The euro zone was launched on a wing and a prayer. The wing has fallen off and the deities are not listening to prayers. Everyone focuses on averting a crash. But it is as vital to ask how to fly securely.
How, then, did the euro zone fall into its plight? A part of the answer is that it lacked mechanisms for handling crises, that its members have diverged hugely and that it was blighted by its early successes.
The easy credit conditions and low interest rates of the first decade delivered property bubbles and explosions of private borrowing in Ireland and Spain, incontinent public borrowing in Greece, declines in external competitiveness in Greece, Italy and Spain and huge external deficits in Greece, Portugal and Spain. When financial markets panicked, borrowers suffered “a sudden stop”, which caused cascading crises of illiquidity and insolvency for sovereigns and banks. The euro zone has been running to catch up. But the crisis runs faster. Almost half of the sovereign debt shows heightened credit risk.
The euro zone had no mechanisms for cross-border financing of borrowers who had lost access to funds. In theory, adjustment should have occurred via the classical mechanisms: a spiral of sovereign defaults, banking collapses, slumps, unemployment, falling wages, fiscal retrenchment and all round misery. Nobody forewarned the public that such brutality lay in wait. Politicians did not understand this either. When the time came, they all flinched.
So what has to be done? The answer comes in two pairs: the first is “stocks and flows”; the second is “financing and adjustment”. Stocks refers to cleaning up the legacy of the past. Flows refer to the need to return to sustainable economic growth. Financing and adjustment refer to the how and the when of efforts to clean up stocks and restore sustainability to flows.
Several euro zone members have emerged from the crisis with huge overhangs of private and sovereign debt. If these stocks cannot be rolled over, a mixture of financing and restructuring remains. Either the official sector provides finance or it ensures a restructuring of debt in terms of face value, maturity or interest rates. In the case of Greece, the decision has been made to finance the debt overhang, via the official sector, indefinitely. No voluntary private financing exists. The private sector debt restructuring now being organised offers next to no relief to Greece, but substantial relief to erstwhile private lenders. In the case of Greece certainly (and Portugal and Ireland possibly), substantial reduction in the burden of debt service are essential.
This stock problem runs through banking, too, where the overhang of bad loans impairs both solvency and liquidity. Again, the solution is financing – injections of capital and support from the central bank – and restructuring – write-downs of assets and some liabilities. So long as the overhangs of bad debt remain, private finance will not return.
Dealing with the stocks is relatively simple. A far bigger challenge is to achieve sustainable flows of income and expenditure, at high levels of economic activity. That means far more than the fiscal austerity with which Europeans are obsessed. To paraphrase the Roman historian Tacitus, “they make a depression and call it stability.” If activity is to be restored, the structural external deficits must fall to levels readily financed through private markets. Greece and Portugal have huge external deficits today, despite deep recessions, a cogent indicator of a severe lack of competitiveness. This is also a bit of a worry for Spain and Italy, but the challenge is smaller. Ireland is in external surplus, which is encouraging for its future.
Adjustments of this kind take time: big changes in relative prices and investment in new activities must both occur. In a bleak paper for London-based Lombard Street Research, Christopher Smallwood argues that Greece and Portugal – and perhaps even Italy and Spain – will find restoring competitiveness via falling wages and mass layoffs extremely painful. Moreover, this would raise the debt burden further. The effort may even cause a political breakdown. To limit the trauma, the euro zone will probably offer some financing. But that could also slow the pace of the needed adjustment.
What makes adjustment still more difficult is that it involves two sides. If external deficits are to fall, so must surpluses elsewhere. That has obvious implications for Germany and other core countries. But the latter do not recognise the need to adjust. They believe one hand can clap. The two-handed nature of adjustment may not matter so much for small debtor countries. It matters far more for bigger ones.
If the needed adjustment proves impossible within the straightjacket of the euro zone, two alternatives exist: exit, with the risks I noted two weeks ago, or permanent financing via a fiscal union, so putting failing economies on life support. Doing the latter may be possible for one or two small economies. But it would be impossible, economically or politically, for larger ones. This is why today’s high spreads on Italian and Spanish debt are so dangerous for the future of the euro zone.
It is the flows, stupid. Merely lowering debt burdens does not solve that problem. The fear must be that deeply uncompetitive economies will not be financed, but cannot adjust. If so, they may just wither away. This is why some people already argue that the way out may have to include exits. In broken marriages, argues Nouriel Roubini of the Stern School in New York, “it is better to have rules – divorce laws – that make separation orderly and less costly to both sides.”
The bare minimum the euro zone needs to cope with its crisis is an effective mechanism for writing down the debts of evidently insolvent private and sovereign borrowers, such as Greece; funds large enough to manage the illiquid bond markets of potentially solvent governments; and ways to make the financial system credibly solvent immediately. The sums required will surely be several times larger than the 440 billion euros of the existing European Financial Stability Fund, as I noted last week.
Yet, alas, the euro zone requires more still: it needs a credible path of adjustment, at whose end we see weaker economies restored to health. If such a path is not found, the euro zone, as it is now, will fracture. The question is not if, but when. The challenge is simply as big as that.