The Euros Three Crises

Sub regional meeting May 2 2013

A banking crisis
A sovereign debt crisis
A growth crisis
Interdependence!

The banking crisis

Initial problems

The size of euro zone banks

300% of GDP vs. 100% in the US, ING

Corporate reliance on banks

Cross-border banking
No supervision at euro zone level
No statutory lender of last resort
No euro zone bank rescue facility

The banking crisis

US subprime contagion

The banking crisis

Hesitant ECB reaction (39% vs. 210%)

The banking crisis

How the two other euro zone crises
worsen it:
The growth crisis
Weak economy and falling asset prices
damage banks balance sheets

The sovereign debt crisis

Sovereign defaults bankrupt banks with
sizable sovereign debt holdings

The sovereign debt crisis

Mixed initial conditions

The sovereign debt crisis

Loss of confidence in 2010

The sovereign debt crisis

Markets punishing fiscal profligacy?

The sovereign debt crisis

Markets fearing unsustainability?

The sovereign debt crisis

Markets punishing public and private indebtedness

The sovereign debt crisis

The problem of dual equlibria

Good equilibrium: A virtuous circle

Trust Low interest rates Small
budget deficit Sustainable public
debt Trust
Bad equilibrium: A vicious circle
Lack of trust High interest rates
Large budget deficit Unsustainable
public debt Lack of trust

The sovereign debt crisis

How the two other euro zone crises worsen
it
The banking crisis
Risk of bank failures leads to higher expected
public debt as a result of bank support

The growth crisis

Weak growth raises debt/GDP ratios via
higher budget deficits and lower GDP

The growth and competitiveness

crisis

The competitiveness crisis

Hard to compete on foreign markets

The competitiveness crisis

Hard to compete on domestic markets

The growth crisis

Fiscal austerity leads to lower growth

The growth crisis

Weak banks are reluctant to lend

The growth and competitiveness

crisis
How the two other euro zone crises worsen
it
The banking crisis
Weak banks with higher capital requirements
slow growth through reduced lending

The sovereign debt crisis

Austerity measures imposed to reduce budget
deficits weaken aggregate demand via lower
public spending and lower disposable income

The euro zones three crises:

Many vicious circles

Solving the euro crisis

Shambaughs suggestions

Fiscal devaluation plus fiscal

revaluation
Monetary policy: Quantitative easing
Recapitalization of banks
Fiscal expansion in solid countries
Banking union
Supervisory agency
Deposit insurance
Bank resolution agency

Solving the euro crisis

The
The
The
The
The
The
The

Other suggestions
dream solution: Economic growth
Baltic solution: All at once
dissolution solution: Back to square 1
Soros (1) solution: Germany leaves
default solution: Sovereign default
Soros (2) solution: Eurobonds
realistic solution: Muddling through

The dream solution: Growth

Higher GDP growth leads to:
Less need for public spending + higher tax
revenues = Lower budget deficits
Lower debt/GDP ratios
Less private defaults = stronger banks
But unachievable because:
Low competitiveness = low foreign demand
Austerity measures = low domestic
demand

The Baltic solution: All at

once
Nominal wage cuts
Public spending cuts
Migration
Political consensus
Too late for euro zone

The Baltic solution

25% public wage cuts

The Baltic solution:

Rapid gain in competitiveness

The Baltic solution:

Migration

The Baltic solution:

Steady growth from a lower level

The dissolution solution

How it works
Exchange rate depreciation leads to rapid
gain in competitiveness
Increased competitiveness leads to export
led growth
Export led growth leads to higher
employment
Higher employment leads to reduced
deficits
Lower interest rates lead to stabilized
asset prices
Stable asset prices lead to financial

The dissolution solution

Is it so unrealistic?

The Soros (1) solution

How it works

Germany leaves the euro

The D-mark appreciates
The euro depreciates
Remaining euro zone rapidly gains
competitiveness and goes for the
growth solution via export led growth

Economically interesting - politically

unrealistic

The sovereign default solution

Countries with unsustainable public
debt enter orderly default
proceedings
Partial debt cancellation, debt
restructuring, moratorium
Defaulted creditors (too big to fail)
saved via nationalization
End of austerity measures resumed
economic growth
Economically interesting - politically

The sovereign default solution

Which countries?

The Soros (2) solution: Eurobonds

How it works

Pooling of all existing euro zone

public debt
= Pooling of all national sovereign
risk
= Lower borrowing costs
= Lower budget deficits
= Existing debt sustainable
Conditions on further Eurobond
borrowing

The realistic solution

Muddling through
Continued austerity measures to reduce
budget deficits
Structural policies to raise aggregate
supply
Reduced demand and increased supply
lead to

Stagnating GDP
Rising debt/GDP ratios
Higher unemployment
Financial instability

Realistic but politically dangerous

Thank you for your

attention!