stability measures with growth to tackle the crisis; or should they limit themselves to long-term supply-side, structural reform with a conviction to expansionary austerity?

Up till this summit, the latter was a preferred approach. The difference, or breakthrough, this time is that there is an acknowledgement and agreement to consider short-term financial stabilisation measures to decisively address the crisis.

The European leaders agreed to adopt policies to stabilise the situation and "affirm that it is imperative to break the vicious circle of banks and sovereigns" in a short summit statement. First, they agreed to establish a single banking supervisory mechanism run by the European Central Bank. Second, they agreed that existing European Financial Stability Fund (EFSF) and European Stability Mechanism (ESM) funds can be used to directly recapitalise struggling banks, avoiding having to be funnelled through governments, and thus providing insulation between the banks and national debts and deficits. Additionally, EFSF or ESM will not gain "seniority status" (preferred creditor status) in case of debt restructuring.

The short-terms measures coming out from Brussels together with a willingness to be more flexible on growth and jobs represent a welcome change and may be a harbinger of more policy changes to follow.

Many policy-makers incorrectly insist that large government deficits caused the crisis. With few exceptions - besides Greece - this is not the case. Instead, the conditions for the present crisis emanated from excessive private-sector borrowing and lending, and overleveraged banks. The collapse of this bubble led to massive decline in output and tax revenue, and in some instances bailouts that were channelled through the government resulted in large budget deficits and debt. The large deficits are a consequence of the crisis, not its cause under the circumstances.

However, all these measures are short on details and remain to be worked out by a meeting of finance ministers on July 9. Moreover, Germany's parliament has to approve the new financial aid instruments and their use. All these may affect the initial optimistic reactions by the market. Whether the euro zone's muddling through will continue remains to be seen.

While the euro zone is searching for a consensus to respond effectively to the crisis, its potential contagion effects cannot be underestimated. Thailand will know the real cost of possible adverse contagion effects from her 1997 financial crisis. A recent IMF research paper, "Systemic Banking Crises Database: An Update", by Luc Laeven and Fabian Valencia provides timely estimates of the magnitude of real economic costs from systemic banking crisis: output losses (measured as the cumulative loss in income relative to a pre-crisis trend); fiscal costs (measured as direct fiscal outlays due to financial-sector rescue packages); and an increase in public debt. According to the authors, Thailand's cumulative output losses over the period of the crisis amounted to 109 per cent of GDP; fiscal costs 44 per cent of GDP; and public debt increased to 42 per cent of GDP.

This should be a reminder for our political leaders and policy-makers.


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