Focus on southern Europe – How financial players failed to spot the periphery’s fall

It is “astonishing” how little major financial markets players differentiated the creditworthiness of Europe’s peripheral nations from those at its core, given it was clear from the Eurozone’s birth that nation states, not Brussels, decided the “soundness of fiscal policy”, according to a leading German academic.

Professor Bodo Herzog, professor of economics at Reutlingen University, says insurers, ratings agencies and banks “failed to sufficiently differentiate the creditworthiness of euro area countries” until 2010.

And they did this even though “the existing shortcomings of economic governance within the EMU have been discussed since 2003”.

As a result of the sudden realisation, Herzog says, and the “abrupt reversal of sovereign yields [there has been] a situation similar to a bank-run in the euro area”.

Only now, as our series of online articles focused on southern Europe this week will show, are managers coming to terms with the fact that Athens was not Berlin.

But Herzog contends that even though the penalty system for breaching the Eurozone stability pact was “identified as too weak and the sanction scheme as too inconsistent”, Greece could still run, unpunished, deficits exceeding 3% of GDP and have debt above 60% of GDP.

But Herzog said in a paper on the Eurozone crisis, published in the online ‘global financial institute’ website of German asset manager DWS Investment, that policy makers “failed to demand the obligatory austerity measures”.

“Now, more than 10 years later and in the heat of crisis, policymakers are demanding such austerity. There is no doubt these measures are necessary, but they are far too late. EMU’s institutions and policymakers failed to create strong disciplinary incentives.”

In an unforgiving critique of the fundamental underlying the current turmoil, Herzog does not spare the finance industry, which largely treated debt from Greece the same way for risk purposes as it did as euro-denominated debt from Germany.

Writing his paper entitled The Euro Crisis and its Implications he said: “During normal times, financial markets – banks, insurance companies, and ratings agencies in particular – failed to sufficiently differentiate the creditworthiness of euro area countries.

“This is astonishing, since the legal and institutional framework of the EMU, including the assigning for the soundness of fiscal policy to national governments, has been clear since the beginning of the monetary union.

“The reasons for this partly ‘irrational’ market opinion on creditworthiness, apart from the clear lack of credibility of the no-bailout clause, are still unclear.”

The solution to the crisis is also unclear, in Herzog’s opinion.

“Given the fact the European Central Bank is the only institutional capable of acting in the short run, the unique institutional problems in the euro area are still unsolved.”

He calls the European Stability Mechanism “another step forward” but notes there are “several flawed incentives within the ESM procedure” – not least its size given Italy’s and Spain’s combined €1.1trn refinancing needs by 2013.

In the long run, he says, there are two options.

‘Centralisation’ would involve a fundamental change to the existing policy framework with transfer union (Eurobonds) and a common finance minister, budget and taxes, and relinquishing a “substantial part of national sovereignty over fiscal policy”. Germany’s constitutional court ruling recently eliminated this alternative.

The option of ‘decentralisation’ involves a de-politicised, rules-based framework “aligned with market forces and consistent institutional incentives” to encourage solid finances.

Combining both is likely to fail, Herzog argues.


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