Fixing the euro zone debt crisis while it’s time

Posted on 24. mai, 2010 by Jean Jacques Ohana in Weekly Focus | Commentaires fermés

We have already stated in our macroeconomic analysis of sovereign debt issues that a country’s solvency risk is at least tridimensional, depending on the current account, the government balance and the outstanding amount of debt.

Indeed, a deficit cut would require either an improvement of the current account balance or an increase in private debt. To put it differently, the private sector and government cannot deleverage at the same time, if the trading balance is kept constant.

Let’s have a look at these three sovereign risk dimensions in the weakest links of the euro zone (data are taken from IMF estimates as of 2010) :


Sources: Bloomberg, IMF. Debt amounts are expressed in Millions EUR

Greece, Portugal and Spain combine massive current account and public deficits. Although Spain and Portugal (contrary to Greece) used to run balanced government budgets before the 2008 financial crisis, the burst of the real estate bubble compelled the private sector to deleverage and governments to substitute public for private debt. Meanwhile, the Irish situation is manageable with a moderate current account deficit linked to higher competitiveness. Lastly, Italy has an issue regarding the amount of outstanding debt accumulated over the past but does not face more difficulty than France regarding the debt trend.

The only way for Greece, Portugal and Spain to reduce deficits in the context of a rigid currency system consists in inflicting an austerity program to households and companies: reducing wages in the public sector, increasing VAT, increasing taxes on companies’ profits, reducing pension benefits. With already high unemployment, these austerity plans will lead to depression and make the debt burden even higher, deteriorating in turn banks’ claims and balance sheets.

Unfortunately, the fall in the Euro effective exchange rate does not alleviate these deflationary prospects. The EUR devaluation may increase further the external surplus of large Eurozone exporting countries such as Germany, but does not change the situation of peripheral European countries. The issue remains a differential of competitiveness between Germany and European trading partners. As pointed out by Paul Krugman, wages in Greece/Spain/Portugal need to fall something like 20-30 percent relative to Germany. Such an adjustment won’t come without social pain for the populations as wages lack flexibility in the Eurozone.

The only sustainable outcome would consist in setting up a default mechanism and sharing the pain between three players:

  • A restructuring of the debt would ensure that creditors take a part of the loss in a well-ordered process where all exposures and losses are communicated to the market. This step is essential to introduce fairness in the market so that debt holders bear the consequences of the risk they took and for which they received a premium. This orderly debt restructuring would contain the problem to the exposed entities rather than deferring losses to the whole financial system. It could come with the setting up of a Club Med weak euro currency or a temporary exit from the Eurozone and an outright devaluation so that the competitiveness gap is filled by a combination of painless currency adjustments and painful wage cuts.
  • Once the debt restructuring is accomplished, European leaders should set up a transparent quantitative easing mechanism exactly specifying the nature and the amounts of debt the ECB is allowed to buy on the primary or secondary debt markets. This way, a part of the Club Med debt problem will be addressed through a contained inflation in the Eurozone.
  • The remaining part of imbalances should be borne by the governments and population which have to revert to competitiveness and long-term fiscal sustainability.

The Euro Zone governments have preferred denying problems, asserting repeatedly that the default of a country within the euro zone is impossible. On May 9, Europe’s Finance Ministers approved, in an emergency meeting, a rescue package that could provide 750 billion Euros for crisis aid aimed at ensuring financial stability across Europe. The package has three components that add cabbages and carrots: stabilization fund, government-backed loans to be issued by a SPV managed by the Commission and an additional contribution of the IMF.

Has anyone seen the money? French Finance Minister Christine Lagarde said “Since it is only a guarantee it won’t be written in the budget plan”. It is clear that the Euro Zone members are bluffing, hoping that Portugal and Spain will never be forced to draw the guarantee. But this hope is vain as Club Med countries are facing a solvency crisis, not simply a temporary liquidity problem. One day or another, governments will have to put the money on the table to rescue Portugal and Spain (as they already have been obliged to do for Greece). This day, the solvency of the whole euro system solvency could be at stake and the Eurozone could be facing a serious political crisis. Some dissent has appeared in the last EU Finance Ministers meeting as German Schaeuble called for a way to manage “orderly state insolvencies” in case emergency lending to distressed governments fails but his request found little backing in the 27-nation meeting, Van Rompuy said when reporting the meeting discussion.

Some politics know that the denial policy proposed by EU Governments is unsustainable. As the poker game continues and more and more euros  are at stake, the likelihood that one country lay down, whether Germany or not, will dangerously increase. Then, a large scale financial crisis is warranted as multiple defaults will occur in the arena of a political clash within the Eurozone.

As usual, denying the possibility of the worst is the surest way to provoke it.

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