Start by Saving the Eurozone

The current global financial crisis has clearly underlined the need for more effective mechanisms of international cooperation. The stumbling initial response of the G7 risked prolonging the credit crunch. Today, while panic has eased somewhat in wealthy countries, the crisis is spilling into developing countries, with potentially devastating effects. Yet there is no coordinated effort to address the problems faced by emerging markets.

As Jeffrey Sachs argues, a Bretton Woods II may be necessary to build a new global financial and economic system. In fact, the multilateral, cooperative spirit of Bretton Woods is urgently needed today. If the crisis only deepens the divide between haves and have-nots, it is difficult to see how an international summit could be successful. And at the top of today’s agenda must be saving the eurozone.

Last week’s coordinated bank recapitalizations helped calm the panic in the wealthiest European countries, but there are signs that the problem has been stamped out in one place only to resurface in another. Most ominously, expectations are rising that some European governments will default on their debts. During the last three months, the implied risk that Ireland, Italy, and Greece will default within five years—based on credit default swap spreads for their sovereign debt—has quadrupled from approximately 3 percent to 12 percent each.

So far, credit default swaps (CDSs) have correctly predicted the spread of risk from mortgage-backed securities, to consumer lenders and investment banks, then to commercial banks. Now they are pointing to some of the wealthiest sovereign nations.

This is only logical. In many European nations, banks have amassed more debt than taxpayers can afford to repay. These liabilities need to be refinanced periodically, but the current crisis has made that more difficult. In addition, bank debt was largely used to buy assets based on real property that is falling in value. In a severe recession, that decline could render much of the European financial sector insolvent.

This is all old news. However, by guaranteeing their systematically important financial institutions, European governments assumed that risk themselves. For example, the Irish announced they would guarantee all liabilities of their major banks—over 3 times current GDP and over 12 times government revenues. ING’s assets equal 2.9 times Holland’s GDP at €1.3 trillion; the recent recapitalization provides €10 billion of new capital, or just 0.8 percent of total assets. If asset values fall sharply, much more capital will be required. Can these countries afford to support all of their core financial institutions? This is the question markets are starting to focus on.

The 1997–98 emerging-markets crisis showed how such conditions can lead to collapse. A country finds that its creditors are increasingly reluctant to hold its bonds due to perceived risk. Interest rates on that nation’s debt rise, making the debt harder to pay off. To win back confidence, the country needs to tighten fiscal policy, but this can be politically difficult. Fear grows that, instead, the country will inflate its debt away or default outright; rates rise further. The prophecy is ultimately self-fulfilling: Fear of a collapse leads to collapse.

The standard policy prescription is to tighten fiscal policy and let the exchange rate depreciate sharply. This raises exports, reduces imports, and improves national savings.

The problem, however, is that eurozone nations no longer have control over their monetary policy: The European Central Bank (ECB) does, and its mandate is to maintain a 2 percent inflation target. Troubled countries, including Greece, Ireland, Spain, Italy, and Portugal will prefer loose monetary policies but are sure to be opposed by the Germans (and French) who insist on the low inflation target. Threatened countries will be forced to tighten their belts using fiscal policy and brace for a deep recession. This will be politically painful.

If there is a sufficiently deep, global recession, the eurozone may not survive. Countries threatened by default will question the merits of the euro; they will suffer high interest rates, negating one of its expected benefits, and will see other nations as benefiting at their expense. Nationalist politicians will argue that they are better off setting policy at home, echoing Iceland’s cry: “Every country for itself.” The costs of abandoning the euro would be very high, but it could happen, given domestic political instability and intransigence within the eurozone. If one nation breaks away, investors will wonder who is next, cutting off financing from other countries. Contracts in euros will need to be abrogated, causing untold dislocation. The damage will be enormous.

However, there is a good chance this scenario can be avoided, if some difficult decisions are taken now before markets demand them through higher interest rates. At the least, failure to act now will require more expensive measures to be taken deeper into the crisis.

First, policymakers must generate confidence that they understand and are dealing with these dangers. The ECB’s insistence on high interest rates has damaged its credibility. Recent joint efforts by governments, along with the 0.5 percentage point interest rate cut, are steps in the right direction.

Second, there need to be mechanisms to ensure that investors who bet against national solvency will lose money. To date, those investors are doing extremely well. We need to discourage such bets and cut the potentially self-fulfilling cycles of higher interest rates that lead to insolvency.

We recommend the following steps for the eurozone:

  1. Lower the ECB base rate now to 2 percent from the current 3.75 percent. The coming global recession will dramatically reduce inflation pressures, and a rate cut is needed to offset the recession. Lower rates will help recapitalize banks by making their lending more profitable, and will allow them to charge less to mortgage holders. The 2 percent inflation target should not be abandoned but should be subordinated to the need for financial stability (without which there will likely be deflation down the road).
  2. Create a European Stability Fund with at least €2 trillion of credit lines guaranteed by all eurozone member nations and potentially other European countries with large financial systems such as Switzerland, Sweden, and the United Kingdom. This fund should provide alternative financing to member countries in case market rates on their government debt become too high. This will prevent a self-fulfilling cycle of rising interest rates. The fund should be large enough to have credibility; countries could access the fund automatically but should then adopt a 5-year program for ensuring financial stability, subject to peer review within the eurozone.
  3. All eurozone nations should launch temporary fiscal expansions of at least 1 percent of GDP. These plans should be aimed at reducing the severity of the upcoming recession and assisting people at risk of default on mortgages or other financial instruments, thereby helping people in trouble and reducing default rates in the financial sector.
  4. The European Union and Switzerland should develop a financial regulatory framework that recognizes that systemically important institutions may need to be bailed out by Europe as a whole. One goal should be to reduce extreme differences in national financial risk and leverage so that these problems are less likely to reoccur.

These measures will not resolve all of Europe’s problems. The coming recession is likely to be severe, and its impact will vary greatly across the eurozone. Some domestic politicians will argue against having one currency for such a diverse area. However, it would be far more costly to abandon the euro now than to keep it. Ultimately, to make good on last week’s promise to support all core financial institutions, the eurozone must also promise to support all of its member nations. Otherwise the eurozone may become fragmented and the benefits of the euro will be lost.


Originally published at The Guardian, at the Peterson Institute and at the Baseline Scenario.com and reproduced here with the authors’ permission.

23 Responses to "Start by Saving the Eurozone"

  1. Sgjoni   November 8, 2008 at 4:40 pm

    There was no Icelandic cry “Every country for it self”.. there was.. ok no one is willing to help us with the mess we are in so I guess that means.. it’s every country for it self! There is a huge difference!Iceland can probalby blame it self for not being within the EU and the Euro-zone to beguin with but being put out in the cold is not easy and was not by choice.The above statement shows you obviously have no idea of the mess this country is in.We are going to have a pre cristmass Bastille Day over here if the foraign exchange markets don’t open up soon.

  2. Francisco   November 9, 2008 at 2:38 pm

    There seems to be an old prejudice in some angloamerican, German and nordic commentators against what they call the PIGS ( that racist acronym invented by the Dutch and copied by nordic and anglo tabloids). Here again the author singles out countries like Spain, Portugal or Italy as being particularly in trouble…well, let us see. In the context of the current financial crisis how many Spanish banks have been nationalised or publicly rescued? None. Compare this fact with the situation in Germany, the Netherlands or the UK..those very virtuous protestant countries. Now, when it comes to saying that Germans and other should better ignore those profligate southerners…really? Did Weimar hyperinflation happened in Spain? Was Germany or Spain the country that imposed its economic cum political troubles on others during the early stages of German reunification? Why should the South pay for the folly of Germany ( after all the Germans were divided because of their historic record, not because of Spain or Italy. As to those protestant virtues…which country did break the Maastricht rules for the last ten years concerning public deficits…Germany or Spain?

    • Guest   November 10, 2008 at 4:43 am

      So you suggest that Spain should not be singled out. “Well, let us see” then. Leave the ECB base rate at above 4 percent and “every country its own mierda”. You forgot btw. to mention that Spain is as well better in football than Germany. I think that´s another important factor in the current situation.

    • Guest   November 10, 2008 at 12:37 pm

      This is absolutely correct.

  3. LUis   November 9, 2008 at 2:46 pm

    I do not know why the authors say that a country like Spain is particularly in trouble when compare with Germany, France or the UK. For the last twelve years Spain has being growing at an average rate of 3,5%, it has ran a budget surplus ( contrary to Germany or France), it has created more jobs than the rest of the eurozone combined. Its multinationals are now at the world’s top in banking ( Santander, BBVA), telecommunications ( Telefonica), infrastructure ( six out of the world’s top ten companies are Spanish), retailing ( Zara), renewable energies ( Iberdrola, Acciona, Abengoa..)and you name it. Spain is the 8th largest world economy ( a fact belatedly acknowledge by its presence in the incoming G20 Washington meeting). Of course now there are troubles, but so there are in Germany, the UK, France, The Netherlands or any other developed economy. Why then, do you have to single out Spain?

    • Guest   November 10, 2008 at 4:17 am

      Are you writing as a Spanish government official or as a citizen with some ability for critical reflection on the society he´s living in?

    • Guest   November 10, 2008 at 11:45 am

      The problem is that if growth is driven by credit rather than productivity then you have a problem in the long run. Ireland’s productivity increased since the start of EMU, Spain’s did not (neither did Portugal’s or Italy’s)“Rotating Slumps”

  4. Guest   November 9, 2008 at 8:06 pm

    To LUis: Spain is singled out because of its high national debt, together with Italy. That is the whole point the article is trying to make: set up a fund so that no country goes bankrupt.

  5. Guest   November 10, 2008 at 4:04 am

    The comments by Francisco and LUis give us a taste of how seriously the EUROzone is already divided, and how much national ingredients make most related recipes indigestible.By the way, is this springs myth still around in Spain of AMERICA being the reason for 40-years-mortgages on overprized Madrilenian houses becoming a burden for underpaid overconsuming families, or are FRENCH Trichet and THE GERMANS now responsible?

  6. Carlomagno   November 10, 2008 at 7:55 am

    This article is complete and utter rubbish. (Shame on RGE Monitor for carrying it.)Countries threatened by default will question the merits of the euro; they will suffer high interest rates, negating one of its expected benefits, and will see other nations as benefiting at their expense.As Willem Buiter has recently pointed out, a country that has its liabilities denominated in Euros has every incentive not to ditch the Euro.http://blogs.ft.com/maverecon/2008/11/eurosceptics-remedial-education-class-1/

    • interested reader   November 10, 2008 at 11:30 am

      All the worse for creditors if the defaulted liabilities are in Euro.

      • Anonymous   November 10, 2008 at 11:39 am

        All Eurozone members have their liabilities denominated in Euros (they don’t fund themselves in FX).

        • interested reader   November 10, 2008 at 11:47 am

          sure but if a country defaults on its Euro debt and devalues then the chances of creditors being paid in full diminish (or at least it will take a longer time.)

          • Carlomagno   November 10, 2008 at 3:42 pm

            My point was simply to make clear that, contrary to what is asserted in the article, a Eurozone country threatened with default will NOT question the merits of the Euro, if its policymakers have any sense. As Buiter argues (taking Italy as an example to illustrate his argument), “Only an economic and financial suicide artist would take Italy out of the euro zone.”

          • BJ   November 10, 2008 at 5:26 pm

            @ Carlomagno: Fact is that Italy’s living standards have eroded while inside the Eurozone, partly due to its own fault (lack of reform), partly due to restrictive ECB policy and strong Euro. If a country is better off outside than inside in the long run it is rational to leave. It’s suicide to stay inside in that situation.

  7. Carlomagno   November 10, 2008 at 5:55 pm

    BJ: do you really think that Italy could choose lower interest rates outside the Eurozone?

  8. BJ   November 10, 2008 at 8:05 pm

    Interest rates? Is that something to eat? What counts is growth, jobs, real income, innovation, realization of potential for young people. Is it better now? Could it have been different? I don’t know, you tell me.

    • Carlomagno   November 11, 2008 at 2:56 am

      BJ: you referred to a “restrictive ECB policy and strong Euro”, i.e. interest rates. If you don’t think it matters, why did you bring it up?

      • BJ   November 11, 2008 at 8:41 am

        Let’s put it this way: The Eurozone (and indeed the world) would be a better place if we had 5% nominal growth and 5% nominal interest rates instead of 2% nominal growth and 2% nominal interest rates.

      • BJ   November 11, 2008 at 8:53 am

        I apologize: I meant inflation instead of nominal interest rates, of course. And make nominal growth potential growth.

        • Carlomagno   November 11, 2008 at 9:26 am

          What’s that got to do with your previous claims? You were making claims about the benefits of being in our out of the Eurozone, not about different hypothetical macroeconomic scenarios within the Eurozone.

          • BJ   November 11, 2008 at 9:54 am

            You’re obviously wilfully misunderstanding but it doesn’t matter. I’m saying that in order to raise living standards (ultimate goal) you need growth. In order to grow, you need incentives to invest which you will not have if you know exactly that as soon as the economy reaches its CURRENT capacity constraint of 2% (which is not cast in stone except in the ECB macro model), the ECB will hike rates until it kills off your investment prospect. If you let inflation go to 5% instead that’s an incentive to expand the existing capacity and thus raise productivity and growth in a sustainable manner until all productive factors are employed. This is the only way to raise living standards and in this sense the ECB is not supporting sustainable growth. One expression of the ECB’s too strict monetary policy stance for a country like Italy is reflected in the too strong currency.If you have anything constructive to add I’ll be happy to continue the conversation, if you’re just playing dumb we’re wasting each other’s time.

  9. Carlomagno   November 11, 2008 at 10:24 am

    I’m most certainly not playing dumb, I’m suggesting that we stick to the topic. You suggested that Italy would be “better off outside than inside [the Eurozone] in the long run” because you apparently believe that Italy could enjoy a lower interest rate outside the Eurozone. I think you are wrong, but if you can advance any arguments as to why that might be the case I’m happy to continue the discussion. Whether or not the ECB’s macroeconomic model and monetary policy are suboptimal is an entirely different issue.