Euro-zone Debt Dynamics
Some countries like Greece and Italy have very
high public debt levels, others such as Ireland
and Spain have public debt levels that are
increasing fast. This situation has raised concerns
about the capacity of these countries to continue
to service their debts in an environment of low
economic growth. A majority of countries in the
Eurozone, however, experience a debt dynamics
that is benign certainly when compared to the
US (and also the UK).
A Textbook “Optimum Currency Area”
Considerations
The adoption of a single currency will have both benefits and costs. •
The benefit will be mainly in the form of lower transaction costs
and of the disappearance of currency risks, and cross country credit
possibilities.
The costs will be due to the inability of national governments and •
central banks to pursue independent monetary policies to stabilize
the economy. The extent to which the loss of this policy instrument
will affect the adjustment to equilibrium will depend on the degree
of flexibility of factor markets and the nature of the shocks hitting
the economy: the more rigid factor markets and the more countryspecific the shocks, the more important will be the loss of monetary
autonomy. If factors of production are not sufficiently mobile,
asymmetric shocks result in high costs of adjustment, in terms of
presence of fixed higher unemployment and lower output, in the
exchange rates.
Insufficient political union behind the
Euro
The structural problem of the Eurozone is the •
absence of a sufficiently strong political union in
which the monetary union should be embedded.
Such a political union should ensure that
budgetary and economic policies are coordinated
preventing the large divergences in economic and
budgetary outcomes that have emerged in the
Eurozone. It also implies that an automatic
mechanism of financial transfers is in place to
help resolve financial crises.
Sovereign Debt Across the Euro Zone :
Differences
The differences are striking. Some countries like Greece and •
Italy have very high public debt levels, others such as
Ireland and Spain have public debt levels that are
increasing fast. This situation has raised concerns about the
capacity of these countries to continue to service their
debts in an environment of low economic growth. A
majority of countries in the Eurozone, however, experience
a debt dynamics that is benign certainly when compared to
the US (and also the UK).
Given the overall strength of the government finances •
within the Eurozone it should have been possible to deal
with a problem of excessive debt accumulation in Greece,
which after all represents only 2% of Eurozone GDP.
Rules to prevent large deficits
Impossible to achieve with no political union •
States within the United states get a big match •
for any dollar spent, and the federal
government tax collection insures the finance
No Insurance Mechanism
An explicit fiscal union is not the only way to •
provide for an insurance mechanism within a
monetary union. It can also be organized using
the technique of a monetary fund that obtains
resources from its members to be disbursed in
times of crisis (and using a sufficient amount
of conditionality).
The Heart of the Federation-like
Problem
The heart of the problem is that the Eurozone •
is a monetary union without being a political
union. In a political union there is a centralized
budget that provides for an automatic
insurance mechanism in times of crisis.
How to reduce relative costs
What makes Greek problems so intractable is •
the fact that there’s little hope for growth for
years to come, because Greek costs and prices
are out of line and will need years of painful
deflation to get back in line.
Spain wouldn’t be in trouble at all if it weren’t •
for the fact that the bubble years left its costs
too high, again requiring years of painful
deflation.
Without devaluation
Look at Latvia which has pursued incredibly •
severe austerity. Its competitiveness was
improved only marginally. •
Successful adjustment?
Estonia as a model?
Estonia is being hailed for its fiscal rectitude, •
which qualifies it for entry into the euro.
Latvia is often cited as an example for Greece •
as it undergoes a brutal internal devaluation
while keeping its currency pegged to the
euro.
More worries over PIIGS after Greece
bailout
Greece sovereign debt is insolvent: needing •
debt restructure
The austerity program implies a medium term •
rise in Greece sovereign debt
Although the Euro depreciates after Greece, •
this is not what Greece needed to recover
competitiveness and could do if not in the
Euro
BOND-BUYING PROGRAM
The European Central Bank has bought just €36bn of eurozone sovereign •
debt since its bond purchase programme began last month, out of a pool
of €7,300bn. But it has achieved its admittedly narrow aim – to restore
functionality to a frozen market. It targeted Greek, Irish and Portuguese
paper in specific segments of the market. Grateful sellers – probably overexposed banks – have thrown themselves at this lifeline, and some
notably freakish developments have been unwound. Greek 2-year yields
have fallen from 18 per cent on May 7 to 7.5 per cent now, for example.
Yet the eurozone government bond market remains friendless. There is no
appetite for bonds that are not German, except from central banks.
Spreads have started to widen again; Spanish 10-year paper yields 1.8
percentage points more than German equivalents. More worryingly, the
Italian 10-year yield, at over 4.2 per cent, is back to where it was before
the ECB intervention began. There are understandable though surely
unfounded fears in Germany that the bond purchases are no more than
hidden transfers to rescue French banks.
Conceptual Framework: Optimum
Currency Area
Benefits: reduced costs of doing business. If •
they are large, forming currency area leads to
a large increase in trade.
Costs: it’s harder to get costs and prices back •
in line after asymmetric shocks—booms and
slumps that affect individual member
countries within the currency union.
Reducing the costs
The difficult adjustment to asymmetric shocks •
is reduced if labor is highly mobile between
the slumping and booming regions (Mundell);
or, if you have fiscal integration (Kenen); or, if
the central bank is a “true” “lender of last
resort” to banks of member states, and there
exists a fiscal unit the can bail out sovereign
debts.
Debt Across OECD Countries
The horizontal axis shows gross debt as a •
percentage of GDP at the end of 2009; the
vertical axis shows the budget deficit as a
percentage of GDP in 2009.
All the crisis countries are in the
eurozone, while the US, UK, and Japan
aren’t —having your own currency
makes all the difference.
The interest rates on 10-year bonds are •
3.59% in the UK, 3.36% in the US,
1.29% in Japan. CDS spreads for Japan
and the UK are only
about a third of the level for Italy
Why is the euro depreciating?
A possible answer is that as the crisis spreads to other large •
Eurozone countries, the risk of monetization of the public
debt becomes more concrete. Even if Greece can be bailed
out by other countries in the Eurozone, this would not be
feasible for the much larger public debts of Italy, Spain, and
Portugal. In the scenario of a widespread crisis, the
possibility that the ECB will monetize the debt of weak
Eurozone countries exists, and fear of the implied inflation
can explain the depreciation of the euro. However, a
massive monetization is an unlikely scenario, as it would
eventually undermine price stability in the Eurozone and
imply a substantial transfer of resources from strong to
weak Eurozone countries.
A breakdown in the euro?
An alternative explanation for the •
depreciation of the euro is the fear of a
breakdown of the single currency itself. In
order to avoid having to bail-out weak
Eurozone countries through debt
monetization, the strong countries might push
the weak ones outside the Eurozone.
Will the entire Euro enterprise
collapse?
The answer is no. The decision to join the euro •
area is effectively irreversible. Exit is
effectively impossible •
reasons
A country that leaves the euro area because of •
problems of competitiveness would be expected
to devalue its newly-reintroduced national
currency. But workers would know this, and the
resulting wage inflation would neutralize any
benefits in terms of external competitiveness.
Moreover, the country would be forced to pay
higher interest rates on its public debt.
The private-sector balance sheet effects , causing •
defaults, will create massive bank runs, as in
Argentina in 2001.
More reasons
A second reason why members will not exit, it •
is argued, is the political costs. A country that
reneges on its euro commitments will
antagonise its partners. It will not be
welcomed at the table where other European
Union-related decisions were made. It will be
treated as a second class member of the EU to
the extent that it remains a member at all.
Three factors are now at the forefront
of investor concerns
The first is the possibility of a break-up of the •
eurozone.
Six months ago such a scenario was unthinkable. •
The political drive behind the euro was
formidable and the possibility of its failure was
nil. But discord and lack of solidarity over Greece
have damaged the credibility of the bloc’s
governance.
The chance that the eurozone will break up is tiny •
but it is no longer zero.
second
There is the question of whether Greece will – •
or should – default. Such an event would
dwarf any sovereign default since 1983. The
two most significant – Russia in 1998 and
Argentina in 2001 – amounted to a combined
$155bn in defaulted debt, according to
Barclays Capital. Greece’s outstanding debt is
some $350bn. A default would be massively
painful but it remains a viable option for
Athens.
third
There is almost no co-ordination among •
governments on regulating financial activities;
Germany’s ban on naked short selling was
symptomatic of an approach that too often
picks on the easy target; but not in an
effective way.
Greece’s default
Argentina set the world’s largest default
For greece to avoid default may be possible but
not easy.
Its debt is 170 percent of gdp
Decades of low investment in statistical capacity,
few trust the figures.
Immense problem of credibility
Greece has been in default one out of every two
years since it first gained independence in the
19th century—reinhart and rogoff data
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