Policy Mistakes and the Euro-Zone Debt Crisis

In a pair of recent posts, Jeff Frankel brings some clear thinking to the euro-zone debt crisis. First he identifies three big mistakes made by European leadership that directly contributed to the crisis.

1. "Mistake number 1 was the decision in 2000 to admit Greece in the first place."
   
2. "The second mistake was to allow the interest rate spreads on sovereign bonds issued by Greece (and other periphery countries) to fall almost to zero during the period 2002-2007... [encouraged by the fact that] the ECB accepted Greek debt as collateral, on a par with German debt."
   
3. "The third mistake was the failure to send Greece to the IMF early in the crisis."

I completely agree with this list. I would possibly add a fourth big mistake, however: underestimating how the debt crisis has the potential to rock the foundations of the EU's political institutions, and as a result, allowing the default policy response to political indecision to be "close-our-eyes-and-hope-for-the-best".

In a new post today Frankel offers a sensible suggestion for the ECB going forward:

[I]t is not too late to apply the lesson of mistake number two: to adjust the ECB policy of accepting the debt of all member states as collateral. This is the policy that short-circuited warning signals that the private markets would otherwise have sent via interest rates during 2002-2007.

My proposal: The eurozone should adopt a rule that whenever a country violates the fiscal criterion of the Stability and Growth Pact (say, a budget deficit in excess of 3% of GDP, structurally adjusted), the ECB must stop accepting that government’s debt as collateral... the result of such a re-classification would be the re-emergence of sovereign spreads of moderate magnitudes, in between the extremes of the 2002-07 lows and the 2009-11 highs (see chart). The interest rate premium would send a message far more credibly, forcefully, and promptly than any warning that any Brussels bureaucracy will ever turn out.

This is a reasonable suggestion, and one that actually stands some chance of being adopted by the ECB.

Mistakes #1 and #3 will be far, far harder to find solutions for, however. What those two mistakes have in common is that politics trumped economics in each case. So the only real way to prevent similar mistakes from happening again will be to change the EU's institutions in such a way that decisions are no longer shaped entirely by political considerations, to the exclusion of serious economic and financial considerations. But given the fact that the EU (as well as the euro-zone) has at its heart always been a political creature, I wouldn't hold my breath for that to happen.