Top Banner

of 13

The European Crisis Deepens: Peter Boone & Simon Johnson

Apr 06, 2018

Download

Documents

babstar999
Welcome message from author
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
  • 8/3/2019 The European Crisis Deepens: Peter Boone & Simon Johnson

    1/13

    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

  • 8/3/2019 The European Crisis Deepens: Peter Boone & Simon Johnson

    2/13

    N u m b e r P b 1 2 - 4 J a N u a r y 2 0 1 2

    2

    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

  • 8/3/2019 The European Crisis Deepens: Peter Boone & Simon Johnson

    3/13

    N u m b e r P b 1 2 - 4 J a N u a r y 2 0 1 2

    3

    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.

  • 8/3/2019 The European Crisis Deepens: Peter Boone & Simon Johnson

    4/13

    N u m b e r P b 1 2 - 4 J a N u a r y 2 0 1 2

    4

    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

  • 8/3/2019 The European Crisis Deepens: Peter Boone & Simon Johnson

    5/13

    N u m b e r P b 1 2 - 4 J a N u a r y 2 0 1 2

    5

    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

  • 8/3/2019 The European Crisis Deepens: Peter Boone & Simon Johnson

    6/13

    N u m b e r P b 1 2 - 4 J a N u a r y 2 0 1 2

    6

    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

  • 8/3/2019 The European Crisis Deepens: Peter Boone & Simon Johnson

    7/13

    N u m b e r P b 1 2 - 4 J a N u a r y 2 0 1 2

    7

    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

  • 8/3/2019 The European Crisis Deepens: Peter Boone & Simon Johnson

    8/13

    N u m b e r P b 1 2 - 4 J a N u a r y 2 0 1 2

    8

    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

  • 8/3/2019 The European Crisis Deepens: Peter Boone & Simon Johnson

    9/13

    N u m b e r P b 1 2 - 4 J a N u a r y 2 0 1 2

    9

    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

  • 8/3/2019 The European Crisis Deepens: Peter Boone & Simon Johnson

    10/13

    N u m b e r P b 1 2 - 4 J a N u a r y 2 0 1 2

    10

    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

  • 8/3/2019 The European Crisis Deepens: Peter Boone & Simon Johnson

    11/13

    N u m b e r P b 1 2 - 4 J a N u a r y 2 0 1 2

    11

    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-

  • 8/3/2019 The European Crisis Deepens: Peter Boone & Simon Johnson

    12/13

    N u m b e r P b 1 2 - 4 J a N u a r y 2 0 1 2

    12

    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.

  • 8/3/2019 The European Crisis Deepens: Peter Boone & Simon Johnson

    13/13

    N u m b e r P b 1 2 - 4 J a N u a r y 2 0 1 2

    13

    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.