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THE

FISCAL

CRISIS

IN

EUROPE

CONSEQUENCES FOR THE EURO AREA AND POSIBLE SOLUTIONS

INTERNATIONAL FINANCE Spring 2011 Enrique Moreno de Acevedo Snchez

THE EUROPEAN UNION CRISIS The European Union is a confederation of 27 nations who collaborated to facilitate the free movement of goods, labor and capital. In fact, 63 percent of all EU trade is done internally in what has collectively become a $14.5 trillion economy. In 1999 the EU agreed to the Maastricht Treaty (February 1992), which initially unified the currency of eight member states into a single denomination. What was once the French Franc, the German Deutschmark and Italian Lira, amongst others, is now the Euro. The European debt crisis initially began in Greece, who adopted the Euro in 2001, despite being in violation of a requirement that a countrys annual deficit be less than 3% of GDP before it used the Euro. Greece had a deficit well above 3 percent of GDP in 2001. Several large banks lent U.S. dollars to Greece in 2001 when their debt was manageable and agreed to be repaid in Euros so it could be classified as a currency trade, as opposed to debt. They disguised the debt so the EU would think Greece was below the 3 percent annual debt to GDP threshold, essentially making it possible for a debt ridden country to legally circumvent safeguards against the instability of the EU with sophisticated financing techniques. When Greece couldnt refinance what they owed to other European nations, the dominos began to fall and the entire European system was on the verge of breaking down. What was the solution then? The European Central Bank created even more debt to finance the bad decisions of broke countries and printed money to stimulate their economies. While the solvency of Greece was caused by government spending, Ireland found itself imperiled by the housing crisis. It seems that the irish banks had estimated losses that amounted to 50 percent of the Irish GDP after housing prices dropped by 36 percent from their 2006 highs. With liquidity needs constraining their ability to lend money to a struggling economy, it became clear that foreign assistance was required. More concerning, this comes after the government had reportedly lent these institutions 120 billion, which impacted the status of their sovereign debt. Ireland has a banking problem, but Portugals dislocated government was then the driving source of great anxiety. Despite promises to implement austerity measures, the budget deficit has increased by 2.3 percent from a year ago. What futile spending cuts were implemented caused so much political backlash that new elections cannot take place until next spring due to constitutional requirements. In the meantime, nothing could be done and the markets have turned their back on Portugal as they attempted to refinance their debt. Spain is now the key issue, with a 21 percent unemployment rate, it is the fourth largest economy in the European Union, and it has the second highest budget deficit and more than three times the public debt of Greece. The sheer size of the Spanish economy would make it too big to fail or bailout. A bailout in Ireland, Greece and Portugal, were necessary to prevent further contagion in the European Union. After all, Portugal owes 33 percent of its debt to Spain, who in turn owes Germany the equivalent of 10 percent of the German economy. Italy owes France what amounts to 20 percent of the French economy, but is waiting for Spain to pay back the $31 billion it owes the Italian treasury. Not to be outdone, Spain hopes Italy can repay the $47 billion it owes the Spanish taxpayers so it can repay Britain an obligation equal to 10 percent of the British economy. Very complicated debt relationships as we can see in Figure 1.

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EXPANSION AND THE BEGINNING OF THE IMBALANCES As the Union grew, very different countries came together, different economies, cultures, cycles, politics, policiesand just two things in common, the currency and the monetary policy. The main collateral effects of the expansion of the European Union can be briefly explained as follows: 1. Inflation and interest rates converged with those of the EUN (Austria, Belgium, France, Germany and the Netherlands). The confidence in the GIIPS surged and the long-term government bond yield spreads of them vs. the EUN, fell from 550 basis points in 19801990 to just 10 in 1999 (Figure 2). 2. Low interest rates and improved confidence fueled a domestic demand surge partly financed by foreign lending. The GIIPS, especially Greece, Ireland and Spain saw an increase in domestic spending accompanied by deteriorating current account balances and rising private debt (Figure 3). 3. The demand surge drove up both prices and wages. From 1997 to 2007 the price of services in the GIIPS rose by an average annual rate of 1.5 percentage points more than that of goods, compared to a difference of 0.5 percentage points in the EUN. Over the same period, per capita employee compensation rose by an average annual rate of 5.9 percent in the GIIPS, considerable faster than the EUNs average of 3.2 percent. The result was a dramatic decline in competitiveness in the GIPPS against other advanced countries (Figure 4). 4. The single monetary policy exacerbated the troubles in the GIIPS. An OECD study estimates for example that policy interest rates over 2001-2006 were approximately 50 basis points too high for Germany but between 300 and 400 basis points too low for Spain, Greece and Ireland. 5. In all of the GIIPS, lower borrowing costs and the expansion of domestic demand boosted tax revenues and tempted governments to expand spending as well (Figure 5). The global financial crisis fully exposed the flaws of the GIIPSs post-euro growth model. Tax revenues collapsed as output growth slowed or disappeared, revealing that the expanded state sector was unaffordable. The problem as we can see is much more complex than just a deficit reduction. Coming from a structural misallocation of resources, with overextended governments, it must require deeper structural reforms and a behavior change. Are these reforms possible?

OFICIAL MEASURES The EMU summit held at the end of March, has brought a number of new measures to try to solve the crisis, calm the markets and transmit the idea that they are all in the same boat/fight: to not just endow the ESM with actual lending capabilities of 500 billion from 2013 onwards but also to increase the EFSF's effective lending power to 440 billion (from the present 260 billion or so) through a combination of higher guarantees, paid-in and callable capital. to reduce the interest on the loans to Greece by 100bp and extends its maturity to 7.5 years. to allow in exceptional cases, where a country has an adjustment programme with the EFSF, purchases of government bonds in the primary market. to press ahead with the ESM's debt restructuring model post mid-2013 as envisaged in the December Council, notably haircuts for private sector investors in cases of a country unexpectedly having not just a liquidity problem but also a solvency one.

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ARE THEY ENOUGH? Before explaining some of the critics these measures have received, we have to say that the Pact for the euro has had a very positive impact so far, as long as it has shown a profound commitment among the euro members to solve the crisis and to hold the union. We will have to wait until seeing how the development of these measures affects this initial welcome. Several voices say that it has been more a political agreement than a financial one, leaving the real problems unsolved: a) First of all, the budget reforms are focused on tackling fiscal irresponsibility, which, with the exception of Greece, was not the cause of the crisis in the peripheral countries. Ireland, for instance, was actually running a fiscal surplus prior to the crisis. Moreover, the problem of existing debt is left unaddressed. Debt levels in the periphery are unsustainable; the gross debt to GDP ratios stand at 130, 93 and 83 percent of GDP in Greece, Ireland, and Portugal, respectively. The prevailing interest rates5.8 percent in Ireland and even higher in Greece and Portugalfar exceed the growth rates these countries can hope to achieve in coming years. To make matters worse, their governments continue to run large fiscal deficits. This means that without more intervention, these countries will become progressively more indebted with each passing year. b) Secondly, the proposals do not address Europes fragile banking system. While a stable financial system was a stated goal of the Summit, nothing substantive was proposed to achieve this objective. For European banks, which remain highly leveraged and extremely exposed to government debt on the periphery, this is a serious flaw. Bank problems tend to become government problems. We will see how the new stress tests to be released on June address this situation. Private debt becoming Public debt? c) Finally, the real competitiveness reforms do not show up. Unit labor costs in the periphery far exceed those in the core, by more than 20 percent in some estimates. Without the option of devaluation, real wages and prices must fall in order to regain competitiveness. This process is slow, and in several countries it has yet to begin. The austerity delusion, as Paul Krugman titled one of his articles in NY Times, is related with the Greece and Ireland experience under the IMF/EU plan. While there has been some progress, they are struggling to meet its budget targets due to a shortfall in tax revenues, forcing even more aggressive spending cuts exacerbating the recession. In the absence of strong economic growth, the peripheral economies may be unable to shrink themselves to solvency. In order to restore it, overburdened borrowers must stabilize debt and begin to reduce the level of borrowing. This requires GDP growth exceeding interest rates, a budget surplus or both. According to the IMFs best estimates, there is little prospect of many European countries returning to balanced budgets any time soon. Given the horrible combination of high cost of funding, low growth and high starting level of debt, it is going to be very difficult for these countries to avoid the way towards restructuring of their debt or default.

CONCLUSSION There are mainly two problems that the politicians are trying to solve. The first is the problem of high government debt-to-GDP ratios. The second is the issue of an uncompetitive economy, as indicated by prolonged current account deficit and epitomised by Greece, Portugal and Spain. The way to deal with a sovereign debt crisis was to impose austerity, a path the Irish and Greeks have duly followed. But austerity tends to weaken the economy, making the plight of the banks even worse. If GDP falls fast enough, the debt-to-GDP ratio can rise, despite a governments best efforts. As the markets see this, they drive up government bond yields, making the problem even worse.

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The rest of the European Union has tried to help out Greece and Ireland, and now Portugal, by providing loans at lower rates than the markets. But a debt is still a debt. The EU is treating this as a liquidity issue when arguably it is a solvency issue; the debt-to-GDP ratios are too high for the governments to pay back, even at an EU-subsidised rate. That is because of the competitiveness problem. Wage costs are too high in Portugal, Spain and Greece. As we said before, the traditional way to deal with that problem is to devalue the currency but, of course, that is not possible within the euro. And even if it were possible, the debt problem would get worse, since the bonds are denominated in Euros. We can think about three/four possible solutions: a) United States of Europe, b) expansion of existing arrangements, c) decision to allow indebted countries to fail, and/or d) euro Break-up. I really think that c) and d) have little chances to be possible futures, just because the economic costs could possibly be much greater than the economic benefits. But even though there are little chances, the near term political events (polls), around Europe, could change everythingIf this were the case, the existing programs (Greece, Ireland, Portugal) would be suspended. There would be debt moratoriums, defaulting on at least some debts and forcing write downs. The defaults would affect the balance sheets of banks, potentially forcing governments (Germany, France and UK) to inject capital and liquidity into their banks to ensure solvency. These countries would have to pay anyway, but in this case to restore the health of their banks rather than foreign countries. Is this the way many people in Germany are thinking? I do not see the c) scenario as a decision, but this could happen as a consequence. A greater unity could be an ideal solution, but to do so we would have to talk about losing power, independency and imposing even tougher austerity packages. Just recently, the Portuguese Prime Minister was forced to resign in the face of opposition to austerity measures. If the European Central Bank continues raising interest rates, as it is expected, the pain could only be multiplied. On the other side the stronger countries could face serious domestic problems in terms of politics if they keep paying for the sins of others. Recently Merkel could feel this popular sentiment in the recent polls her party lost in Baden-Wuertemberg. This scenario, even as a desirable one, turns to be almost impossible given the different economies, cultures, structures, etc., the current circumstances and the requirements needed. Extending the packages is the more probable solution in the short term. But this is a buying time solution, solving mostly liquidity, but not solvency. As we have seen in the post EU era the roots of the current situation are much deeper than fiscal imbalances. The two speed European Union is going to be exacerbated if this path is the one finally selected. You have to work not only in the cost side, the revenue side has to grow, and this requires more measures than the ones already taken. With growing financing needs, high indebted banking system, excessive unemployment and almost no growth (and what it is worst, not expected enough one in the short term), it seems we are heading with agonizing slowness towards some kind of debt restructuring. And that creates a dilemma for the remaining EU governments led by Germany. The longer the crisis goes on, the more of the debt of Greece, Ireland and Portugal, will end up in the hands of the IMF and the other euro-zone countries in the form of a new special purpose vehicle, the European Financial Stability Facility. The IMF always gets the first claim. So when these countries do eventually default, the taxpayers of France and Germany may have to lose out; there will be noone else left to bear the burden. So it seems that the sooner, the better. With this perspective, no expected improvement in the economies of the troubled countries, no real structural reforms to prepare them for a future growth, the option of some default/restructuring gets closer. At the end some countries need to know that there is no free lunch anymore. This could be the hardest way to learn some lessons, but perhaps the shortest one to begin again under new and better regulation..

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ANEX/FIGURES

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REFERENCES/SOURCES BBVA .Situacin y Perspectivas de la Economa Mundial, Portuguesa y Espaola. January 2011. Catherine Mathieu and Henri Sterdyniak. European Debt Crisis and Fiscal Exit Strategies. 2011 Charles Wyplosz. European Debt Crisis: What Is The Way Out. April 2011. Danske Bank. Several articles. European Economic Advisory Group. The EEAG report in the European Economy 2011. European Commission. Reinforcing economic policy coordination, May 2010. John Whittaker. Intra-eurosystem debts. March 2011. Marco Annunziata. Decisin Time. March 2011 Matthias M. Matthijs. Germanys Role in Crafting a Solution to the 2010 EMU Sovereign Debt Crisis: Persuading with Power or the Power of Persuasion. March 2011. Mckinsey&Company/Fedea. Growth agenda for Spain. 2011. Nomura Global Economics. Europe will work. 2011. Paul de Grauwe. Should we cheer the European Stability Mechanisn?.2011 Paul Krugman. NY Times. The Austerity Delusion. March 2011. Paul Taylor. Reuters. The Unfinished Business of Euriopes Bailoiut. March 2011. Satyajit Das. The European Debt Crisis. 2011. Wells Fargo. European Debt Crisis: Whats next. January 2011. Yanis Varoufakis. The Modest Proposal for the Euro. November 2010. http://online.wsj.com/home-page www.ft.com/home/us www.td.com/economics http://seekingalpha.com/ http://www.cnbc.com/id/42071870 http://www.dailyfinance.com/story/credit/why-the-european-debt-crisis-is-far-fromover/19892180/ http://www.eurointelligence.com/homepage.html