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The biggest question in any debt crisis is whether a credible path back to solvency can be found. For Greece, this now seems very unlikely. The same is true, to a lesser extent, for Ireland and Portugal. This raises three further questions. First, how big is any required restructuring? Second, who should bear the cost? Finally, is restructuring enough? If the answer to the last question is No, then one has to ask whether the currency union will last in its current form.

On the first of these questions, an analysis by Citigroup provides a negative answer. According to this analysis, by 2014 the ratio of gross debt to gross domestic product will have risen to 180 per cent in Greece, 145 per cent in Ireland and 135 per cent in Portugal. In none of these cases will the debt ratio start moving downwards over this horizon. Spain looks far better, with a debt ratio at about 90 per cent of GDP in 2014, though its path, too, will not have turned down. (See chart.)

The assumptions behind these forecasts are: a cumulative fiscal tightening between 2011 and 2014, inclusive, of 10.8 per cent of GDP in Greece, 8.3 per cent in Portugal, 7.3 per cent in Ireland and 5.7 per cent in Spain; interest cost of new funding rising from close to 5 per cent to 5.6 per cent in 2014 for Greece, Portugal and Ireland (determined by a weighted average of rates from the International Monetary Fund and the European Financial Stability Fund) and higher rates for Spain, since the latter will rely on the market; and, finally, privatisations and bail-outs. The analysis also assumes that a percentage point of fiscal tightening would lower growth by half as much.

Assume that these countries could borrow affordably in private markets at a gross debt ratio of 80 per cent of GDP. Assume, too, that European governments ensure that the IMF takes no losses. Then, the reduction in value of the rest of the debt would need to be as much as 65 per cent of GDP for Greece, 50 per cent for Ireland and 45 per cent for Portugal. The total “haircut” would be €423bn: €224bn for Greece, €107bn for Ireland and €92bn for Portugal.

One can quibble over the figures: these may be too pessimistic. But, without a big restructuring, these countries are now most unlikely to be able to finance themselves in the market on bearable terms. That is also what markets are saying: spreads on 10-year bonds over yields on German Bunds are 1,340 basis points, or 13.4 percentage points for Greece, 875 basis points for Ireland and 818 basis points for Portugal. This is why they are all now in official programmes. Worryingly, spreads for Spain are also now uncomfortably high, at 240 basis points, while those for Italy have reached 190 points. The eurozone, in short, is confronting a frightening sovereign debt challenge, aggravated by the dependence of its banks on support from its states and of its states on finance from its banks.

Now turn to the second question: who should bear the losses? If all the haircuts were to fall on private creditors, their losses in 2014 would be 97 per cent of their holdings of Greek debt, 63 per cent of their Irish debt and 60 per cent of their Portuguese debt. Official creditors would, by then, have to bear a substantial part of the total losses. Since governments would also need to bail out some of the holders of the restructured debt, particularly the banks, the eurozone would be revealed as a “transfer union”. Note, moreover, that this would occur despite a big fiscal effort in the affected countries. But even that would be insufficient to reverse the unfavourable debt dynamics in the medium term, partly because GDP growth is likely to remain so weak.

Against this background, proposals for rollovers by the banks, whether or not deemed technically a default, are neither here nor there. Much more to the point would be debt buy-backs at levels close to current market prices, as discussed in last week’s statement on Greece of the Institute for International Finance, which brings together the biggest international banks. That would crystallise losses. So be it. Let reality be recognised. As the Financial Times has also argued this week, the case for offering a menu of options with partial guarantees, similar to those under the 1989 Brady plan for Latin American debt, is powerful.

The question is whether such voluntary debt reductions would be enough, particularly for Greece. The answer is No. Governments would also have to play a part, by either accepting losses on the face value of their loans or ensuring lower interest rates, as proposed by Jeff Sachs of Columbia University. These are just two ways of achieving a lower net present value of debt service.

The dangers of debt relief are great. But the chances of success with denial are close to zero. True, it is possible for an ever greater share of the debt to be assumed by governments, so bailing out private creditors. Yet, ultimately, the cost of the debt owed to official sources will have to be cut by lowering interest rates or reducing sums outstanding.

It is not a question of whether such adjustments will have to be made, but of when. The history of such crises strongly suggests that it should be done sooner rather than later. Only after debt is on a sustainable path is confidence likely to return. Allowing foolish lenders, incompetent regulators and sloppy policymakers to hide past mistakes is a bad excuse for endless delays.

The doubt, in truth, is not over whether relief on the present value of the debt service is required. The real questions are elsewhere. One is over how to manage a co-operative debt restructuring. The other is over competitiveness and the return to growth. Some point to the success of Latvia in managing its so-called internal devaluation. But its GDP is 23 per cent below its pre-crisis peak. That is a depression. Moreover, the more successful a country turns out to be in cutting its costs, the worse the debt burden becomes. Thus, debt restructuring is merely a necessary condition for an exit. It is unlikely, in all cases, to be enough. Some economies may just wither away.

Alternatively, politicians may pull their countries out of the eurozone regardless of short-run costs. It is far too early to assume this will be the outcome, though some already do. But if there is to be any chance of avoiding this outcome, realism is required. At some point, the present value of the cost of debt must be drastically lowered. This does not have to happen today. But it has to happen soon enough to give people hope. In its absence, failure is not just likely. It is close to a certainty.

Moment of truth for the eurozone, Financial TimesBy Martin Wolf.

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The European authorities have had a year to address the sovereign-debt-come-banking crisis in the euro area. They have failed. The situation is much worse than a year ago, the latest manifestation being another downgrade of Greek sovereign debt. There is a real and present danger of contagion and the disorderly break-up of the euro area.

The economics of the problem are very simple. The economics of its solution scarcely more complicated. Alas, the political problems are thorny. For political, not economic reasons, default is looking as if it may be the default option. A break-up of the euro area is a distinct possibility. No-one can seriously assess the outcomes of such a scenario – although that does not stop some commentators pronouncing on the issue as if they did. In my view, it is highly risky. Above all it is completely unnecessary. It can and therefore should be avoided.

Let’s start with the simple, but often neglected, basic economic facts about sovereign debt.

Government debt dynamics depend on precisely four variables. The existing level of debt, the size of primary deficits or surpluses (where ‘primary’ means excluding interest payments), the nominal interest, and the economic growth rates (where ‘nominal’ means at current prices).

A country that owns its own currency can never go broke and need never default. (At least not in its own currency: it can, of course, if it unwisely takes on debt denominated in another currency.) Whatever the government’s debts and deficits, and quite apart from its capacity to oblige the private sector to pay taxes, it can create the currency to service its debts. ‘Printing money’ drives the interest rate down and the nominal growth rate (that is real growth plus inflation) up thus reducing nominal debts as a share of nominal GDP. Such a policy may have negative consequences (notably inflation), but the point remains that a monetary and fiscal sovereign can always service its own-currency-denominated debts. And that very fact reassures investors. It makes a run on government bonds unlikely and is the reason why genuine, in the monetary sense, sovereigns pay a lower interest rate than private sector actors. This is why the US, Japan and the UK can still issue bonds at very low rates of interest despite debt and deficit numbers that are, on the face of it, as bad or worse than those of euro area countries facing default and exorbitant bond rates.

A country that does not control its own currency, such as a member of a currency union, cannot avoid the inexorable logic of the mathematical link between the debt and deficit and the interest and growth rate variables; specifically, lacking control of the nominal interest rate, it is forced, on its own, into a real rather than nominal adjustment. The problem facing euro area members – Greece, Ireland, then Portugal, and prospectively also Spain, Italy and Belgium, can be stated succinctly as follows. The post-crisis combination of high government debt and large current deficits is such that, given the prospects for nominal GDP growth, and at the prevailing interest rates demanded by the market, government debts cannot be brought under control. (The italicised caveat is crucial: statements as to whether a country’s debt is sustainable or not are meaningless without specifying the interest and growth rate.) This is because, under these prevailing conditions, fiscal policy would have to be tightened (in order to achieve the required primary surpluses) to an extent that is either politically impossible, or that will damage growth prospects so badly that even drastic enforced consolidation will not ensure sustainability. (The second point is also crucial: it is not just a question of lily-livered governments unwilling to wield the knife.) Once markets perceive a risk of unsustainability, investors become unwilling to lend; the interest rate demanded rises, substantially worsening the problem. The prospect of consolidation worsens further and the country is essentially shut out from market finance. In the absence of outside intervention it must default.

And that is where the politics starts to come in.

The essence of the EU/ECB/IMF packages for Greece, Ireland and Portugal is to avoid the country having to access private capital markets to roll-over its debts (i.e. to pay creditors as their bonds fall due). Instead, the needed refinancing is provided, in various ways, and by a combination of public authorities; the precise form is irrelevant in economic terms, but may be important politically. This support is provided at a politically determined rate of interest and conditional on a set of fiscal consolidation measures required by the lending authorities and designed to bring government debt dynamics under control such as to permit a subsequent return to the markets.

Yet the provision of such support alters nothing about the fundamental requirement that the combination of debt level, primary deficits/surpluses, interest and growth rates be such as to ensure debt sustainability. The simple fact is that with the EU/IMF packages this is not the case. And that is why the crisis is getting worse and not better. The interest rate is too high, and the austerity measures are either unfeasible or self-defeating by virtue of the damage they wreak on growth prospects. This failure was predicted (GreeceIreland). The failure manifests itself either in ever more bail-out packages, and possibly contagion to other countries, and very possibly in the default that the packages were intended to avoid.

The economics of the implied policy choices are thus simple. If the debts are to be repaid in full, the interest rate must be lower and/or the nominal economic growth rate must be higher. If not, there will have to be some form of default (call it restructuring, voluntary, forced, what you will). And that is what the whole confused and confusing political debate is, at heart, about. Eurobonds, Brady/Trichet bonds, blue bonds, restructuring, reprofiling, privatisation, even selling the Acropolis; it is all about these basic choices.

But, in economic terms, it is, or should be, a non-debate. For the balance of costs, benefits and risks is so blindingly obvious. Consider:

One, collectively the euro-zone countries and the ECB are in control of their common currency. Two, the three currently affected countries account for a mere 6% of euro area GDP. And three, getting these countries on their feet quickly is in the interest of all of Europe, not just of the citizens directly affected. Taking these three basic facts together, the economic solution is self-evident. Some combination of the Member States and the ECB, who can, respectively, borrow and create money more or less at will announce that all sovereign debts in the euro area will be honoured in full. Immediate effect: the massive interest-rate spreads, which are a function of default fears (and not a conspiracy by ratings agencies) melt away. External finance is provided for a defined but extended period at a low interest rate and steps are taken to shore up nominal growth such that the balance between interest and growth rates puts debt ratios on a credible downward path. The government agrees to a politically feasible medium-run trajectory for the primary budget balance that ensures sustainability over a reasonable time-frame. This system is maintained for until such time as the markets are willing to resume lending at ‘normal’ rates of interest. This will not be very soon, but it will be for a limited period: all that markets need, in addition to the short-run no-loss guarantee, is to see debt ratios credibly falling.

In an appendix to this column I provide an illustrative and simplified calculation, using round numbers that approximate to the Greek case.

It’s really that simple. It costs nothing: other eurozone governments merely have to lend on what they themselves can borrow on the markets. For the euro area economy the magnitudes are entirely manageable. The euro area could, in theory, pay off every last euro of the combined government debt of Greece, Ireland and Portugal overnight, by borrowing some 9% of GDP. The peripheral countries stabilise quickly and begin to grow, avoiding the threat of a collapse in export demand from other eurozone countries. Avoiding the risks of banking collapses. Avoiding the risk of contagion.

Given this option, why take the risk of even talking about various default options? All they do is push up spreads further. Risk-averse financial institutions dump the government paper of the peripheral countries as fast as they can, ensuring more of it ends up in (quasi)public institutions anyway. (According to reports in the German media, German insurers have sold around half of their holdings of Greek bonds, and banks around one third).

The answer, in short: it’s the politics stupid. Core-country politicians have utterly failed to explain to voters the basic facts: properly conceived, bail-outs are costless. Pro-cyclical austerity policies are not in the interests of either peripheral or core countries. They are a senseless waste of resources and a serious threat to the future of the European integration project.

Currently, nationalistic parties fan the flames of resentment, unchallenged by mainstream parties who either don’t understand the issues or are running scared of voters (or both). Some on the Left see an opportunity to ‘hit the banks and the speculators’ by calling for a default. I agree that hitting the speculators is preferable to hitting public sector workers and the users of public services. But it is a high-risk strategy and it is, in principle at least, unnecessary. The banks are not separate entities from the economy. All will be hurt if they come crashing down. It is not the real alternative. The real alternative is between nationalistically inspired austerity policies and European growth-oriented policies. The former has been tried and has failed. It will continue to fail if policymakers persist with it. The task of progressives is to fight for the second strategy.

Frankly speaking, I don’t have an answer to how to overcome the political barriers to European solutions Europe. There is certainly no way forward as long as the debate is couched in terms of ‘the core won’t lend any more and the periphery won’t reform any more’. The fact is that most Member States and all the European institutions are in the hands of conservative-liberal majorities. Elsewhere I have proposed a ‘blueprint’ which, if implemented, would enable the various problems afflicting the euro area as a whole and its individual countries to be tackled together. In that way burdens can be shared and political solutions found on the basis of a common understanding of common interests.

The purpose of this column was more limited. To make the economic arguments clear, and to point out where the problems lie. In the politics, stupid!

Appendix: An illustrative and simplified calculation using round numbers that approximate to the Greek case

The debt to GDP ratio is 150% and the current deficit is 10% of GDP.[1]

The EU lends the country sufficient funds to shield it from capital markets at the same rate at which Member States  can borrow on the markets (roughly 3%), a costless transaction. This is instead of the penal roughly 6% being charged under EU/IMF programmes.

What about the nominal growth rate going forward? On the one hand there is a massive output gap implying a large potential for rapid catch-up real economic growth. On the other, the peripheral countries have an overblown nominal price and wage level, implying a need for low inflation. Real growth could be stoked by EU-supported investment. Price and wage inflation could be held in check with an incomes policy. Let us suppose an average of 3% real growth and 1% inflation. (3% real growth may seem high to some, but we are talking about the future, not the past. Depressed economies do bounce back, once confidence is restored. Encouragingly Greece grew at an annual rate of 2.4% in the first quarter of 2011, even if this is not expected to continue.)

This growth-interest-rate constellation would mean, taken by itself, that the country’s debt would fall every year by around 1½ pp of GDP a year. This is already a start: the debt ratio is on a declining, rather than an exploding trend, although the pace of improvement is slow.

Now what about the primary balance? The interest rate burden is 4.5% of GDP (3% * 1.5). If the country posts, on average during a consolidation phase, a balanced budget, then it is running a primary surplus of 4.5%. Add to this the 1.5% resulting from the growth-interest differential, and every year Greece would reduce its debt by 6 percentage points. Note: This requires merely that the government spends no more than it takes in in current taxation. This would represent a sensible average pace of debt reduction, comparable to that achieved, for instance, by Belgium during the 1990s and 2000s, which steadily brought its deficit ratio from around 120% to 80% of GDP. As such it would be convincing to market actors, who would be willing to lend money again to the government in question on favourable terms, once the effective consolidation became apparent.

The figures mentioned are averages over the consolidation phase. In fact, because it takes time to reduce current deficits if growth is not to be unduly stifled, the consolidation path would not be at this average rate across the period; initially debt to GDP ratios will in fact rise, and it is precisely during this crucial period that external financing is needed. However, as confidence returns and growth picks up, fiscal policy can be tightened further, accelerating the path of debt-paydown.

I have made some simple simulation calculations (to be presented in the near future) which show how a low interest-rate support strategy, coupled with measured fiscal consolidation (and ideally some externally financed, growth-enhancing public investment) might compare with the current strategy of high interest rate and enforced and pro-cyclical fiscal consolidation. On plausible assumptions, fiscal consolidation performance, in terms of the debt-to-GDP ratio, is worse under the growth-inhibiting austerity approach, in spite of the faster reduction in current deficits and the much higher primary surpluses than under one based on European solidarity and growth. And it goes without saying that real incomes recover much faster under the latter strategy and also perform much better in a longer term perspective.


[1] The actual figures for Greece for 2010 are debt: 143% and deficit -10.5%. The figures for Ireland and Portugal respectively are: debt: 96% and 93% and 32% and 9%. The calculation simplifies somewhat: after the first year the basis is no longer 150%, but 146%, but the basic dynamic is unchanged.

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Eurozone Economics are Simple. It’s the Politics Stupid!.

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It happened the day after a controversial decision to subject sanctions to a political vote. I was sitting in the office of a well-known European central banker, who was jumping up and down. The eurozone would now not have any means to control fiscal profligacy, he said.

That was in 1998. Not much has changed. The French and the Germans have once again been discussing whether sanctions should be automatic or not. And central bankers are just as furious. For Jean-Claude Trichet to issue an official note of disagreement – after European Union finance ministers last week drafted a watered-down sanctions package – is extraordinary on several levels. The president of the European Central Bank had demanded a great leap forward. But the French and the Germans are not leaping. They go round in circles. Since the start of the euro, the world has suffered its worst financial crisis ever and the worst recession in 70 years – and the eurozone’s political leaders are still obsessed with the minutiae of the stability pact, which is supposed to police government debt and budget deficit levels.

The real irony is that the pact, in whatever form, is not even relevant to the eurozone’s future. This may be a shocking statement. But look at the evidence. Contrary to popular narrative, fiscal profligacy played only a minor role in the eurozone’s sovereign debt crisis. Successive Greek governments cheated, but on my information, this occurred with at least partial knowledge of the senior European officials involved in the process. They chose not to apply the pact for political reasons. When the full extent of the Greek deficit became public in the autumn of 2009, EU leaders did not want to impose sanctions on a newly elected government. Everybody wanted to give George Papandreou, the Greek prime minister, a last chance. That turned out to be a good decision.

As for Spain and Ireland, they did not breach the rules ever, and would thus never have been subject to sanctions, automatic or otherwise. Even Ireland’s shockingly large projected deficit of 32 per cent of gross domestic product this year will not be a breach. Ireland’s bank bail-out is considered an exceptional circumstance, and not subject to the pact’s sanctions procedure.

Portugal exhibited persistent bouts of fiscal profligacy, but the real problem, again, was the banks. In all three countries, the crisis was caused by private sector imbalances, which far outweigh the relatively small discrepancies between national budgets. Germany may appear a paragon of virtue, but its debt-to-GDP ratio is close to that of France. It is larger than Spain’s and only a little lower than Portugal’s. But Germany’s pre-crisis 8 per cent current account surplus and Spain’s 10 per cent current account deficit were large and real. They have improved, but on the projections I have seen, are deteriorating again.

So if you really want to fix the eurozone’s problem, the pact is not the place to start. Obsession with it does not come out of concern for the eurozone’s future, but from an inter-institutional battle in Brussels.

What about the various proposals on macroeconomic surveillance, including that of the task force chaired by Herman van Rompuy, president of the European Council? He is proposing an early warning system, in addition to the already agreed European Systemic Risk Board. At the very least, one would expect all those new rules and institutions to pass the hindsight test. Had they been there 10 years ago, would they have prevented the Spanish or the Irish housing bubble? I cannot see how. Would José Luis Rodríguez Zapatero, Spain’s prime minister, have really imposed bubble-bursting real-estate taxes, after receiving a high-level delegation from Brussels or Frankfurt? Of course not. There can be only two explanations for Mr van Rompuy’s hubris about his macroeconomic surveillance proposals. Either he is naive, or he has a different agenda.

What about the proposed crisis resolution mechanism? When Angela Merkel, the German chancellor, gave ground last week on automatic sanctions, she gained the concession from Nicolas Sarkozy, the French president, that he would support Germany on crisis resolution.So the €440bn European Financial Stability Facility, set up in May to support eurozone countries with funding difficulties, will not be renewed. In 2013, it will be replaced by a tough crisis resolution mechanism to address the logical inconsistency of a system that rules out exit, default, and bail-out. The Germans continue to support the no bail-out principle; and have accepted that you cannot force a state to exit against its will. This leaves default. Having been very pessimistic on the default-probability of eurozone states, global investors may now be too optimistic again. If Ms Merkel gets her way – and I think she will – this means the eurozone’s future crisis resolution mechanism will be based on default.

The eurozone thus ends up with tough rules, poor implementation, no effective framework to deal with private sector imbalances, and an officially instituted mechanism that encourages default. The crisis was obviously not big enough to bring about genuine policy change. If, or rather when, that next crisis comes, it will probably be too late.

By Wolfgang Münchau

Published: October 24 2010 20:02

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