10 QUESTIONS ABOUT THE EUROZONE CRISIS AND WHETHER IT CAN BE SOLVED

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1 UCL EUROPEAN INSTITUTE 10 QUESTIONS ABOUT THE EUROZONE CRISIS AND WHETHER IT CAN BE SOLVED Professor Department of Economics UCL 8 September 2011

2 The Eurozone crisis entered a new and dangerous phase in August. The three countries already in the bailout regime organized by the troika of the European Commission, the ECB and the IMF were small. But in August, the slow-down in the world economy triggered concern about the ability of the much larger economies Spain and Italy to remain solvent. This extension of the crisis to large countries was reflected in rising interest rate spreads on government bonds (above the rate on German long-term bonds) and falling prices for bank shares, revealing the interconnection of the fiscal and banking problems of the Eurozone. There is no simple solution to the crisis. Although the crisis only emerged in early 2010, its roots go back to the formation of the euro. One way of trying to make sense of the current difficulties is to address the following 10 questions: 1. What was the attraction of joining a single currency area for countries in the south and for those in the north of Europe? A single currency was seen as an important part of the European Single Market project to increase competition and with it, productivity growth in the European Union. In addition, for the countries that had struggled to control high inflation rates in the 1970s the move to a single currency via the European Exchange Rate Mechanism (ERM) offered the chance to acquire a credible inflation-targeting monetary policy. For Germany, the single currency was attractive because it meant Germany could operate in a large internal market where inflation-prone countries could no longer recover lost competitiveness through periodic devaluations. 2. Did it work? How did the Eurozone perform in its first decade, i.e. before the global financial crisis of 2008? The Eurozone s first decade from 1999 was widely viewed as a success and there were many celebratory events and publications, including by independent economists. The European Central Bank (ECB) more or less hit the target in terms of its policy objectives. It delivered low and stable inflation with GDP close to what was judged by the OECD to be equilibrium (an output gap close to zero, in the jargon). However, on closer inspection, the good average performance concealed differences in performance among member countries. For example, the countries in the centre of the Eurozone crisis from 2010 all had inflation rates well above the ECB s 2% target. On the other side, inflation was persistently well below 2% in the Eurozone s largest economy, Germany. Countries with higher inflation tended to have domestic booms (house price and construction booms) whilst Germany grew slowly. All of the countries in trouble in 2011 (in the order in which they have entered the crisis, Greece, Ireland, Portugal, Spain, Italy, 1

3 GIPSI) had current account deficits from This means they were borrowing from abroad to finance spending at home: for example, high German household savings financed housing developments in Spain and Ireland. In some cases, the borrowing from abroad financed private sector spending as in Ireland and Spain; in other cases it financed government spending (Italy) and in Greece and Portugal it financed both. Of course there is nothing in principle wrong with a current account deficit but it seems in retrospect that much of the spending private and public that was financed during the first decade was not based on a sustainable long-run ability to service the debt. Higher private and public consumption and wasteful construction projects were funded rather than investment in human capital and in productive projects that would produce higher income streams in the future. The imbalances in the Eurozone are in many ways a microcosm of similar imbalances that built up in the global economy over the same period. 3. Why did the global financial crisis cause particular problems for the Eurozone? Not only the ECB but the Fed in the US and the Bank of England were congratulating themselves on achieving low and stable inflation in the pre-crisis period; unemployment was low and growth buoyant. Economists referred to the two decades before the global financial crisis as the Great Moderation. The global financial crisis revealed deep problems in the banking system, including in European banks. Banks head-quartered in Eurozone countries were among those that became dangerously leveraged in the 2000s, i.e. they had borrowed too much as they sought to benefit from rising asset prices in what seemed to be a low-risk macroeconomic environment. When asset prices began to fall (initially in the sub-prime housing market in the US), banks found themselves in difficulty. Just as rising asset prices made financial institutions want to borrow more to profit from increased lending, when prices fell they sought to reduce their leverage. When many so-called highly leveraged financial institutions tried to do this simultaneously there were few willing buyers of risky assets (such as mortgages, mortgage-backed assets etc.) and prices fell further, exacerbating the solvency problems of banks. One of the first banks to fail in 2007 was a German one. In Ireland, the banks had become highly leveraged as their lending fuelled the construction boom and property price bubble. When banks were threatened with failure, governments stepped in to extend guarantees to retail depositors to prevent panic and classic bank runs. The ability of governments to raise taxation lies behind their role in a banking crisis. Governments use current and future taxpayers money to bail out banks. They do this because they believe the economic costs of allowing banks to fail are greater than the costs of bailing them out. But by doing so, they create a moral hazard banks will be less prudent if they know they will be bailed out. The tension between the costs of the moral hazard of bailouts and the costs of the alternative is a recurrent theme in the financial crisis and in the Eurozone crisis. 2

4 Many Eurozone banks were large relative to the size of the economy where they were based. This matters because although there is a common monetary policy, national governments retained responsibility for fiscal policy and for bank regulation and rescue. The financial crisis pushed banks into insolvency; in the Eurozone, national governments were responsible for preventing the collapse of their financial system; this led to increased fiscal deficits and to large explicit and implicit bank guarantees, which led to doubts about the solvency of governments. 4. How did the financial crisis morph into a sovereign debt crisis in the Eurozone? It is common for financial crises preceded by housing booms to lead to a build-up of government debt (Reinhart & Rogoff, 2009). In extreme cases, a sovereign debt crisis follows. A sovereign debt crisis arises when fears emerge in the financial market that a government is insolvent, which means it will be unable to repay the interest and capital on the bonds that it has issued. Ultimately, access to capital markets is closed off and the government is unable to roll over its debt as it becomes due. At this point, the government defaults. Sovereign debt crises are more common in emerging economies where governments have borrowed in foreign currency. The usual story is that there is a financial crisis, followed by a depreciation of the local currency and then a sovereign debt crisis because the government has bailed out banks and is running an enlarged budget deficit while revenue raised in local currency goes less far in paying the interest on government bonds denominated in foreign currency. Eventually the country runs out of foreign exchange and defaults on the debt, which means there is a restructuring so that holders of the bonds receive only a proportion of the face value. A sovereign debt problem does not arise in the same way in a country that has its own currency and where government debt is denominated in domestic currency. In this case, the most likely outcome is that the crisis is followed by a currency depreciation and the central bank prints money to fill the gap in debt servicing that remains after tax revenue has been used for the government s spending obligations. For countries in the Eurozone, the situation is more like that of an emerging country issuing debt in foreign currency (Boone and Johnson, 2011). Eurozone members do not have an independent currency and they issued government bonds in euros. Until the financial crisis, the market viewed bonds issued by the Greek government as very close substitutes for bonds issued by the German government. The chart shows that the interest rate differential between Eurozone country bonds became very small after Eurozone entry. This means that either the market viewed the likelihood that a Greek or Irish government would not honour its debts to be as improbable as a German government failing to do so or they believed that a Eurozone government would not be allowed to default. In other words, that there would be a bailout. Some Eurozone governments like Greece had large government deficits and high government debt before the financial crisis. Others like Ireland did not. But 3

5 in the latter, deficits ballooned when the crisis hit because they were faced with bailing out banks, paying higher unemployment benefits and receiving less tax revenue in the recession. Once it became clear that the underlying health of different Eurozone economies in the financial crisis differed markedly, financial markets changed their views about the bonds denominated in euros issued by different governments. Interest rate spreads widened sharply Interest rate spread over German bonds: 1990 Q Q2 10 Greece Spread over German 10-year bond yields, % Ireland Portugal Spain Italy France Q Q Q Q Q Q Q Q1 Source: OECD.stat As noted above, in a country with its own currency, in extremis the central bank can be compelled to buy newly issued government debt thus preventing default. Bondholders lose out but indirectly, via the inflation that accompanies currency depreciation. This is not the case for a Eurozone member where the issuing of bonds in euros means there can be a genuine problem of lack of liquidity because the Greek government, for example, cannot command the printing of euros. This is why fears of insolvency began to emerge. There is no cut and dried measure of government insolvency because it refers to what may happen in an uncertain future. One way of thinking about solvency is to calculate what the government needs to do in order to prevent the ratio of government debt to GDP from increasing every year. Financial markets attach importance to the idea that current fiscal plans, if carried into the future, will guarantee that the debt to GDP ratio does not rise indefinitely. The basic arithmetic is as follows. If the nominal interest rate the government has to pay on its debt is greater than the nominal growth rate of the economy, the interest payments due will be adding to total debt (the numerator) faster than growth is increasing GDP (the 4

6 denominator), thereby increasing the debt ratio. In order to prevent this from happening, the government must run a sufficient primary budget surplus as a percentage of GDP, i.e. its revenue must exceed its spending (excluding spending on debt interest). The calculation at any point in time has to take a view about the likely interest rate and growth rate in the future. It will also take account of the government s contingent liabilities related to bank rescues. Given the underlying problem of liquidity for a Eurozone member government, once financial markets began to see insolvency as a possibility for some members, fear drove up interest rates on their bonds, which made the calculation worse. In this way, a crisis can become self-fulfilling (de Grauwe, 2011). This helps explain why interest rates on Spanish bonds are higher than on British ones even though the UK s debt ratio is higher. Suppose that the objective economic conditions in Spain and the UK were the same in terms of the condition of the banks, the government deficit and debt at the outset of the financial crisis. The fact that Spain is in the Eurozone meant that destabilization through higher interest rate spreads made its position worse, and depreciation was not available to alleviate its plight. The financial weakness of European banks remains at the core of the Eurozone crisis. Ireland and Spain have to run substantial primary budget surpluses because of the direct and indirect effects of the banking crisis their governments neither ran deficits nor had high debt levels before the crisis. The absence of a pan-european solution to Europe s over-indebted banks has increased the scale of sovereign debt problems, extending the crisis beyond countries where governments had been profligate (such as Greece), shifted the burden from bank bond- and share-holders to tax-payers, and concentrated the blame on governments. Reasonably enough, German tax-payers object to bailing out spend-thrift governments elsewhere; they would have less cause to object if it was clear that these bailouts were supporting German banks; and they should welcome a serious European bank resolution scheme. 5. What has the ECB s role been in the crisis? The first role of the central bank is to deal with the liquidity crisis that arises in a credit crunch from the malfunctioning of money markets (when banks cannot borrow from each other). The second role is for the central bank to reduce the policy interest rate in order to stem the collapse in aggregate demand that follows as the financial crisis is transmitted to the real economy (from Wall St to Main St). The ECB did both of these things, which ended the credit crunch and eased the post-crisis recession. 5

7 The Maastricht Treaty was clear that the ECB should be independent of governments and not provide financing to governments. Governments could not require the ECB to print new money and use it to buy newly issued government bonds (i.e. to finance a budget deficit). The famous no bailout clause in Article 103(1) states: The Community shall not be liable for or assume the commitments of central governments However doubts about whether this would stick in a time of crisis and hence whether it would adequately discipline governments led to the incorporation of fiscal rules (the Stability and Growth Pact). (Issing, 2008: 194-5). The problems of fiscal indiscipline, including by Germany and France in the early years of EMU, were not reflected in penalty interest rates; and the possibility of irresponsible bank behaviour leading to a sovereign debt crisis was neglected. What has happened during the crisis is that the ECB has become more and more involved in actions that mean it is supporting a high moral hazard regime for both banks and governments (Boone and Johnson, 2011). It is providing liquidity to keep banks and governments afloat. It has become clear that during the period before the crisis when leverage ratios of banks around the world were rising to dangerous levels, the foundations for the high moral hazard regime in the Eurozone were laid. Highly leveraged European banks have large amounts of government debt on their balance sheets they were able to use these bonds as collateral in borrowing cheaply from the ECB before the crisis. This in turn made it easier for governments to issue short-term debt. In a situation in which market participants believed there was a benign macroeconomic environment, what seemed like purely technical aspects of ECB operations ended up contributing to dangerous levels of indebtedness of banks and of some governments. The ECB is now very aware of the interconnected vulnerabilities of the banking system and the fiscal position of many governments. Calls for private sector holders of government bonds to participate in the losses (to take a hair-cut) have an appealing logic. But in such a delicate situation, the attempt to switch from an implicit high moral hazard regime in which it was assumed creditors would be bailed out to the regime demanded by the Germans in which they are not, could produce a chaotic situation in financial markets. Any indication that a switch is likely (such as statements from German Chancellor, Angela Merkel or Finance Minister Wolfgang Schäuble) has been followed by heightened nervousness in financial markets and higher interest rate spreads on the government bonds of the troubled Eurozone members. This helps explain why the ECB opposes burden-sharing with the private sector. The ECB s diehard support for continuing the bailout regime (expressed in ECB President Trichet's phrase in June of no defaults, no credit events, no selective defaults ) appears to contradict the famous no bailout clause. In a limited sense there is no contradiction because the ECB is not providing finance directly to governments (it is buying bonds in the secondary market) but its actions to prevent default contravene the spirit of the no bail out clause. Nevertheless, this makes perfect sense when the fragility of the interconnected banking, sovereign debt and central bank system is recognized. 6

8 6. What is a transfer union and why is it believed to be part of the solution by some and opposed vehemently by others? Some proponents of European monetary union always saw it as part of a longer-term project of fiscal or political union. In other words, the idea for some was that eventually, there would be a European government with tax raising and spending powers with a role similar to that of the federal government in the USA. In a system of this kind, the federal government plays a stabilizing role when different parts of the federal system are affected by shocks. For example, in this way transfers take place to states in recession from those unaffected by the shock. In the USA, states are only able to borrow to finance investment projects otherwise they run self-imposed balanced budgets. Over the years, there have been cases of states (or cities) breaking the balanced budget rule and in most of them, the federal government did not bail out the state (or city) (Melitz, 2010). The famous case of New York City in 1974 is an example. So in the USA, the federal budget provides stabilization to the states; the states have balanced budget rules; the failure of a bank headquartered in a state is not the responsibility of the state but of the federal regulators and the federal government; and the federal government does not bail out delinquent states. The situation in the Eurozone is very different. In fact it is more or less the polar opposite: there is no federal stabilization; the members have national fiscal autonomy; bank failures are dealt with at national level; and member governments are being bailed out. Measures that are being taken in the teeth of the Eurozone crisis involve the transfer of taxpayers money from stronger to weaker members but this is not taking place with a democratic mandate. In exchange for bailouts, there is increasing European involvement in national policy-making. The European bailouts are accompanied by the requirement that countries adopt reforms and austerity policies. Whilst reforms and austerity are necessary in the crisis-ridden countries, the bailout conditions are nevertheless worrying both in terms of moral hazard and from a political perspective. The moral hazard argument is that if governments know they will be bailed out, they may be less prudent in the future. On the other hand, if reforms are forced through as a condition of the bailout this may produce a political backlash against the European project. The danger is the threat this poses to the very substantial economic benefits of the single European market. The conditionality may also produce poorly designed economic policy. Hastily adopted balanced budget rules in Eurozone members without a federal stabilization (transfer) mechanism are liable to lead to deep recessions and slow growth. A substantial federal budget does not exist and there would not seem to be any political appetite for one. In the meantime, there are ad hoc transfers as part of the bailouts and simmering political discontent about Europe in both recipient and donor countries. 7

9 7. Is a Eurobond part of the solution? One way to take the fear away from financial markets would be to provide joint European backing for the bonds issued by Eurozone governments. On the one hand, this would make it clear that Europe was committed to the future of the Eurozone since there would be collective responsibility for government debt. On the other hand, the problem of moral hazard rears its head again: if the Greek government can issue bonds guaranteed by all the countries participating in the scheme, what incentive does it have to be prudent? Once again, the contrast with the USA is helpful. The US government bond market is very large and deep and the US benefits from slightly lower borrowing costs as a result. Europe could benefit from this as well if there was a unified bond market. However, the sticking point remains the awkward political relationship between Europe and the member countries. Eurobonds do not provide a technical solution to the political dimension of the high moral hazard regime. This is why the Germans are so strongly opposed to this approach. 8. Can austerity packages in the crisis countries solve the problem? When a Eurozone government faces the threat of insolvency, a dangerous dynamic emerges. A primary fiscal surplus is needed to ensure solvency. This means higher taxes and lower government spending. The financial markets require austerity without sufficient austerity, bonds are sold, the price falls and the interest rate rises further. But with austerity, the automatic stabilizers in the economy that cushion an economic downturn are overridden and growth falls. This worsens the solvency calculation. The market response of higher interest rates to statements from the ratings agencies about increased country risk suggests that both too little austerity (primary surplus too low) and too much austerity (growth too low) are punished. As noted in Question 4 above, less austerity would be required and growth would be higher if the problem of restructuring the banks was removed from the national to the pan-european level. 9. Are supply side reforms necessary? For countries to prosper in a currency union with a low inflation target, they must be able to sustain the competitiveness of the tradeables sector of the economy without relying on periodic depreciation. This requires adequate productivity growth and institutions that keep control over nominal wage growth. What happened in the Eurozone s first decade is that Germany, which started off with weak competitiveness following the difficulties of reunification, achieved a recovery of productivity growth in tradeables and sufficiently low growth of money wages to more than claw back its initial competitive disadvantage and establish the basis for the strong growth of net exports. The booms of Spain and Ireland before the crisis and the more modest growth of Greece, Portugal and Italy were based on domestic demand rather than tradeables. The imbalances cancelled out for the Eurozone 8

10 as a whole but stored up trouble as they accumulated at member country level. The focus of supply-side reforms must be on the twin objectives of measures that raise productivity growth and that allow the growth of nominal wages to be controlled (Carlin 2011). 10. What can be done in the second wave of the financial crisis? The second wave of the global financial crisis has seen volatility in financial markets as weak economic data have come in from around the world in August and politicians in the US and Europe have failed to take decisive and coordinated policy measures. Governments are stretched because of high deficits and increased debt, and central banks are running out of policy instruments; the financial sector has yet to return to health and households are still rebuilding their balance sheets. The type of recession i.e. a balance sheet recession and the global scope of the slowdown have meant that there has not been a rebound of confidence and of private sector growth in response to fiscal austerity packages that some, such as the British government, had placed their hope in. If households and governments around the world are trying to save more, and no one is spending more, growth falls and the higher planned saving does not eventuate. All that happens is a slump in growth. A major missing element in the response of the political leadership in Europe to the Eurozone crisis is a strategy for growth. And it may be possible to implement elements of such a strategy even though the deeper problems of monetary union remain to be addressed. Austerity measures should be back- rather than front-loaded in other words, governments need to reduce their commitment to future pension payments and other elements of public spending growth but minimize the effect on current aggregate demand. If these commitments are credible, then interest rates will be lower and growth higher, which will improve the solvency arithmetic. At the European level, Eurozone countries in sound fiscal shape should be using the environment of very low interest rates to shift the timing of planned infrastructure projects closer to the present. Stronger growth in those economies will boost demand for exports from the weaker economies. Similarly, the EU should be supporting such projects in the crisis-hit countries. Although some of this is happening, it does not appear to be part of a coherent overall strategy. Three scenarios about how the crisis may evolve have been discussed, all of which involve substantial risks. The first two are premised on the Eurozone remaining intact. Scenario #1 a more decisive approach based on current policy (bailouts) Policy-makers need the existing bailout schemes to be successful and to be seen to be working in the next year to keep Italy out of the bailout regime 9

11 to develop a replacement for the high moral hazard regime for banks and for governments but to do this in a way that does not undermine the bailout regime in the meantime. Scenario #2 large-scale restructuring of bank and government debts (defaults) Policy-makers need to move decisively now to end the high moral hazard regime by accepting that default on bank and government bonds on a much larger scale than envisaged in Scenario #1 is necessary to engage in restructuring sovereign debt and bank debt by, for example, forcing bond-holders to swap existing short-term bonds for long-term ones. Scenario #3 a break-up of the Eurozone This could happen in a number of different all more or less disruptive ways. Some of the crisis-hit countries could leave the Eurozone. The new currency or currencies would depreciate against the euro. Such an exit would have to be accompanied by debt restructuring (default), since just as in the emerging economy situation discussed in Question 4 above, repaying euro-denominated debt in a devalued domestic currency would increase the burden. Access to international capital markets would be very restricted. For these reasons, Eurozone exit does not get rid of the need for either austerity or reform. A primary budget surplus would still be required. Reforms would still be required. Depreciation is a way of a country regaining competitiveness by cutting real wages. But unless the boost to tradeables provided by the depreciation is taken advantage of through effective reforms to boost productivity, all that happens is that the country becomes poorer. Another alternative would be for Germany and perhaps some other northern members to leave the Eurozone and establish a new currency. The new currency would appreciate against the euro tilting the competitiveness balance against Germany and in favour of the remaining euro economies. Germans opposed to continued participation in the Eurozone bailout regime would need to consider the costs of an appreciated exchange rate as well as the loss of benefits of the single European market. Conclusion European policy makers have a difficult course to steer. Angela Merkel and Nicolas Sarkozy suggest that the default of a Eurozone country like Greece would threaten the euro. This is not the case (a country could default and remain in the Eurozone or leave either way, this does not directly threaten the currency). But it threatens the banks that are holding Greek government debt. The current state of the debate encourages citizens from northern Eurozone countries to blame southern governments for the crisis, and indirectly their citizens for electing them. The IMF s recent report on Ireland (2011) says: It should be recognized, however, that there is a strong sense that burden-sharing between taxpayers and creditors for the cost of supporting the banks has been unfair. Taxpayers in 10

12 core and periphery are both suffering from the pain imposed on them by the banks. The unwillingness of policy-makers to recognize the on-going role of the banks in the crisis and the benefits of a pan-european solution worsens both the economics and the politics of the situation. References Boone, P. and Johnson, S. (2011) Europe on the brink Peterson Institute for International Economics Policy Brief, July Carlin, W. (2011). Stabilization policy in a common currency area with heterogeneous national wage-setters: the Eurozone s first decade Mimeo, UCL. De Grauwe, P. (2011). A fragile Europe in search of a better governance CES-ifo Working Paper IMF (2011) Ireland third review under the extended agreement IMF Country Report No. 11/276 Issing, O. (2008) The Birth of the Euro, Cambridge University Press. Melitz, J. (2011) How to save the euro? Lessons from the US Vox.eu Reinhart, C. and Rogoff, K. (2009). This Time is Different: Eight Centuries of Financial Folly. Princeton University Press Note: a good source for economic analysis of the crisis is 11