CHAPTER 3
across emerging Europe often did not use all the tools at their disposal. The presumption that a convergence-driven “new Europe” was at hand led to complacency among bankers and bureaucrats. In several countries, deep output falls and a slow climb to recovery are the result. What lessons can be learned? First, fiscal policy should have done more to counterbalance private sector behavior, even though it was not the source of the imbalances across emerging Europe. To this end, boom-proofing public finance will require more determined action going forward, ranging from the discipline to save the revenue overperformance of boom cycles to, in some cases, a more deliberate effort to counterbalance private sector behavior—if not one-to-one, at least as a signaling device to avoid a buildup of vulnerabilities. Second, private finance has to be crisis-proofed. Macroprudential tools must play a greater role in the future, and nationally, they should be deployed to limit the buildup of vulnerabilities (even though the experience of countries that used these policies suggests that their effects are transitory, and thus might require frequent modifications). For example, many countries are now taking steps to improve credit quality, an area in which most countries did little in the years preceding the global crisis. In addition, at a supranational level, countries that are less financially and institutionally developed must have recourse to measures that could require special treatment within the single market―and still in conformity with the single market principles. The newer elements of the European financial architecture are, as a result of the current sovereign debt crises, likely to strengthen financial stability. But the initial conditions in the small, open economies at income levels much below the EU average may occasionally call for more proactive interventions. This remains an area for further discussion among EU members.
Helping markets deal with overindebtedness The debt challenges faced by Eastern Europe are different from those in the EU cohesion countries, yet the future of these countries is interconnected. Indeed, while at the time of writing the center of gravity has shifted toward Greece, Italy, Portugal, and Spain, spillover effects could still reach east given the interlinkages in Europe’s financial system. It is against this background that policymakers in emerging Europe have to assess whether a debt overhang threatens the recovery. This requires assessing how widespread the use of debt is, in particular among firms and households. It is worth noting that a debt overhang does not necessarily mean that governments should take over this debt. Removing institutional and structural bottlenecks that act as a disincentive to private debt restructuring efforts is the logical first step (even with no debt overhang). But in extreme cases, debt relief with public resources might be needed to strengthen coordination between debtors and creditors.26 These public actions, however, are not costless. By intervening, the public sector internalizes the economic implications of default that, in turn, could eventually weaken growth prospects.27 Moreover, just the hint of a debt relief intervention could lead to a lack of payment discipline (“debtor moral hazard”) or excessive risk-taking (“creditor moral hazard”; box 3.5).
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