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8/3/2019 The European Crisis Deepens: Peter Boone & Simon Johnson
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N u m b e r P b 1 2 - 4 J a N u a r y 2 0 1 2
The European Crisis Deepens
P e t e r B o o n e a n d S i m o n J o h n s o n
Peter Boone is a principal at Salute Capital Management UK, nonresi-dent senior ellow at the Peterson Institute or International Economics,visiting senior ellow at the London School o Economics, and chairman
o Eective Intervention. Simon Johnson, senior ellow at the PetersonInstitute or International Economics since 2008, was previously theInternational Monetary Funds economic counsellor and director o itsResearch Department (200708). He is the Ronald A. Kurtz Proessor oEntrepreneurship at MIs Sloan School o Management (2004present).He is also a member o FDICs Systemic Resolution Advisory Committeeand the Congressional Budget Ofces Panel o Economic Advisers.
Note: Te authors thank the Institute or New Economic Tinking, theFord Foundation, the ERANDA Foundation, and the Smith RichardsonFoundation or support.
Peter G. Peterson Institute or International Economics. All rights reserved.
Te crisis takes a much longer time coming thanyou think, and then it happens much aster than you
would have thought, and thats sort o exactly the
Mexican story. It took orever and then it took a night.
Rudiger Dornbusch1
S u m m a r y
n Successive plans to restore condence in the euro area
have ailed. Proposals currently on the table also seem
likely to ail. Te market cost o borrowing is at unsus-
tainable levels or many banks and a signicant number
o governments that share the euro.
n wo major problems loom over the euro area. First, the
introduction o sovereign credit risk has made nations
1. Interview with Rudiger Dornbusch or Frontline Special on Murder,
Money, and Mexico, PBS, available at www.pbs.org/wgbh/pages/rontline/shows/mexico/interviews/dornbusch.html.
and subsequently banks eectively insolvent unless they
receive large-scale bailouts. Second, the ensuing credit
crunch has exacerbated diculties in the real economy,
causing Europes periphery to plunge into recession. Tis
has increased the nancing needs o troubled nations well
into the uture.
n With governments reaching their presumed debt limits,
some commentators are calling on the European Central
Bank (ECB) to bear the costs o additional bailouts. Te
ECB is now treading a dangerous path. It eels compelled
to provide adequate liquidity to avert systemic nancial
collapse, yet must presumably limit its activities in order
to prevent a loss o condence in the euroi.e., a change
in market and political sentiment that could lead to a
rapid breakup o the euro area.
n Five measures are needed to enable the euro area to
survive: (1) an immediate program to deal with excessive
sovereign debt, (2) ar more aggressive plans to reduce
budget decits and make peripheral nations hypercom-
petitive in the near uture, (3) supportive monetarypolicy rom the ECB, (4) the introduction o mechanisms
that credibly achieve long-term scal sustainability, and
(5) institutional change that reduces the scope or exces-
sive leverage and consequent instability in the nancial
sector.
n Europes leaders have mainly ocused on a potential long-
term scal agreement, and the ECB under Mario Draghi
is setting a more relaxed credit policy; however, the other
elements are essentially ignored.
n Tis crisis is unique due to its size and the need to coor-
dinate 17 disparate nations. We give our examples o
economic, social, and political events that could lead to
more sovereign deaults and serious danger o systemic
collapse. Each trigger has some risk o occurring in the
next weeks, months, or years, and these risks will not
disappear quickly.
1750 Massachusetts Avenue, NW Washington, DC 20036 Tel 202.328.9000 Fax 202.659.3225 www.piie.com
Policy Brief
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1 . T h e e u r o a r e a S La S T S T a n d
For over two years Europes political leaders have promised to do
whatever it takes to save the euro area. Yet problems are growing
and solutions still seem ar o. Te October 27 and December
9, 2011 agreements o European leaders ailed to change the
dangerous trends in Europes economies or markets. As gure 1
illustrates, the implicit risk o deault priced in sovereign bondmarkets reached all-time highs in the last three months. Te
trend is similar with bank deault risk. Te crisis is continuing
to get deeper, broader, and more dangerous.
A combination o misdiagnosis, lack o political will, and
dysunctional politics across 17 nations have all contributed
to the ailure so ar to stem Europes growing crisis. We start
by outlining our view on the main problems that are pushing
the euro area towards collapse. We then turn to potential solu-
tions (although we are very aware that the complexity o the
problems in Europe renders any solution questionable), and
nally we outline several actors that could trigger rapid nan-
cial collapse in the euro area.
2 . K e y S y S T e m i c P r o b L e m S i n T h e e u r o
a r e a
Within the complex sphere o Europes crisis, i we had to pick
one issue that turns this crisis rom a tough economic adjust-
ment into a potentially calamitous collapse, we would argue
it is the transormation o Europes sovereign debt market.
We outline this in section 2.1 and then discuss the economic
ramications in sections 2.2 and 2.3.
Figure 1 Five-year sovereign credit default swaps, January 2, 2006 to December 9, 2011
basis points
100,000
10,000
1,000
100
10
1
2006 2007 2008 2009 2010 2011
Source: Bloomberg.
Greece
Portugal
Ireland
Italy
Spain
SovX index
Belgium
France
Austria
Netherlands
Germany
Finland
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2.1 European Sovereign Bonds Are Now Deeply
Subordinated Claims on Recessionary Economies
In an earlier Policy Brie, we laid out the case that the euro
areas immediate problems, in large part, refect transition
rom a regime where sovereign debts were perceived to be
sacrosanct (risk-ree) to one in which investors perceivedthat sovereign deaults were possible.2 Neither investors nor
Europes politicians understood the ull ramications o no
bailout clauses in the Maastricht treaty until recently. With
the new risk premium needed to compensate or deault risk,
some European nations will need to radically reduce their debt
levels and change its maturity structure.
Te treatment o private investors in the upcoming Greek
debt restructuring has made it ever clearer that Europes sover-
eign bonds bear substantial risk. On July 27, 2011, the EU
Council o Ministers nally admitted that a Greek deault was
neededalthough to date they preer to describe this deault as
voluntary, reerring to it as private sector involvement (PSI).3By choosing a deault over bailouts, the politicians have de acto
inserted a new clause into all European sovereign bonds:
In the event that the issuing sovereign cannot
adequately nance itsel in markets at reasonable
interest rates, and i a sucient plurality o the EU
Council o Ministers/Eurogroup/ECB/IMF/the Issuer
determine it is economically or politically expedient,
then this bond may be restructured.
Soon ater this announcement it was apparent Greece
could not aord the proposed deal, and more unds would beneeded. At the summit on October 27, 2011, Europes leaders
announced that or Greek debt the PSI haircut would rise
rom 21 to 50 percent in order to provide these unds, while
the ocial creditors promised no additional unds specically
or Greece.4
Tose nonocial creditors holding Greek bonds learned
a new lesson: Tey are the residual nanciers to European
issuers when the troikas programs ail.5 Te Greek press
2. Peter Boone and Simon Johnson, Europe on the Brink, Policy Bries in
International Economics 11-13, July 2011, Peterson Institute or International
Economics, available at www.piie.com/publications/pb/pb11-13.pd.3. For the denition o PSI in the euro area context, see page18 in European
Financial Stability Facility(EFSF), available at www.es.europa.eu/
attachments/aq_en.pd.
4. At the July 21, 2011 summit euro area leaders called or 109 billion o
ocial assistance. On October 26 they committed to 100 billion o ocial
assistance. Te IMF did not provide any additional commitment in October.
5. Te troika is the inormal name given to the European Union, ECB, and
the IMF, which negotiates the terms o external assistance to Greece and othertroubled peripheral countries.
reported that the government was prepared to change laws
governing its bonds in order to orce nonocial creditors to
bear these losses. For nonocial creditors, a urther clause has
thus been eectively and implicitly inserted into European
sovereign bonds:
In the event o deault (i) any non-ocial bond holderis junior to all ocial creditors and (ii) the issuer
reserves the right to change law as needed to negate
any rights o the nonocial bond holder.
We should not underestimate the damage these steps have
inficted on Europes 8.4 trillion sovereign bond markets. For
example, the Italian government has issued bonds with a ace
value o over 1.6 trillion. Te groups holding these bonds
are banks, pension unds, insurance companies, and Italian
households. Tese investors bought them as sae, low-return
instruments that could be used to hedge liabilities and provide
or uture income needs. It was once hard to imagine thesecould ever be restructured or deault.
Now, however, it is clear they are not sae. Tey have
deault risk, and their ultimate value is subject to the political
constraint and subjective decisions by a collective o indi-
viduals in the Italian government and society, the ECB, the
European Union, and the International Monetary Fund
(IMF). An investor buying an Italian bond today needs to
orecast an immediate, complex process that has been evolving
in unpredictable ways. Investors naturally want a high return
in order to bear these risks.
Investors must also weigh careully the costs and benets
to them o ocial intervention. Each time ocial creditorsprovide loans or buy bonds, the nonocial holders become
more subordinated, because ocial creditors including the
IMF, ECB, and now the European Union continue to claim
preerential status. Despite large bailout programs in Greece,
Portugal, and Ireland, the market yield on their bonds remains
well above levels where they are solvent. Tis is partly due to
the subordinated nature o these obligations. De acto, i not
de jure, Europes actions have turned these bonds into junior
claims on troubled economies.
Once risk premiums are incorporated in debt, Greece,
Ireland, Portugal, and Italy do not appear solvent. For example,
with a debt/GDP ratio o 120 percent and a 500-basis-pointrisk premium, Italy would need to maintain a 6 percent o
GDP larger primary surplus to keep its debt stock stable rela-
tive to the size o its economy.6 Tis is unlikely to be politically
sustainable.
6. A 500-basis-point risk premium is consistent with an annual 10 percent risk
that something will trigger a decision to restructure and that there would be a50 percent mark-to-market loss on bonds under such an event.
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2.2 Crisis Spreads into Europes Core Banks and
Incites Capital Flight rom the Periphery
On August 27, 2011, Christine Lagarde, the managing
director o the IMF, shocked European ocialdom with a
speech decrying inadequate capital levels in European banks.7
She reerred to analysis by IMF sta showing that, i Europeanbanks were stressed or market-implied sovereign deault
risks, they were 200 billion to 300 billion short o capital.
Lagardes speech was courageous and the logic o her analysis
raised deep concerns.8 Tis was the rst time the IMF admitted
that sovereign deault risk needed to be taken into account or
the largest banks in Europe. Europes regulatory regime does
not require banks to have equity capital unding or sovereign
debtthere is no capital requirement, in banking jargonso
banks accumulated these debts over many years under the
assumption no additional capital would be needed. Tey must
now revisit those portolios to take account or capital needs
on risky sovereign debt.However, the IMF analysis o the capital needs to oset
this risk was odd. Markets price in a small risk o sovereign
deault, yet a major sovereign deault would be a large, discrete
event. Regulators need to decide: Sovereigns are sae, in which
case banks need little capital protection against sovereign
deault, or they are not sae. I they are not sae, then banks
need to accumulate adequate capitalraising their equity rela-
tive to total assetsto survive plausible sovereign deaults. For
example, Bank or International Settlements (BIS) data show
French banks in June 2011 had claims worth $109 billion (on
an ultimate risk basis) on Greece, Ireland, Italy, Portugal, and
Spain (GIIPS); i these nations were to deault on their sover-
eign claims, then French banks would surely experience large
losses on the entirety o this portolio while the repercussions
or Frances own economy would add urther domestic losses. 9
I sovereign deault risk is not removed, then banks need
nearly ull equity unding to cover plausible states o nature
where disorderly deaults do happen. Te lesson or banks is
7. Christine Lagarde, speech at Federal Reserve Bank o Kansas City coner-
ence, Jackson Hole, August 27, 2011, available at www.im.org/external/np/speeches/2011/082711.htm.
8. European politicians rst dismissed Lagardes analysis and later the
European Banking Authority revised down the needs to 114 billion. Tey
argued that the IMF ailed to take into account a potential rally in the price
o sae haven bonds, such as France and Germany, which banks hold on theirbalance sheets. We believe the analysis ar underestimates the potential capital
needs since it does not take into account the ull macroeconomic ramications
o sovereign deault.
9. Bank or International Settlements, able 9D: Consolidated oreign claims
o reporting banksUltimate risk basis, BIS Quarterly Review, December2011, available at www.bis.org/publ/qtrpd/r_qa1112_anx9d_u.pd.
clear: Tey need to reduce exposures to troubled nations and
batten down the hatches.
In addition, Europes peripheral banks are suering large
deposit losses as capital moves to saer nations. Figure 2 shows
the enormous capital fight that is occurring through the
banking sector across the euro area. Tese arget2 balances
show a cumulative transer o 440 billion rom peripheralnations to Germany rom early 2009 to October 2011. Were
it not or these implicit bailouts through the payments system,
the euro area would have already collapsed.
2.3 Macroeconomic Programs: Too Timid to Restore
Confdence or Growth
While it may already be too late to avoid extensive deaults,
we can still consider what needs to be done to reduce the
risk o deault. o avoid deaults and restructurings, Europe
needs to introduce policies that bring market risk premiumson sovereign (and hence bank) debts down. Investors need
to eel condent that, with a 2 to 3 percent risk premium, it
is worth the risk to hold onto several trillion euros worth o
troubled nations sovereign debts, as well as the much larger
nonsovereign debts.
In a nation with a fexible exchange rate, adjustment is
usually achieved with budget cuts and a sharp devaluation.
Since euro area nations have orgone their right to devalue,
they need to regain competitiveness through price and wage
cuts, while even more sharply cutting budget spending. In
essence, they need to increase volatility o their wages, prices,
and budgets i they are prepared to orgo similar changes thatcould be achieved through the exchange rate.
Te available evidence rom the outcomes o the troika
programs in Portugal, Ireland, and Greece, as well as the recently
announced budget plans in Italy and Spain, suggests current
policies will ail at this task. Tese programs all plan or gradual
reductions in budget decits, implying continued buildup o
total government debts, while partially substituting private debt
or ocial debt. In Portugal and Ireland the programs rely on
external nancing until 2013 when it is anticipated the program
countries will reenter markets to nance ongoing budget de-
cits and ever higher debt stocks at modest interest rates. In Italy,
optimistic growth assumptions help bring the budget to balancein 2013, but debt stocks remain ar too high. Spain announced
it would miss its 2011 budget decit target o 6 percent, raising
it to 8 percent. In Greece, budget revenue and GDP growth
orecasts are again proving too optimistic.
Any successul program must recognize the act that
appetite or periphery debt amongst investors will not recover
to precrisis levels, because deault risk is now a reality that
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was not oreseen prior to 2009 and because debt stocks are
now higher in the periphery. For example, Ireland is currently
running a budget decit measured at 12.5 percent o GNP.10
10. Irelands GNP is substantially smaller than its GDP. Due to its role as a taxhaven, many oreign companies have set up operations in Ireland, with a con-
trolling shell company located in a tax-ree nation, in order to take advantage
o Irelands regulations that speciy that the controlling owner, rather than the
resident company, is subject to tax. For this reason companies such as Google,Yahoo, Microsot, Forest Labs, and many others channel license revenues and
royalties through Irish subsidiaries. Tese royalties and revenues are in largepart excluded rom the tax base in Ireland. Tese companies would move i
Ireland changed rules and made such revenues taxable. Since the relevant con-
cept or scal sustainability is the taxable base, it makes sense that this shouldbe used to measure Irelands indicators. No other nation in Europe has a large
dierence between GNP and GDP. Te IMF regularly reported Irish GNP in
its sta reports but abruptly removed all reerence to GNP in the most recent
report. Tis raises concerns that the IMF is attempting to mask scal sustain-ability problems by not reporting these data.
Te troika program calls or that budget decit to all to 10.6
percent o GNP in 2012. Irelands stock o ocial debt will
reach 145 percent o GNP in 2013, while it also has contin-
gent liabilities to its banking sector that amount to over 100
percent o GNP. An investor looking at these numbers must
recognize there is serious risk o deault. Since market access is
highly unlikely, who will nance Ireland rom 2013 onwards?
A successul program must also take steps to quicklyimprove competitiveness. Figure 3 shows the change in
European unit labor costs within and outside the euro area. 11
Te only nation that shows moderate improvement is Ireland,
but this is largely a statistical arteact driven by the decline
11. Unit labor costs also include nontraded goods and are not a perect mea-
sure o competitiveness, but the general pattern shown in gure 3 appears tobe accurate. Germany has really diverged rom its European trading partners.
Figure 2 Net claims of national central banks on the Eurosystem
billions of euros
600
400
200
0
200
400
600
GIIPS = Greece, Ireland, Italy, Portugal, and Spain
Source: Eric Dor, The Enormous Loans of the Deutsche Bundesbank to Distressed European Countries Central Banks , Working Paper 2011-ECO-08, November 2011, ESEG
School of Management, Lille Catholic University, France.
GIIPS Ita
ly
Irelan
dSp
ain
Gree
ce
Portu
gal
Belg
ium
Fran
ce
Austr
ia
Slovakia
Cyprus
Slove
nia
Malt
a
Estonia
Finlan
d
Luxe
mbo
urg
Netherlan
ds
Germ
any
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o unproductive industry in the weighting.12 Italian Prime
Minister Mario Montis program includes no general wage
cuts.13 In Portugal, the government abandoned attempts to
engineer unit labor cost reductions through internal devalua-tion ater meeting political opposition. In Ireland, the Croke
Park accord prevents the government rom urther reducing
public-sector wages.14 Despite nearly two years o troika
programs, Greek unit labor costs have hardly budged.
With sovereign risk premiums rising, and capital fowing
out o the periphery rom banks while decits and compe-
tiveness improve little, it is not surprising that peripheral
economies are in trouble. Figure 4 shows a leading indicator o
12. Irelands nontraded goods sector is less productive than its traded goodssector (which includes companies such as Google that choose to report earn-
ings in this low corporate tax environment.) As part o the Irish recession, thenontraded goods sector has contracted while exports rom large multination-als have remained relatively robust.
13. See, or example, Alex Roe, Montis Measures or Italy, Italy
Chronicles, December 5, 2011, available at http://italychronicles.com/
montis-measures-or-italy.
14. See Harry McGee, Freeze on cuts ater Croke Park accord, Irish
imes, July 21, 2011, available at www.irishtimes.com/newspaper/ire-
land/2011/0721/1224301063698.html.
economic activity or Europes major economies and troubled
nations. A level below 50 o the Purchasing Managers Index
(PMI) indicates output is likely to decline in the uture. Tese
data present a bleak picture. It is no coincidence that a newmajor downturn started soon ater German politicians made
clear they were planning to let Greece deault. It is also clear
that the troika programs are ailing to restore growth.
Figure 5 shows the pattern o unemployment across
the euro area. Te stark contrast between Germany and the
periphery refects the dynamics o the crisis. Te strong core is
becoming stronger, while Greece, Ireland, Portugal, and Spain
have high unemployment. Italys troubles are recent, so with
a sharp recession beginning, we anticipate Italian unemploy-
ment will soon rise sharply too.
3 . S o Lu T io n S
Europe may continue to veer towards a major nancial
collapse. European economies are in decline due to capital
outfows rom ear o sovereign and bank deaults. Recessions
and continued budget decits only raise the risk o deault.
Macroeconomic adjustment programs are not strong enough
Figure 3 OECD nominal unit labor costs in total economy, 200311
index
140
135
130
125
120
115
110
105
100
95
90
Sources: Organization for Economic Cooperation and Development; Bloomberg.
Italy
Ireland
Spain
Greece
France
Germany
2003 2004 2005 2006 2007 2008 2009 2010 2011
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and do not refect the large measures needed given the lacko exchange rate devaluation. As the GIIPS decline, there is
serious risk that other indebted and heavily banked nations in
the euro area, such as France, Belgium, and Austria, could be
pulled into trouble themselves.
3.1 The Big Bazooka
Some analysts are now calling or a massive ECB-led bailout
to arrest sovereign risk and stop this dangerous trend. Te
general hope is that, i the ECB oered to massively nance the
periphery, investors would return to buying those sovereign and
bank bonds. Lower interest rates would give breathing space or
sovereigns to correct budget decits and banks to build capital.
o see how easible this is, rst consider the sums required.
Any bailout would need to unequivocally convince investors
that or several years these nations will simply not see serious
nancial problems. Tis means the bailout would need to have
enough unds to buy up a large portion o the existing stock o
risky sovereign debts plus nance those nations or, say, veyears. Te bailout must buy the debt, rather than simply re-
nance debt rollovers, since otherwise secondary market interest
rates would stay high. Te secondary market rates will determine
the lending capacity o local banks and their creditworthiness.
Te second bar o gure 6 shows the sums required to
purchase 75 percent o the outstanding government debts
o the troubled nations (leaving aside debt owed to ocial
lenders), plus nance their decits over ve years. In this base
case we assume troika programs are implemented and decits
decline gradually over ve years. Te total adds to 2.8 tril-
lion, or 29 percent o euro area GDP.
We then contrast this with alternative assumptions. In the
rst bar we assume a more rapid reduction in budget decits,
so that by 2016 most nations are near balance. In the third bar
we assume only a modest improvement on 2011 budget decit
levels.
Te last bar illustrates the dangerous risk acing the euro
area i a bazooka is employed and yet the troika programs
Figure 4 Manufacturing Purchasing Managers Index, 200611
index
65
60
55
50
45
40
35
30
25
Source: Bloomberg.
Octob
er200
6
Janu
ary20
07
April
200
7
July
200
7
Octob
er200
7
Janu
ary20
08
April
200
8
July
200
8
Octob
er200
8
Janu
ary20
09
April
200
9
July
200
9
Octob
er200
9
Janu
ary20
10
April
201
0
July
201
0
Octob
er201
0
Janu
ary20
11
April
201
1
July
201
1
Octob
er201
1
Germany
Spain
France
Italy
United Kingdom
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ail to restore growth and improve budgets. Here we assume
budget decits decline only modestly, and we calculate the
nancing needed to cover decits until 2020. Our negative
outcome implies nearly 5 trillion would be needed just or
GIIPS, something the IMF implicitly fagged when they
reported recently that Greece alone may need 500 billion
(one hal trillion) by 2020.15
Successul bazooka interventions oten occur when the
extra nancing is no longer needed, so that the nancing acts
as a backstop but is hardly used. For example, when Poland
launched its stabilization program in early 1990, the $1
billion stabilization und was never spent. Te US roubled
Asset Relie Program (ARP) was quickly repaid by almost all
15. Tis is a stress scenario in the IMFs debt sustainability analysis or Greece.
In our view, this scenario could reasonably be regarded as something closer toa baseline orecast.
banks. Tis is not possible or the euro area. Some euro area
nations have too much debt in the new regime with deault
risk. In the early days o such a program we expect large
purchases would be needed. Te ECB would have to drive
market interest rates down to levels where private creditors
would not be well rewarded to hold the debts. As the ECB
purchased the debts, private creditors would be urther subor-
dinated, and this would add to their desire to sell their bonds.
Tere are many reasons we believe such ECB bazooka
programs wont occur and are potentially dangerous to euro
area survival. First, while using the ECB balance sheet may
make such risks more opaque, any large bailout still poses
potential heavy losses or Germany and other healthy members
o the euro area. In the event there is deault in the GIIPS,
Germany would be responsible or 43 percent o the capital
needs o the ECB. Hence with a bailout und o 2.8 tril-
lion, Germany would be assuming 1.2 trillion, or 45 percent
Figure 5 Monthly unemployment rates for selected European nations, 200811
percent
25
20
15
10
5
0
Source: Bloomberg.
Janu
ary2
008
March
2008
May
2008
July
2008
Septembe
r200
8
Nove
mbe
r200
8
Janu
ary2
009
March
2009
May
2009
July
2009
Septembe
r200
9
Nove
mbe
r2009
Janu
ary2
010
March
2010
May
2010
July
2010
Septembe
r2010
Nove
mbe
r201
0
Janu
ary2
011
March
2011
May
2011
July
2011
Septembe
r201
1
Nove
mbe
r201
1
Spain
Portugal
Germany
Greece
Italy
Ireland
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o German GDP, in credit risk. Te Bundesbank and other
national central banks are likely to reuse.
Second, this measure on its own does not resolve competi-
tiveness problems or large budget decits in the periphery. It
would undoubtedly cause the euro to all but the benets o
euro depreciation are somewhat muted since Germany would
remain relatively competitive compared with the periphery.
Te periphery will still need aggressive scal and wage cuts to
improve their decits and competitiveness relative to Germany.
Tird, it would place the unelected ECB governors in a
political role they were never intended to play and were legally
orbidden to play according to the Maastricht treaty. Te
ECB could quickly become the largest creditor to peripheral
nations, and as their nancier it would ultimately need to
negotiate budget programs, wage cuts, and structural change.It may choose to relinquish those powers to the IMF, but it
would be the true power behind all these negotiations.
Finally, the bazooka could well incite an eventual crash
o the euro area. As gure 6 illustrates, i the ECB embarked
on a program to backstop troubled nations, observers would
quickly recognize that the potential sums needed to maintain
stability could be large. Our bad case scenario implies over
341 percent o the ECB monetary base and 46 percent o euro
area GDP might be needed. For markets, what matters are
the perceived uture bailout costs. Hence, an announcement
o a bazooka will lead to varying reactions in markets as the
perceived bailout needs rise and all. Investors could become
very araid i peripheral adjustment programs appear to ail
or bailout needs spread to more nations. Such concerns could
rapidly cause nancial-market turmoil and euro area collapse
(see section 4).
3.2 A More Comprehensive Solution
I the bazooka is unlikely and probably wont work, while the
status quo is ailing, what is an alternative? Te ocus needs
to be on returning the relevant sovereigns to solvency. Oncethe sovereigns are solvent, most commercial banks will have
breathing space to rebuild capital through operating prots
and retained earnings.
However, there is no easy means to achieve this. In our
assessment, the GIIPS will need to restructure their debts by
extending maturities and reducing coupons to levels that they
can aord. Tere is some scope or ocial assistance to oset
Figure 6 Possible bazooka needs under alternative defcit outcomes
billions of euros
5,000
4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
0
Sources: Bloomberg; International Monetary Fund; and authors calculations.
Good case to 2016 Base case to 2016 Bad case to 2016 Bad case to 2020
Spain
Portugal
Ireland
Italy
Greece
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Some analysts are now call ing for
a massive ECB-led bailout to arrest
sovereign risk and stop this dangerous
trend. We believe such ECB bazooka
programs wont occur and are potentially
dangerous to euro area survival.
the total costs o such restructuring by subsidizing debt swaps.
However, the Greek example suggests Europes politicians have
little appetite to provide more taxpayer unds or this purpose.
While preemptive restructuring seems attractive, the
needed extent and scope is unclear. Carmen Reinhart and
Kenneth Rogo argue that countries with no lenders o last
resort typically run into problems when debt levels reach 60
percent o GDP.16 Even i we assume advanced European
economies could manage more debt, it would not be higher
than the 90 percent that Reinhart and Rogo fag as a threshold
or developed markets. Such gures imply that greater than 50
percent writedowns o nonocial debt in Portugal and Ireland
may be needed, while Italian debt writedowns might be close
to 50 percent.
I the GIIPS ollowed preemptive restructurings, Europes
core banks, insurance companies, and pensions unds would
need substantial recapitalizations, and the costs o this could
draw France and other core nations into debt crises o theirown. Hence, any plan to preemptively restructure debts would
need to be applied careully across Europe.
Te second ingredient is a ar more aggressive program
to reduce budget decits and improve competitiveness in the
periphery. Tese nations need to be highly competitive i they
are to generate growth soon given the large risks overhanging
their economies. Tis requires large wage cuts, public-sector
spending cuts, changes in tax policy to attract investment and
business, and stable politics.
I these two steps were implemented, then a bailout
program rom the ECB would pose lower risks. Te debt
restructuring and measures to improve competitiveness wouldmean ar less unds were needed. Te ECBs role could be
to provide condence that stability would be maintained
16. Carmen Reinhart and Kenneth Rogo, Growth in a ime o Debt,
paper prepared orAmerican Economic Review Papers and Proceedings, January
7, 2010, available at www.economics.harvard.edu/les/aculty/51_Growth_
in_ime_Debt.pd.
a sensible central bank rolerather than to renance large
amounts o debt and decits.
While these steps would be a major improvement on
current programs, they are hardly likely to be implemented.
As discussed in section 2, the troubled nations have declined
to implement large budget and wage cuts. Political conditions
have prevented them. Meanwhile, creditor nations are claimingthere will be no more debt restructurings beyond Greece, and
at the same time the creditors are reusing to substantially
raise bailout unds needed to prevent high interest rates and
deault. None o this leads to a credible path out o crisis.
4 . P La yin g w iT h F ir e : w ayS T h e e u r o a r e a
co u Ld co m e T o a n e n d
Policymakers oten have trouble grasping the danger that
small tail risks pose to leveraged systems. As we discussed
above, a mere 10 percent annual risk o an Italian crisis isalready inconsistent with Italian long-term solvency. I Italy
has a disorderly crisis, how sae are French banks? And i
those banks arent sae, how sae is Frances sovereign debt?
Low-probability bad events can very quickly generate a wave
o collapse through leveraged systems.
Our concern is that, when compared with nancial crises
elsewhere, the potential triggers or a euro area collapse are
numerous.
4.1 A Unilateral Exit, or the Credible Threat o One
At a midnight press conerence on November 2, 2011 insouthern France, German Chancellor Angela Merkel and
French President Nicolas Sarkozy or the rst time entertained
the idea that a nation could leave the euro area. Merkel and
Sarkozy chose to take a hard line with Greek politicians and
their electorate: either complete the existing agreement or
leave. Te background to this threat was the tough politics
in Greece. Ater 18 months o large budget cuts and some
structural reorms, Greeces economy remains in decline.
Prime Minister George Papandreous government was weak,
and in a last desperate gesture he attempted to orce urther
reorms through by oering Greek citizens a reerendum with
an implicit choice o reorm or exit.
An exit rom the euro area can be orced in minutes. Te
Eurosystem only needs to cut o a national central bank rom
the payments system and prevent that nation rom printing
new cash euros. Once this is achieved, a bank deposit in Greece
would no longer be the same as a deposit in Germany, because
one would not be able to get cash or a Greek deposit and
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When compared with f inancial crises
elsewhere, the potential triggers for
a euro area collapse are numerous.
one would not be able to transer it to a non-Greek bank. O
course, the moment people understand such a change could
be imminent in their nation, they would run to their banks
and attempt to withdraw cash or transer unds. Tis is what
is now happening in Greece. Te country is losing 2.5 percent
o GDP monthly in deposits rom banks.17
Tere would be enormous, painul ramications or allo Europe i Greece or another nation made a disorderly exit.
Since there is no legal basis or exit, all nancial contracts and
indebtedness between Greek and non-Greek entities would
have uncertain value as the parties could dispute whether
these are to be paid in drachmas or euros. rade between the
exiting nation and the rest o the euro area would dry up. Te
mere act that a country did exit would have ramications or
the other troubled nations, most likely inciting urther capital
fight rom those nations and producing sharp economic
downturns. Tis in turn would question the viability o
Europes core banks and some o the core sovereigns. Te euro
itsel would probably weaken sharply, and currency risk
would be added into the euro.
4.2 The Weak Periphery Lashes Out against Germany,
while Germany Fights Back
Te political dynamics o crisis invariably pit creditors against
debtors, potentially leading to fareups that cause creditors to
give up. In Ireland, against strong popular opposition, the ECB
is orcing Irish citizens to take on urther debt in order to bail
out creditors o bankrupt banks. In Greece, Prime Minister
Papandreou was essentially ordered to revoke his planned
reerendum, while Greeces opposition leader was ordered to
write a letter promising he supported Greeces troika program,
despite the act that he clearly did not support it nor did he
participate actively in any negotiations to agree to it. French
and German politicians are also playing an instrumentalrole in supporting Italys new technocratic prime minister,
while they eschewed ormer prime minister Silvio Berlusconi
towards the end o his term. Meanwhile in Germany, bailout
17. Deposits have declined by 61 billion, or 24 percent o GDP, since spring
2009. See Bank o Greece, Aggregated balance sheets o monetary nancial
institutions (MFIs), available at www.bankogreece.gr/Pages/en/Statistics/
monetary/nxi.aspx.
atigue has set in as electorates and politicians turn against
more unds to nations that, they perceive, are ailing to reorm
suciently quickly.
While there are many outcomes o such discord, one
possibility is that it leads to a messy grab or power. Te
troubled nations already have the power to take over decision
making at the ECB. Tey may well usurp control in order toprovide much larger ECB bailouts. Tis would raise concerns
in nancial markets and could lead to rising long-term yields
on all euro-denominated debts. Germany would be orced
to pay more to nance itsel, and German savers would ulti-
mately be paying or the periphery bailouts through infation
and a weak euro. In Germany this would lead to rising calls to
leave the euro area.
Once there is a small risk that Germany could leave,
market prices or euro-denominated assets would again
change sharply. New risk premiums would need to be added
to national debts where nations are expected to have weak
currencies, while Germany and other strong nations might
see their risk premiums all even urther. Such changes would
reinorce the dynamics, outlined in section 2, where the core
nations continue to strengthen relative to the periphery, but
those changes would also be highly destabilizing or nancial
markets.
4.3 Economics o Austerity May Fail
Te third risk or the euro area is that economic, political, and
social realities eventually prove that the system simply cannot
work. Ater all, the euro area is a dream o political leaders thathas been imposed on disparate economies. Few nations sought
popular support to create the euro. Te German leadership
avoided a reerendum, and in France the Maastricht treaty was
passed with a thin majority o 51 percent. Marine Le Pen, who
is third in opinion polls or the spring 2012 French presiden-
tial election, is calling or France to leave the euro area and
reintroduce the ranc. Even though most European leaders are
highly committed to maintaining this dream, no one can be
sure what the costs are in order to keep it.
A plausible negative scenario is that those costs, in
the eyes o the electorate, eventually appear too high. Te
evidence to date suggests Europes periphery, even in a airlybenign outcome, will be condemned to many years or even a
decade o tough austerity, high unemployment, and little hope
or uture growth. A good comparison is the lost decade o
the 1980s in Latin America when nations hardly grew due to
the large debt overhangs rom unaordable debts. However,
those nations had the benet o fexible exchange rates, while
Europes periphery aces a more dicult period with uncom-
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petitive economies. Latin Americas problems ended only
when the creditor nations accepted large writedowns and debt
restructuring.
Another comparison would be the heavily indebted
United Kingdom during the 1920s when the government
managed policies to restore currency convertibility ater the
war. Britain suered with a weak economy or a decade, beoreending in the Great Depression, despite a booming global
economy throughout the 1920s. However, this too is not a
good comparison since Britain had ar more fexible wages and
prices than Europes periphery, with nominal wages alling 28
percent during the 192021 recession.
4.4 Markets Lose Patience
Our nal scenario is the most likely. Faced with the reality o
ailing adjustment programs, dicult politics, and rising risks
that one or more peripheral nations may rebel, or Germanymay rescind its support, investors may simply decide that the
cumulative risks mean the euro area has a moderate risk o
ailing.
I investors decide there is a low but signicant probability
that the euro area might ail, we believe Rudiger Dornbuschs
observation that crisis happens much aster than you would
have thought would be realized. Heres why: Te ailure
o the euro area will be a calamitous nancial event. I one
believes the euro might ail, one should avoid being invested
in European nancial institutions, and in euro-denominated
assets, until the outcome o the new pattern o currencies is
clearer. As a result, a large swathe o euro-denominated assets
would quickly all in value. Te euro itsel would cheapen
sharply, but so would the value o European bank debt and
European shares, and most sovereigns would see their bonds
trade o sharply. Tis in turn would make it expensive or
even the Germans to raise nance in euros. Despite their
impeccable credit record, they would be attempting to issue
bonds in what is perceived as a fawed currency.
A small risk o the euro breaking up would have great
importance or the euro swap market. Tis market is used
by Europes insurance companies, banks, and pension unds
to hedge their interest rate risk. A swap contract allows, orexample, a pension und to lock in a long-term interest rate or
their investments, in return or promising to pay short-term
interest rates to their contract counterparty. It is an impor-
tant market that underlies the ability o insurance companies,
pension unds, and others to make long-term commitments
to provide society with annuities, pensions, and savings rom
insurance policies. Te notional value o these swaps is many
times euro area GDP.
Te trouble is, the euro swap market could quickly collapse
i markets begin to question the survival o the euro. Euro
swap rates are calculated as the average interest rate paid on
euro-denominated interbank loans or 44 o Europes banks.
Approximately hal o these banks are in troubled nations.So the interest rate will refect both infation risk and credit
risk o the participating banks. I investors decided that the
euro may not exist in several years time, swap interest rates
would naturally rise because people would be concerned that
banks could ail and that the euro interest rate could turn
into something elseor example, the average o a basket o
new currencies with some, such as the Greek drachma, likely
to be highly infationary.
I euro swap interest rates start to refect bank credit risk
and infation risk rom a euro breakup, then the market would
no longer unction. A pension und could no longer use it to
lock in an interest rate on German pensions since it would not
refect the new German currency rates. Te holders o these
contracts would, eectively, have little idea what they would
be in a ew years time. Hence, investors would try to unwind
their swap contracts, while the turmoil rom dislocations in
this massive market would cause disruptive and rapid wealth
transers as some holders made gains while others lost. I the
euro swap market ran into trouble, Europes nancial system
would undoubtedly ace risk o rapid systemic collapse.
Tis example illustrates why a small perceived risk o
a euro area breakup could rapidly cause systemic nancial
collapse. Te swap market is only one mechanism throughwhich collapse could ensue.
On November 23, 2011 Germany was unable to sell
as many bonds as it wished.18 Te auction ailure caused an
immediate steepening in the German sovereign bond yield
curve. Some German ocials argued this ailure was due to
volatile markets, but there is a more undamental concern.
Germanys ability to pay low interest rates in euro-denomi-
nated assets requires the euro area be a nancially stable
region. oday, German yields remain very low and are not
at worrying levels. However, i these rates were to rise due
to ears o currency breakup risk, then the euro area would
quickly enter deep crisis as even Germany would have troublenancing itsel.
18. Paul Dobson, German Auction Disaster Stirs Crisis Concern,
Bloomberg News, November 23, 2011, available at www.bloomberg.com/news/2011-11-23/germany-ails-to-receive-bids-or-35-o-10-year-bunds-
oered-at-auction.html.
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5 . d r e a m S v e r S u S r e a L i T y
Tere is no doubt that European political leaders are highly
committed to keeping the euro area together, and so ar, there
is widespread support rom business leaders and the population
to maintain it. Tere is also, rightly, great ear that disorderly
collapse o the euro area would impose untold costs on theglobal economy. All these actors suggest the euro area will hold
together.
However, many nancial collapses started this way. A
ar more dramatic creation and collapse was the downall
o the ruble zone when the Soviet Union collapsed in 1991.
Argentinas attempt to peg its currency to the dollar in the
1990s was initially highly successul but ended when its poli-
ticians and society could not make the adjustments needed
to hold the structure together. Te Baltic nationsEstonia,
Latvia, and Lithuaniahave managed to maintain their pegs
but only ater dramatic wage adjustments and recessions.
More relevant, the various exchange rate arrangements that
Europe created prior to the euro all ailed. With the creation
o the euro, Europes leaders raised the stakes by ensuring the
costs o a new round o ailures would be ar greater than those
o the past, but otherwise arguably little has changed to make
this attempt more likely to succeed than the previous one. Small
probabilities o very negative events can be destabilizing. A lot o
things can go wrong at the level o individual countries within
the euro areaand one countrys debacle can easily spill over to
aect deault risk and interest rates in the other 16 countries.
Te euro swap market is based, in part, on interest rates charged
by 44 banks in a range o countries; about hal o these banks
may be considered to be located in troubled or potentially trou-
bled countries. I the euro swap market comes under pressure or
ceases to unction, this would have major implications or the
unding o all European sovereignsincluding those that are arelatively good credit risk.
At the least, we expect several more sovereign deaults and
multiple urther crises to plague Europe in the next several
years. Tere is simply too much debt, and adjustment programs
are too slow to prevent it. But this prediction implies that the
long-term social costs, including unemployment and reces-
sions rather than growth, attributable to this currency union
are serious. Sometimes it is easier to make these adjustments
through fexible exchange rates, and we certainly would have
seen more rapid recovery i peripheral nations had the leeway
to use exchange rates.
When we combine multiple years o stagnation with
leveraged nancial institutions and nervous nancial markets,
a rapid shit rom low-level crisis to collapse is very plausible.
European leaders could take measures to reduce this risk
(through urther actions on sovereign debt restructurings,
more aggressive economic adjustment, and increased bailout
unds). However, so ar, there is little political will to take these
necessary measures. Europes economy remains, thereore, in
a dangerous state.
Te views expressed in this publication are those o the authors. Tis publication is part o the overall programso the Institute, as endorsed by its Board o Directors, but does not necessarily refect the views o individual
members o the Board or the Advisory Committee.