Issueno.

7,January2012

MACRO ECONOMY PROCEEDINGS

THEEUROONTHEBRINK: MULTIPLECRISESANDCOMPLEXSOLUTIONS
PaolaSubacchi StephenPickford

AnearlierversionofthispaperwaspresentedattheconferenceChallengesfortheglobaleconomyaftertheTohoku earthquakeheldinTokyobyNomuraFoundationon7November2011.Theauthorswouldliketothankconference participants, in particular Barry Bosworth and Christopher Allsopp, for their comments, and Richard Varghese for researchsupport.ThesupportofNomuraFoundationisgratefullyacknowledged.

THE EURO ON THE BRINK: Multiple Crises and Complex Solutions

P AOLA S UBACCHIAND S TEPHEN P ICKFORD Abstract

Europes sovereign debt crisis has exposed the deficiencies in the governance of the European Monetary Union (EMU),andhasshownthelimitsofitsframeworkofpolicycooperation.Ithasitsrootsintheimbalanceswithin Europeandthestructuralweaknessesofitsmodelofgrowth.Mostofall,thecrisishasintrinsicallythreatenedthe politicalfundamentalsofthecurrencyunionandgreaterintegrationinEurope.Thispaperdiscussestheoutlookof theeuroarea,inparticulartheeuroperiphery,andassessesthevulnerabilitiesandstresspoints.Itarguesthatthe factorsunderlyingthecurrentcrisispredatethe200708globalfinancialcrisisandareamixofstructuralproblems in some member states and faults in the design of the EMU framework. It identifies that in the shortterm, the countriesintheeuroareahavetonormalisetheaccessofbankstomarketfunding,convincemarketsthattheir publicdebtisonasustainabletrack,andimprovetheirexternalpaymentsposition,whereasinthelongerterm, the challenge is to improve competitiveness, restore growth, and rebalance the intraEMU growth pattern. The paper concludes by assessing the chances of the euro to survive in its present form if the necessary structural measuresarenotimplemented.

alwaysbeenclearthatEuropefallsshortofthe 1 requirementsforanoptimalcurrencyarea. Anda monetaryunionthatwasnotaccompaniedbyafiscal unioncouldonlysucceedbyputtinginplacerobust governanceandstrongrules.Yetrulesintheeuroarea havebeenovermanyyearsdisregardedforthesakeof politics. Twoofthecountriesthatendedupatthecentreofthe sovereigndebtcrisis,GreeceandItaly,wereadmittedto thesinglecurrencyunionwithpublicdebtswellin excessofthe60%ofGDPlimitthatwassanctionedin theMaastrichtTreatyin1992.Buttheeuroproject neededcriticalmassandItaly,oneofthesignatoriesof theTreatyofRomein1957andoneofEuropeslargest economies,wasdeemednecessarytotheeconomicand politicalsuccessoftheeuro.Asaresult,Italyqualified forEMUmembershipontheassumptionthatrecent
1.Foradetaileddiscussiononoptimalcurrencyarea,see Mundell(1961,1963,1973a,and1973b).Inaddition,fora discussiononMundellswork,theeuroandoptimalcurrency areasseeMcKinnon(2000).

INTRODUCTION
Europessovereigndebtcrisis,thatbeganinJanuary 2010andstillcontinues,hasexposedthedeficienciesin thegovernanceoftheEuropeanMonetaryUnion (EMU),andhasshownthelimitsofitsframeworkof policycooperation.Ithasitsrootsintheimbalances withinEurope,inthestructuralweaknessesofitsmodel ofgrowthwiththepossibilitythattheregions potentialoutputhasbeenpermanentlydownshifted andinthedifferenceswithintheregionasocalled twospeedEurope.Mostofall,thecrisishasintrinsically threatenedthepoliticalfundamentalsofthecurrency unionandgreaterintegrationinEurope. Theeurocrisisdidnotdevelopovernight,butincubated overtheyearsandwasbasedonthefactthatthewhole processofEuropeanintegration,ofwhichthecurrency unionwasthemostadvanced,thoughasyet incomplete,element,ismainlydrivenbypoliticsrather thansoundeconomicprinciples.Economictheoryhas

 effortstoputitsdebtonareducingpathandthedrastic dropofitsdeficitdowntotherequired3%ofGDPwere enoughtoguaranteefuturefiscalconsolidation.Asfor Greece,itsadmissiontotheEMUcameduringthe preparationsforthe2004Olympicswhenmassive investmentshadboostedeconomicgrowth.Inanycase, accountingforonlyabout2%2ofthetotaleuroarea economy,Greecewasbelievedtobetoosmalltohave anysignificantimpactonthestabilityofthecurrency union.Thisassumptiononlylookedathowinflationin memberstatesaffectedtheinflationfiguresforthe euroareaasawhole,andthereforeitseffectonthe conductofmonetarypolicy.Alllinkagesthroughthe financialandbankingsystem,andthepossiblespillovers ontherealeconomy,werecompletelydisregarded. Theothercountriesaffectedbythepresentcrisis Ireland,Portugal,andSpainsufferedfrominterest ratesinappropriatefortheirpaceofeconomicgrowth and/orofexcessivecreditgrowth.Indeedthecommon monetarypolicysetbytheEuropeanCentralBank(ECB) wastoolooseforthemandneededtobeoffsetby suitabledomesticpolicies.Forinstance,strong economicgrowthandpotentialoverheatinginIreland andSpainrequiredpolicymeasurestoavoidexcessive creditgrowthandtoprickthepropertybubble.Thisdid nothappen.Instead,largeprivatesectorborrowing, andwideningcurrentaccountdeficits,weresignalsof thebuildingupoflargeimbalances.Intheaftermathof thecollapseofLehmanBrothersinautumn2008 governmentinterventionwasnecessaryinbothIreland andSpainaswellasintheUKtorescuethebanking system.Atthesametime,theimpactofthefinancial crisisontherealeconomyandtheneedtosupport economicgrowthrequiredextremelyaccommodating fiscalpolicies. Theresultoftheseinterventionswasthewideningof publicdeficitsanddebt,evenforfiscallyvirtuous countriessuchasGermany.IrelandandSpain,andto someextentPortugal,endedupjoiningthegroupof countrieswithlongtermpublicfinanceproblems (includingGreeceandItaly).Forsomeofthemthe bankingcrisismorphedintoasovereigndebtcrisis althoughthefundamentalsoundnessoftheirfiscal positions,especiallyinthecaseofIreland,could eventuallyresultinaneasierpathtofiscal consolidation. TheEuropeanCouncilhasrecentlyagreedonmeasures toaddresssomeoftheweaknessesleadingtothecrisis. Butatthetimeofwritingthecrisisiscontinuing,and thishindersanycompleteandobjectiveassessmentof
2.Unlessotherwisementioned,allthedatausedinthispaper arefromtheInternationalMonetaryFund,WorldEconomic Outlook,September2011(IMFWEO).

thesituationandthedrawingofcomprehensivepolicy recommendations.Nevertheless,itisclearthata numberofstepswillhavetobetakentoaddressthe crisis,boththeimmediateproblemsandthelonger termissuesthatlieattheoriginoftheprotractedbuild upofimbalanceswithintheeurozone.Finally,thereare asetofissuesaboutthefuturegovernanceoftheeuro areaand,tosomeextent,oftheEUasawholethat needtobeaddressediftheeuroistosurvive. Itisagainstthisbackdropthatthepaperdiscusses possiblesolutionsandassessesthelongterm consequencesofthecrisis.Herewearguethatthe factorsunderlyingthecurrentcrisisintheeuroarea predatedtheglobalfinancialcrisisof200708andarea mixofstructuralproblemsinsomememberstatesand faultsinthedesignoftheinstitutionalframeworkthat underpinstheEMU.Adistinctionismadebetween shorttermmeasuresthatareneededtodealwiththe immediatecrisisandthelongertermstructuralchanges thatareessentialtomakethecurrencyunion,andmore broadlytheprocessofEuropeanintegration,more sustainable.Itisurgenttoregaincontrolofeventsand torestoreconfidence,astheGreekcrisishasspread overothercountrieswhilereducingmarketconfidence. However,theimmediatepriorityofrestoring confidenceandresolvingthecrisisshouldnot overshadowtheotherfundamentalgoalofrethinking thegovernanceandtheinstitutionalframeworkofthe Europeanmonetaryunion.Structuralmeasuresthat addressthelongtermchallengesofrebalancingthe euroeconomy,dealingwithregionalgrowth differentialsandsupportingGDPgrowthneedtobe includedintheagendaofactionsforthefuturesurvival andstabilityoftheeuro.Thecrisishasmadeitclear thatrebalancingwouldbepossibleonlythrougha substantialshiftintheintraEMUgrowthpattern.The weaknessofallthesouthernEuropeaneconomies, coupledwiththeneedtorebalancetheeconomyofthe eurozone,theconstraintsimposedbyafixedexchange rateregimewithintheEMU,andtheneedforsome EMUmemberstatestoimplementstructuralreformsin theireconomies,hasshiftedtheburdenofadjustment towardssurpluscountries.Thepaperconcludesby assessingthechancesoftheeurotosurviveinits presentformifthenecessarystructuralmeasuresare notimplemented. Thepaperisorganisedasfollows.Part1discussesthe outlookoftheeuroperipheryandassesseswhere vulnerabilitiesandstresspointsare.Part2looksat thelongstandinganddeeprootedcausesoftheeuro crisis.Part3analysespossiblesolutionsandconcludes.

1.THEEMUONTHEBRINK
1.1THECRITICALOUTLOOKFORTHEEURO PERIPHERY
Thesovereigndebtcrisishaswidenedthedivide betweencountriesthatarewelladaptedtosurviveand prosperwithinthemonetaryunionandthosewhichare not.Theeurozonescoreeconomies,including Germany,arenowkeytothesinglecurrencyareas survival.Countrieswithproblematicdebtpositions haveseensharprisesinthecostofgovernment borrowingsincethecrisiseruptedandateachcritical pointinitsdevelopment(figure1).IndeedItalianand Spanishbondyieldshavespikedtounsustainablelevels whileFrancesAAAcreditratingisincreasingly 3 vulnerable. Moreover,adisastrousGermandebt auctionprovidedtheclearestsignthateventhe strongesteurozonecountryisnotinsulated, reconfirmingthistobeasystemiccrisis.Germanyfailed toattractinvestorsforabout35%ofits6billion10 yearbundissueattheendofNovember2011, suggestingthatinvestorsareshyingawayfromtheeuro areaingeneral,andnotjustfromthecountrieswith unsustainablesovereignpositions(FinancialTimes 2011). Italy,deemedtoobigtobebailedout,continuestobe themajorconcernandissubjecttotheIMFs enhancedmonitoringofitspoliciessincetheG20 CannesSummitinNovember2011.Withits10year benchmarkgovernmentbondyieldshoveringabout7%, recentdevelopmentsinthecountryhavebroughtthe eurozonetothebrink.AlthoughItalydoesnotpay7% onallitsoutstandingdebt,thecurrenthighlevelsof yieldsinthesecondarymarketindicatethatinterest paymentsareexpectedtoincreaseinthenearterm. Italyscostofdebtservicingisexpectedtorisebyabout
3.RatingagencyStandard&Poor's(S&P)havealready downgradedFrancebyonenotchtoAA+,whereasFitch RatingshaveplacedFrancesAAAcreditratingsoutlookon negativeduetodeepeningpolitical,financial,andmonetary problemswithintheeurozone.Moodysmaintainsastable outlookforFrance;however,ithaswarnedthatthecountrys outlookisatrisk.Explainingwhatpromptedthedowngrades ofEuropeansovereignsingeneral,S&Pstatedthepolicy initiativesthathavebeentakenbyEuropeanpolicymakersin recentweeksmaybeinsufficienttofullyaddressongoing systemicstressesintheeurozone.Inourview,thesestresses include:(1)tighteningcreditconditions,(2)anincreaseinrisk premiumsforawideninggroupofeurozoneissuers,(3)a simultaneousattempttodeleverbygovernmentsand households,(4)weakeningeconomicgrowthprospects,and (5)anopenandprolongeddisputeamongEuropean policymakersovertheproperapproachtoaddress challenges.Forfurtherdetails,seeStandardandPoors2012.

30billioninthenextcoupleofyears,whichinturnwill costtheItalianTreasury5.1%ofGDPin2012,upfrom 4.2%in2011,andanticipatedtoriseto5.6%in2013 (SeeDonovan2011). FIGURE 1. THE COST OF GOVERNMENT BORROWING (spread overGermanbunds,basispoints)
3500 3000 2500 2000

1500 1000 500

0
Jan08 Jul08

Belgium France Greece Ireland Italy Portugal Spain

Jan09

Jul09

Jan10

Jul10

Jan11

Jul11

Note:Basedon10yeargovernmentbondyields. Source:FinancialTimes.

ShorttermfinancingfromEuropeanmechanisms(in particular,theEuropeanFinancialStabilityFacility, EFSF 4 )andtheIMFhasallowedGreecetocontinue meetingitsimmediatefinancingneeds.Butthishas onlyprovidedshorttermrelief,andhasnotaddressed thestructuralfiscalproblems.Andintheabsenceof thesefurtherfiscalactionsmarketsentimenthas remainedverynegative.Greeceisstillfarawayfrom beingabletoaccesscapitalmarketsandachieve financingfromprivateinvestors. ThegeneralconsensusisthatGreeceisnowinsolvent. Indicatorsofdebtsustainability,suchaspublicdebtto GDP(165.6%),publicdebttogovernmentrevenues (about400%),andbenchmarkgovernmentbondyields (10yearbondyieldatabout30%),allpointtowardsa highlikelihoodthatthecountrywillbeunableto honouritsobligations.Financingaloneisonlylikelyto leadtofurtherwithdrawalsofprivatecapital,untilthe pointisreachedwhereallGreekdebtisownedbyother Europeangovernments,eitherdirectlyorthrough Europeaninstitutions(includingtheECBandEFSF).In July2011,privatebankcreditorshadagreedtoaccepta voluntarydebtrescheduling,calculatedtobeequivalent toa21%haircut.ButthedecisionoftheEuropean SummitattheendofOctober2011toseekwritedowns ofatleast50%onprivatedebtrecognizesthescaleof restructuringneededinordertoreturntoamore sustainablepositionforGreece.
4.OnJanuary16,2012,S&Ploweredthelongtermissuer creditratingontheEuropeanFinancialStabilityFacility(EFSF) toAA+fromAAA.

1.2STRESSPOINTSANDSPILLOVERS
Thepressureforaresolutionofthesovereigndebtcrisis isnotonlyonthecountriesdirectlyinvolved,butonall theeurozonememberstates.Withbanksacross Europeholdinglargeamountsofthedebtofcountries intheeuroperiphery,thesovereigndebtcrisishasthe potentialtogeneratelargespilloverstoprivatefinancial institutionsandahugeshocktothefinancialsystem. AccordingtotheBankofInternationalSettlements (BIS)consolidatedbankingstatistics,thetotalforeign claims(forthesecondquarterin2011)onGreecealone amountedtoUS$120billionforallthebanksin Europeanreportingcountries(figure2).Theamount,a roughindicatorofthedirectandindirectexposureof privatebankstothesovereigndebtcrisisinEurope, shootsuptoaboutUS$2.2trillionwhenforeignclaims onIreland,Italy,PortugalandSpainareincluded(with ItalyandSpainaccountingforabout68%ofthetotal). FIGURE2.FOREIGNCLAIMSONGREECEBYBANKSIN EUROPEANREPORTINGCOUNTRIES,Q22011(US$billions)
France,55.7 Portugal, 10.1 Germany, 21.4 Other,18.4 Ireland,0.8 Spain,1.2 Belgium,1.7 Austria,3.3 Italy,3.7

demandawayfromGermanbunds(asobservedinlate November2011). Asindicatedinfigure3,Europeanbanksexposureto foreignclaimslocatedinGreeceisonlythetipofthe iceberg,whencomparedtotheirexposuretoforeign claimsinSpainandItaly.Thissuggestsdebt sustainabilityconcernsinthesetwocountriescould potentiallycauseameltdownintheEuropeanbanking sector,sparkcrosscountrycontagion,andthreatenthe veryexistenceofthesinglecurrency. FIGURE3.EUROPEANBANKSCOMBINEDEXPOSURETO FOREIGNCLAIMSLOCATEDINAFFECTEDCOUNTRIES,Q22011 (US$billions)

Greece

Portugal
0 100 200 300 400 500 600 700 800 900 Ireland Spain Italy

Source:ConsolidatedBankingStatistics,BankforInternational Settlements.

1.3ATWOSPEEDEUROPE?
Netherlands, 4.4

Source:ConsolidatedBankingStatistics,BankforInternational Settlements.

Marketshavealreadyrespondedtothispotential deteriorationinfiscalpositionsbyraisingthespreadson sovereignborrowing.SpreadsonItaliandebtandtoa certainextentSpanishdebtremainunsustainableover thelongrun;andcreditratingagencieshavealso respondedwithdowngradesand/orwarningsoffurther downgradesduetotheincreasedriskoffiscalliabilities arisingfromtheeurozonessovereigndebtcrisis.In addition,Frenchbankscreditratingsweredowngraded alsoduetoinvestorconcernsabouttheeurozonecrisis andtheirrelianceonwholesalefunding(SeeDaneshkhu andAlloway2011). Ascapturedinfigure2,alongwith banksinFrance,somebanksinGermanytoohave sizeableexposurestoforeignclaimslocatedinGreece. Germanysfiscalpositionaswellasitsgrowthprospects havekeptalidonitssovereignborrowinguntilnow; however,globalriskaversioncoulddrivethemarket

TheconceptofatwospeedEuropeisusedto distinguishbetweenthosecountriesthatcanlivewithin theconstraintsimposedbythesinglecurrencyand thosewhichcannot. 5GreeceandIreland,butalso Spain,Italy,andPortugal,arecountrieswith problematicdebtpositions 6 andareoutofsynchin termsofgrowthandinflation.Thesearecountriesat theeuroperipherynotonlybecauseoftheir geographicaldistancefromtheeurocore,butalso becauseoftheirconceptualdistancefromGermanys economicmodel(figure4).WhileGreece,Ireland,and Spain,andtosomeextentItaly,Cyprus,andPortugal, standoutintermsofGDPgrowthandinflation,Finland, Germany,andSlovakiascorewellonbothterms.
5.This,however,doesnotnecessarilyimplythatproblematic countriesshouldleavetheEMU.Certainlytheyneedto implementthenecessaryadjustmentsandresolvethe mismatch. 6.ItisimportanttoacknowledgethattheSpanishgovernment debtisestimatedtobe67.4%ofGDP,muchbelowitspeers. However,thevulnerabilitiesintheSpanishbankingsector couldspillovertothepublicbalancesheet.

 FIGURE4.GDPGROWTHANDINFLATION,EUROAREAAND INDIVIDUALMEMBERS,2010(percent)
Inflation
4 3 2 1 1 Ireland 2 3 Spain 2 1 0 0 1 2 3 4 5 Cyprus Slovenia France Italy Portugal Luxembourg Belgium Malta Austria Finland Euroarea Germany Netherlands Slovakia Greece 6 5 4

43.5%respectively(figure6).ThefiguresinIrelandand Italy,ataround30%,arenotonlysignsofeconomic malaise,buttheyalsohighlightanareaofpossible socialtensionandconflict.Germanyouth unemployment,runningat9.1%,underscoresthestark differencewithintheeuroareaandreinforcesthe conceptofatwospeedEurope. FIGURE6.YOUTHUNEMPLOYMENT,EUROAREA(percent)

Spain

RealGDPGrowth

Note:InflationisbasedontheHarmonizedIndexofConsumerPrices (HICP). Source:Eurostat.

Moreover,currentaccountimbalanceswithintheeuro areaalsohighlighttheconceptofatwospeedEurope. Althoughtheeurozone,takenasawhole,runsamodest currentaccountsurplus(estimatedtobe0.1%ofGDPin 2011),thefiguremaskslargeunderlyingimbalances. ExceptingIreland,allotherEuropeaneconomiesfacing severefiscalcrisisarerunningacurrentaccountdeficit, reflectingtheirlackofexportcompetitiveness. However,thesurplusesrunbynorthernEuropean economiesmorethanmakeupforthedeficitsinother partsoftheeuroarea(figure5). FIGURE5.CURRENTACCOUNTBALANCES,EUROAREA MEMBERS,2011(%GDP)
10 5
Netherlands Germany Austria Finland Ireland Belgium France Italy Spain Greece Portugal

Greece Slovakia Ireland Italy Portugal France Cyprus Estonia EU EuroArea Finland Belgium Malta Luxembourg Slovenia Germany Netherlands Austria 0

10

20

30

40

50

Notes: Unemployed aged 1524 years old as a percent of the total labour force (both employed and unemployed) in that age group. Sept.2011,exceptGermany,August2011;Greece,Estonia:July2011. Source:Eurostat.

Thechallengesforthecountriesintheeuroperiphery, andindeedfortheexistenceoftheeuroitself,areamix ofurgentprioritiesandlongtermmeasures.Inthe immediatefuture,withtheexceptionofGreece,they havetoconvincemarketsthattheirpublicdebtisona sustainabletrack.Theyalsohavetonormalisethe accessofbankstomarketfundingandtoimprovetheir externalpaymentsposition.Thelattershouldbe helpedinitiallybydeleveragingandtheslowdown(and, insomecases,contraction)ineconomicactivity.Inthe longerterm,thechallengeistorestoregrowthandto improvecompetitiveness.

10

2.THELONGGENESISOFTHEEURO CRISIS
2.1THEMORPHINGOFTHEGLOBAL FINANCIALCRISIS
IntheaftermathofLehmanBrotherscollapseinthe lastquarterof2008itseemedpossiblethattheglobal financialcrisiscouldhaveaselectiveimpactonEurope, affectingonlythosecountriesexposedthroughtheir bankingandfinancialsystems.Forinstance,theUnited

Source:IMFWEO,Estimatesfor2011.

Theeuroperipherysgrowthproblemstranslateinto highunemploymentrates.Again,Greece,Spain,and Italyhavedeeplyrootedunemploymentwithhigh percentagesamongtheyoungandwithsignificant regionaldifferencesespeciallyinItaly.Thelatest labourmarketfiguresshowyouthunemploymentin SpainandGreecefastapproaching50%,at48%andat

 Kingdom,Ireland,andSpain,havinggonethrough substantialhousingbooms,wereparticularlyaffected bythecreditcrunch.Similarly,thenewmemberstates ineasternandcentralEuropethathadexperienced strongforeigncapitalinflowsanddomesticcredit boomsonthebackofloansdenominatedinforeign currencies,suchaseurosorSwissfrancs,found themselvesatthecentreofthefinancialcrisis(Subacchi 2011). Excessivecreditgrowthfueledbyforeigncapitalflows notonlycreatedimbalancesthatbecameunsustainable intheaftermathoftheLehmancollapse,butalso facilitatedthetransmissionofthecrisisfromtheUnited StatestoEurope.WhentheUSfinancialandbanking systemcloggedup,foreigncapitalflowsdriedup. Strugglingparentbankscutbackfundingtotheirlocal subsidiariesthroughtightenedcreditorhighercostsof borrowing.Thepressureonlocalcurrenciestookits toll,regardlessofwhethercountrieshadfloating exchangeratesorcurrencypegstotheeuro.Afew westernEuropeanbanks(basedprimarilyinSweden, BelgiumandAustria)hadaparticularlyhighpercentage ofloanstoEasternEuropeandfundedmuchofthe 7 Baltic'screditfueledgrowth. Allthesecountriessawearlyandsharpcontractionsin investmentandprivateconsumptionasbusinessesand consumerswerestarvedofcredit.Grossinvestment declinedby12%inSpainandalmost20%intheUKin thefinalquarterof2008;inIrelandthecorresponding figurewas37%.Theyalsowitnessedadecelerationin privateconsumptionfromthebeginningof2008:from thepeakofthecrisisin2008toitstrough,private consumptionfellby34%inIreland,21%inSpain,and 15%intheUK.Incomparison,thefiguresforFrance andGermanywere0.7%and2.8%,respectively.Inthe finalquarterof2008,IrishGDPhadcontractedbyabout 9%yearonyearthemostseriousrecessionintheEU. Then,inlate2008,thecrisisbegantohaveawider effectontherealeconomythroughthetradesystem.It draggedtheworldeconomyintotheworstrecession since1929.Countrieswithalargeexportsector,such asGermanyandJapan,whichuptothenhadbeen almostunscathedbythecrisis,wereseverelyhitbya suddenandsharpdropintheirexports.Althoughthe severityofthedownturnvariedconsiderablywithinthe region,in2009theworldeconomyinaggregate
7. Forsomeofthemostexposedcountries,includingSweden andBelgium,loanstoemergingEuropeanmarkets representedasmuchas30%ofGDP;intheparticularcaseof Austria,thisfigurewasastaggering70%,includingmorethan 30%ofthecountrystotalbankingassets(IMF,2009;Arvaiet al.,2009).

recordedtheworstcontractionsincetheGreat Depression,withGDPfallingby0.7%.InEuropethe recessionwasevenworse,withacontractioninGDPof 4.2%. Policyinterventionrequiredbothmonetaryandfiscal measurestobailouttroubledbanksandtosupport weakeningeconomies.Thebankingsectorwasthe mainrecipientofgovernmentandcentralbankmoney toensurethatcreditflowswerenotfrozenandsoto avoidapossiblebankingcollapse.Troubledfinancial institutionsweresupportedthroughcapitalinjections, guarantees,orpartialnationalisation.TheUKwasone oftheearliesttorespond,nationalisingtroubled mortgagelenderNorthernRockinSeptember2007 8 afteritsufferedabankrun. Asthecrisisdeepenedin 2008,morecountrieswerepressedtosupporttheir troubledbanks,withthemajorrecipientsbeingUBS (Switzerland),Fortis(Benelux),ING(theNetherlands), RBS(UK)andLoydsTSB(UK).Thesemeasuresensured thatamoreseverecrisiswascontained,yetspiraling baddebtsfromtheeastremainedaproblemforsome 9 time. Interventionsinsupportoftherealeconomywerealso massiveevenincountriessuchasGermanythatwere reluctanttoriskafurtherdeteriorationoftheirfiscal position.Thesizeofthestimuluspackagesvaried acrossEuropefrom3.8%ofGDPinSpainto0.2%ofGDP inSweden. Fiscalinterventionsalongsidefallingtaxrevenuesand theimpactofautomaticstabilisersresultedinan increaseindebttoGDPratiosamongEuropean economiesfromaprecrisisaverageofaround61% (59%in2007and64%2008)toasmuchas74%in2009. Forsomecountries,thefiscalpositiondeteriorated morerapidlyandwidelythanforothers,becauseofa numberoffactorsincludinghighpreexistinglevelsof debt(Italy),largecurrentspendingwithlittlescopefor easycutsandefficiencygains(Greece),arapiddropin GDPgrowthandconsequentimpactonfiscalrevenues (SpainandPortugal),andalargebankbailout(Ireland). Giventhepatternofpublicindebtedness,problems seemedtobeconcentratedincountriesthathadfast butunsustainablegrowthintheprecrisisyearsorhad preexistingcriticalfiscalpositions,orboth(table1). WiththeexceptionofIreland,thesecountrieswere concentratedinsouthernEurope.

8.ItwasthefirstintheUKsincethe19thcentury. 9.AmajorAustrianbankthatwasheavilyexposedinthe regionwasnationalisedaslateasDecember2009.

 TABLE1:SOVEREIGNDEBT,EUROAREA
(%OFGDP)

EuroArea 2010 Finland 48.4 Spain 60.1 Netherlands 63.7 Austria 72.2 France 82.3 Germany 84.0 Portugal 92.9 Ireland 94.9 Belgium 96.7 Italy 119.0 Greece 142.8 Internationalcomparison UnitedKingdom 75.5 UnitedStates 94.4 Japan 220.0 Source:IMFWEOSeptember2011.

2011 50.2 67.4 65.5 72.3 86.8 82.6 106.0 109.3 94.6 121.1 165.6 80.8 100.0 233.1

Chinawasbeginningtoflexitseconomicmuscles,the Europeaneconomywasgrowingonaveragearound2% peryear(althoughthisrosecloserto3%bythelatter partofthedecade). IfEuropesoverallperformancewasdisappointinginthe precrisisyears,therewere,however,casesofstrong growth.Spainmanagedtogrowatanaveragerateof 3.8%from1997to2007.Similarexamplesofhigh growthwereregisteredincentralandeasternEurope. ThePolisheconomygrewatanaveragerateof4.5% overthesameperiod,whilethethreeBalticeconomies grewat6.58%(reachingaround10%in200506). Butthisoutstandingperformanceprovedtobe unbalanced,eitherbecausegrowthtendedtobe concentratedinafewsectorsorbecauseitwasfueled bystrongforeigncapitalinflows.InthecaseofSpain, nearly20%ofGDPwasinsomewayrelatedtoreal estateorconstruction,andonesixthoftheworkforce wasemployedinit(MartinTorres2009).Intheyears precedingthecrisis,Spainhadthelargesthousing sectorintheEU,with900,000housingstartsrecorded in2006;between2000and2007,theaveragehouse pricegrewby134%(anannualaveragerateof13%). Overthesameyears,Spainexperiencedawideningof itscurrentaccountdeficitfrom3.9%in2000to9.9%in 2007(MartinTorres2009). Allcountriesthatinonewayortheotherhavebeenhit bythesovereigndebtcrisisGreece,Ireland,Portugal, Spain,andItalyhaveacommonproblemof competitiveness.Usingnominalunitlabourcostsasa proxyforcompetitiveness,allthesecountries,and especiallyGreeceandPortugal,sawastrongincreasein labourcostssince1990andasaresultexperienceda deteriorationoftheircompetitivenessagainstGermany (figure7). FIGURE7:NOMINALUNITLABOURCOSTS(1990=100)
350 300

Theworst,however,hadstilltocome,withGreeces deeprootedfiscalproblemsbecomingunmanageable andspillingovertotheprivatesector.Thefirstcritical pointwasinMay2010whentheEuropeanCouncil, togetherwiththeIMF,puttogether750billionin emergencyfunding.BythenGreecesspiralingpublic debthadgeneratedaseriouscrisisinconfidence.What hadbeenmistakenlythoughttobeanisolatedand relativelyinsignificantepisode,givenGreecesrelatively smallweight,wassendingshockwavesthroughthe entireEuropeanbankingandfinancialsystem.Asthe riskofcontagionfromGreecetoothercountrieswith criticalfiscalpositionsrapidlyincreased,investors startedtoworryaboutitspreadingtootherEuropean economies.Thisledtoaviciouscycleofwidening sovereignspreads,differentialsincreditrates, difficultiesforrefinancing,andhigherborrowingcosts (seefigure1).

2.2THEBUILDINGUPOFIMBALANCES
Longstandingproblematicfiscalpositions,under performingeconomies,andimbalancesarethemain causesofEuropesvulnerabilitytotheglobalfinancial crisisandlatertothesovereigndebtcrisis.The sequenceofeventsisclearandunmistakable. BelowtrendGDPgrowthandlackofeconomic dynamismpredateboththeglobalfinancialcrisisand thesovereigndebtcrisis.Duringthe1990s,whenthe USwasexperiencingstrongproductivitygrowth 10and
10USbusinesssectortotalfactorproductivity(TFP)growth averagedabout1.6%peryearfrom1996to2004(andannual labourproductivitygrowthaveraged3.2%)afterapoor performanceinthelate1980sandearly1990s,whenannual TFPgrowthaveraged0.4%between1987and1995.

250 200

Germany Ireland Greece Spain France Italy Portugal

150 100

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Notes:CompensationperemployeetorealGDPperpersonemployed. Source:EuropeanCommission,DirectorateGeneralforEconomicand FinancialAffairs,AnnualMacroeconomicDatabase(AMECO).

 Growthinconsumerpricesisanothersignof imbalancesanddifferentialsincompetitiveness betweensouthernEuropeancountries(plusIreland) andGermany(figure8).InthecaseofIrelandandto someextentSpain,inflationabovetheECBtargetwas partlyareflectionofstrongeconomicgrowth.Inthe years20012005,accordingtotheOECD,theaverage inflationrateforIrelandandSpainwas3.5%and3.2% respectively,comparedwith1.5%inGermany.Buthigh inflationinGreeceandPortugalwasmoreareflection ofinefficienciesanddistortionsinthelabourmarket andintheservicesmarket.Greecesinflationratewas onaverageabove3%throughoutthe2000s,whileit wasaround5%intheyears19962000. FIGURE8:CONSUMERPRICEINFLATION(1991=100)
300 280 260

Poorcompetitivenessalsohashadadirectimpacton currentaccountimbalances.In2010thecurrent accountdeficitsofGreeceandPortugalwere10.5%and 9.9%ofGDP.Thecomparisonwiththe5.9%UScurrent accountdeficitin2006,whenitwasatitspeakand deemedunsustainable,showstheextentofthe challengethatthereductionofthesedeficitsposes. SpainandItalyneedalsotoaddresstheircurrent accountdeficits,althoughat4.6%and3.3%respectively theyaremoremanageablethanthoseofGreeceand Portugal.Thedeficitsoftheeuroperipheryare mirroredbythelargesurplusesoftheeurocore.In 2010Germanyhadasurplusinitscurrentaccountof 5.7%ofGDP,whiletheNetherlandshadanevenhigher surplusof7.1%. Itseemsclearthatunderlyingeconomicimbalances haveofferedafertilegroundforthefinancialcrisisto developonthebackoftheshockwavesoftheUS bankingcrisis.Excessiveleverageandproblematicfiscal positionsprovidedfurtherfueltothedeepeningofthe crisis. Greecedisplayedallthesymptomsofimbalance.Along withalargecurrentaccountdeficit,highinflationand lowgrowth,thelongstandingproblemswithpublic finances,thatgobacktothe1980s(boxA),the inappropriatemonetarypolicystance,andtheremoval oftheexchangerateriskthatcamewithEMU membershipresultedinexcessiveleverageinthe privatesectoraswell.Thehouseholdnetsavingsrateas apercentageofdisposableincomewasinnegative territorythroughoutthe2000suntil2008(themost recentdataavailable).Greeceepitomisesthefailureof severalgovernmentsattemptstomanagepublic financesandthespilloverintotheprivatesector. InthecaseofIreland,ontheotherhand,itwasthe unsustainablecreditgrowthandtheriseofproperty pricesthatinfectedthepublicsector.IftheGreekcrisis canbeclassifiedasatypicalpublicfinancecrisis(the originsofwhichpredateEMUmembership),theIrish crisishasitsorigininthedisconnectbetweentheIrish economyspaceofgrowth,thebuildingupof imbalancesinthebankingsector,andthemonetary policystancethatprevailedinthecurrencyunion(box B).TheIrishgovernment,however,failedtomitigate theimpactoflowinterestratesbynotimplementing fiscalandregulatorymeasuresthatcouldactina countercyclicalmannertooffsettheexpansionary impactoftheEMUmembershipandthegeneral overheatingoftheeconomyintherunuptothecrisis (Honohan2010;ReglingandWatson2010).

240
220 200 180 160

Germany Greece Ireland Italy Portugal Spain

140
120 100

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Note:Basedonconsumerpriceindices. Source:OECD.

PoorcompetitivenessreflectsindifferentialGDP growth,withthegrowthdynamicsofGreeceand PortugaltrailingwellbehindthatofGermany(figure9). FIGURE9:GDPAT2005MARKETPRICES(1000ECU/EUR)

100

90 80
70 60

50 40
30 20 Germany Spain Ireland Italy Greece Portugal

10 0

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

Notes:Adjustedbytermsoftradeperpersonemployed.1000 ECU/EURWeightedmeanoft/t1nationalgrowthrates(weights:t1 currentpricesinECU/EUR) Source:AMECO

BOXA GREECE:DEEPROOTEDTWINDEFICITS
AlthoughGreecesGDPcomprisesamere2%oftheeurozonestotal,thecountryssovereigncrisishasbeen sendingshockwavesmuchbiggerthanwasinitiallythoughtpossible.Indeed,despitelongstandingfiscal problemsandmodesteconomicperformance,GreecewasadmittedtotheEMUontheassumptionthatitwastoo smalltocreatesignificantproblemsforotherMemberStates.Experiencefromthelastcoupleofyearsshows howwrongthatassumptionwas. Fromtheearly1980stothemid1990s,theGreekeconomyfeaturedmodestGDPgrowth,doubledigitinflation, andpersistentbudgetdeficits,leadingtoaccumulationofhighlevelsofdebt.Between1980and1994,inflation averagedabout19%peryear.Itwasonlyinthelate1990s,inanticipationofEMUmembership,thatinflationwas substantiallyreduced.Inaddition,inflationbasedindexationofwagessetoffaviciouscycleofwageand consumerpriceinflation.Thisledtoasustainedincreaseinnominalunitlabourcosts,erodingtheGreek economyscompetitiveness(figureA1)andpushingitscurrentaccounttopersistentdeficits. Greecehashadlongstandingpublicfinanceproblems.Overthelast20yearspublicdebthasbeenaround100% ofGDP,evenduringtherunuptoEMUmembershipinthelate1990s.Thoughatighterfiscalpolicyhelped reducethedeficit,thecountrynevermanagedtoachievefiscalsurplusestosubstantiallyreduceitsgrossdebt. Evenduringthebenigneconomicperiodinthe2000s,thecountrynotonlyfailedtobringdownthedebtlevel, butalsoranchronicbudgetdeficits(figureA2). GreecesbudgetcycleisinseparablylinkedtotheelectoralcycleasindicatedbytheverticallinesinfigureA2, andsothepoliticalsystemisunableandunwillingtoundertakethenecessaryreformmeasurestoachievethe muchneededfiscalcorrection.AnattemptatfiscalconsolidationwasinitiatedinMay2004withintheEMUs ExcessiveDeficitProcedure(EDP),butwasmismanaged. InOctober2009,thethennewgovernmentdiscoveredalargerthanexpectedholeinthepublicaccountwhich ledittorevisethedeficitfigureupto12.5%ofGDP.Thisbroughtaboutalossofcredibilityforthecountryand asubstantialspikeinthecostofgovernmentborrowing.BurdenedwithunsustainablebondspreadsinApril 2010,theGreekgovernmentsoughthelpfromtheEU.InMay2010,Greecebecamethefirsteuroareacountryto receiveabailoutastheEUandIMFannounceda110billionrescueprogrammewhileimposingausterity measuresonthecountry.Thoughtherewasatemporaryreductioninitsborrowingcosts,thecountrysoonslid intoasocialcrisis.Withnorespitetoitssovereigndebtwoesandapoliticaldeadlockstallingfurtherassistance, Greecesdebtconcernshavesparkedcrosscountrycontagion.Thecountryspublicdebtwas143%ofGDPin 2010,andisprojectedtobe165.6%in2011.ThefutureoftheGreekeconomyremainsunclear.

155 145 135 125 115 105 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 95

0 2 4 6 8 10 12 14 16 18 Note:Verticallinesindicateelectionyears. Source:IMFWEOSept.2011.

Notes:Deflatedbyunitlabourcostsinthetotaleconom;12trading partners. Source:Eurostat.

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Fig.A1:Greece'sRealEffectiveExchange Rate(1980=100)

Fig.A2:Greece'sFiscalDeficit(%GDP)

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BOXB IRELAND:ABANKINGCRISISSPILLINGOVERTOTHEPUBLICSECTOR
Duringthe1990sIrelandsdynamiceconomybecameasymbolofeconomicsuccess.Between1991and2000 GDPgrowthaveraged6.8%peryearandtheIrishpopulationexperiencedadramaticriseinlivingstandards.Fiscal consolidationinthelate1980s,asshowninfigureB1,wasasignificantfactorincreatingastablemacroeconomic conditioninthecountry.Inaddition,structuralreformsinthelate1980s,inparticularthewageagreements betweenunions,employers,andthegovernment,ensuredmoderationinwageinflation.Irelandbecamea destinationforforeigndirectinvestment(FDI)andbegantoreapthebenefitsoftheEUsinglemarket. Withtheeconomyoperatingatfullemploymentfromthemid1990s,however,wagesbegantorise, competitivenessbegantoerode,andthecurrentaccountbalancewaspushedintodeficitinthe2000s.In addition,theEMUwidemonetarypolicyprovedtobetooloosetosuittheIrisheconomywhilefinancialmarket integrationandtheeliminationofcurrencyriskwithintheEMUmadecrossborderbankfundingwidelyavailable, improvedIrishbanksaccesstowholesalefundingmarkets(suchastheeurodenominatedLondonmarket),and increasedcompetitionbetweendomesticandforeignbanksinthedomesticmarket(ReglingandWatson2010). Allthisgeneratedexcessivecreditgrowth,asignificantriseinhouseholdindebtedness,andrapidincreasesin propertyprices.Between2003and2006,householdsgrossdebttoincomeratioincreasedfrom124.9%to 187.3%andnominalhousepricesroseanaverageofabout12%peryear.Assetconcentrationrisksinthe constructionsector,heavyrelianceonshorttermwholesaleforeignborrowing,andincreasingloantovalue ratioswereidentifiedasfailuresofbothregulatorsandthebankingcommunity(Honohan2010).Furthermore, Irishcompetitivenessdeterioratedrapidlyduringthe2000s,asindicatedbytherisingrealeffectiveexchangerate (figureB2). Theglobalfinancialcrisisof2008resultedinahardlandingwiththeIrishbankingsystemabsorbingsevere losses.InlateSeptember2008,aftertheeconomyhadslidintorecessionandthepropertybubblehadburst,the Irishgovernmentguaranteedalldepositsandsomedebtinstrumentsofthesixdomesticbanks.Theguarantee shiftedtheproblemtothegovernmentsbalancesheet.Despiteaprudentfiscalstancethroughoutthe1990s (butwithcurrentexpendituresgrowingfrom2001)Irelandended2010withafiscaldeficitof32%ofGDP(figure B1)whilepublicdebthadjumpedto95%ofGDP(projectedat109%in2011)fromonly25%in2006. ThesignificantincreaseintheIrishsovereignspreadovertheGermanbund,questionsaboutIrelandsabilitytoservice itsdebt,andfearsofcontagiontoothertroubledcountriesresultedinajointEUandIMFfinancialassistanceof85 billioninNovember2010.Inrecentmonths,theIrisheconomyseemstohaveturnedacornerwithamodestexport ledrecovery.However,thedownsiderisksfromthesovereigndebtcrisisinEuropeandthepossibleeffectofthelarge fiscalcorrectionremainmajorconcerns.

5 0 5 10 15 20 25 30 35

Fig.B1:Ireland'sFiscalDeficit(%GDP)
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 115 110 105 100 95 90 85 80 1980

Fig.B2:Ireland'sRealEffectiveExchange Rate(1980=100)

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

Note:Verticallinesindicateelectionyears. Source:IMFWEOSept.2011.

Note:Deflatorisunitlabourcostsinthetotaleconomy,12trading partners. Source:Eurostat.

2010

11

3.SOLUTIONS
3.1INTHESHORTTERM...ALENDEROFLAST RESORT
Addressingtheeurocrisishasbeenanexerciserequiring politicalanddiplomaticskillswhichhavenotalwaysbeen sufficientlyinevidence.Economicandfinancialsolutions thathaveneededtobeimplementedrapidlyinorderto respondtomarketpressuresandgrowingdistrusthave oftenbeenoverturnedorpostponedbecauseofpolitical prioritiesandconsiderations.Despiterepeatedassurances thatkeepingthemonetaryunionstableandcohesivewas 11 Germanysobjective, untillate2011GermanChancellor AngelaMerkelseemedtobetakingapoliticalstancethat wasinconsistentwiththatobjective.Theinsistenceon involvingtheprivatesectorinGreecesbailoutinorderto avoidmoralhazard,evenifcorrectinprinciple,triggered anadversemarketreactionandresultedincontagion spreadingtoItaly.Merkelsmoreconciliatoryapproach, helpedbyachangeofgovernmentinbothItalyand 12 Greece, shouldmakeiteasiertodealwiththecrisisand limitcontagion. However,suchachangemighthavecometoolateasthe chancesofavoidingthebreakingupofEuropesmonetary unionarenowhigherthanjustafewmonthsago. AllowingthesovereigndebtcrisistospillovertoItalyhas turnedthecrisisintoonethatthreatensthesurvivalofthe singlecurrency.WithItalynowonthebrink,thewhole approachtocrisisresolutionhasfundamentallychanged, asitnowinvolvescomplexsolutionsdealingwiththe governanceofthewholemonetaryunion.Butcomplexity hasnotbeenmatchedbyclarity.Indeed,thekeyquestion ofwhetherItalywillbeabletorefinancethe114.1 13 billion ofitsdebtearlyin2012isstillunansweredand stilldependsonwhetherinvestorsbelievethatItalyison tracktowardachievingfiscalconsolidationwithout undermininggrowth. 14
11.Nobodyshouldtakeforgrantedanother50yearsofpeace andprosperityinEurope.Theyarenotforgranted.ThatswhyI say:Iftheeurofails,Europefails.GermanChancellor,Angela Merkel,SpeechtotheGermanParliamenton7September2011. 12.BothItalyandGreecehaveresortedtotechnocratic governmentstoseethemthroughthecrisis.InItaly,Mario Monti,aformerEuropeanCommissioner,tookthehelmofthe interimgovernmentuntil2013.MeanwhileinGreece,afterdays ofnegotiationsbetweenpoliticalparties,inearlyNovember 2011,LucasPapademos,aformerEuropeanCentralBankvice president,wasnamedheadofaninterimgovernmentuntilthe electionsinFebruary. 13.Thefigurereferstothetotalamountofbondsreaching maturityinthefirstthreemonthsof2012. 14.InaninterviewwiththeFinancialTimes,ItalysPrime MinisterMarioMontistressedhowgrowthpromotingpolicies

Mostofall,thereisadisconnectbetweenthereaction timeofEUdecisionmakingandthenationalpoliticsthat underpinitandmarketexpectations.Sofar,thepolicy responsehasfocusedoncomplicatedsolutions,negotiated betweenmanycountriesthatrequirelongterm implementation.Howlongmarketsarepreparedtowait beforecompletelystoppinginvestingineuroarea countriesremainstobeseen.Evenifthedisorderlybreak upofthemonetaryunionhasnotbeenfullypricedinby financialmarketsandindeedtheeurohasbeen 15 remarkablyresilient contingencyplanstodealwiththe scenarioofabreakingupoftheEuropeanMonetaryUnion areopenlydiscussedintheprivatesector.Without suggestingthateurozonepolicymakersshoulddothe sameanoptionwhichcouldtriggeramassiveconfidence crisisnonethelessthereshouldbemorefocusoncrisis resolutionmeasuresthatdealwithshorttermpriorities. Theneedremainsforafinancialsafetynettosupport Europesbankingsystemandforfirewallsaround problematiccountriestoavoidthespreadofcontagion. 16 TheDecember9,2011agreement attheEuropean Councilforaprovisionof150bnfortheIMF 17isagood start,butsurelynotenoughtosupportItaly.However, thisprovisionaswellastheEFSFarenotlargeenoughto withstandtheimpactintheeventofofItalyspartial default.TheItaliandebt,at1.9trillion,istoolargeanda
arethenecessarycomplementtofiscalrigourifmarket confidencehastoberestored(FinancialTimes2012). 15.Theeurohasremainedremarkablyresilientsincetheonsetof financialcrisisinearly2010.SinceJanuary2010,thecurrency hastradedbetween1.2and1.5dollarspereuro.However,there aregrowingpressuresonthevalueofthecommoncurrencyas observedbytherecentdevelopmentsintheforeignexchange market. 16.On9December2011,theEuropeanCouncilagreedto enhanceexantefiscalsurveillanceandthesolidityandcredibility ofbudgetaryprocessesintheeuroarea.Moreimportantly,it agreedonatreatyamong26governmentstosupport recommendationsthattheEuropeanCommissionmakesinthe frameworkoftheExcessiveDeficitProcedure,leadingtogreater automaticityofsanctionsandtoadoptabalancedbudgetruleat theconstitutionalorequivalentlevel,andtorecognisethe jurisdictionoftheCourtofJusticetoverifyitstransposition. Furthermore,toensurethefinancialstabilityoftheeuroarea, theleadersagreed:1)thattheEuropeanStabilityMechanism (ESM)shouldenterintoforceinJuly2012insteadofJuly2013;2) privatesectorinvolvementintheGreekdebtreduction programmewillremainauniqueoneoffcase;3)urgentdecisions intheESMcanbetakenbyqualifiedmajority;4)theadequacyof thecombinedceilingfortheEFSFandESMof500bnwillbe reassessedinMarch2012;and5)theeuroareaandother memberstateswillconfirmin10dayswhethertheycanprovide upto200bninadditionalresourcestotheIMF,throughbilateral loans,toensureithasadequateresourcestodealwiththecrisis. 17.Thoughmemberstateswereexpectedtoconfirmthe provisionofupto200billioninadditionalresourcestotheIMF, thefailuretoensureBritishparticipationmeantthatthetarget hadtoberevisedto150billion.

 debtwritedownastheonedecidedforGreeceattheend ofOctober2011wouldhavesubstantialimplicationsfor thehealthofItalysprivatecreditors,inparticularthe countrysbankingsystemaswellasbanksinother eurozonecountries.Manyofthesebanksarealready strugglingtoraisesignificantamountsofcapitalandsoto restoretheircapitaltothelevelsestimatedbythe EuropeanBankingAuthority(EBA)asneededtoprotect themagainstadverseshocks.AdebteventinItalywould requiregovernmentinterventionsinmanycountriesin Europetoinjectcapitalintotheirbanksatatimewhen governmentsalreadyfacesubstantialfiscalpressures.The EFSFcouldprovidethenecessaryfinancialsafetynetifit waslargeenoughtofulfillthisrole.Butsofaralltalkson additionalfinancingbystrongereurozonecountriesor fromoutsideEurope(theIMFortheBRICs)havenot resultedinanysubstantialimprovement. ItisessentialtoreduceItalysdebtservicingcost,andin theabsenceofothersolutionstheECBcouldprovide shorttermassistancebyactingasafullyfledgedlenderof lastresort.Thiswouldmeaninterveningdecisivelyin supportoftroubledcountriesbondswhilethecrisis continues;andeventuallyagreeingtoanexpansionofits statutoryroletobecomeamarketmakerandstabiliser forthebondsissuedbymemberstates.Inrecentmonths theECBhascontinuedtointerveneinsupportofboth sovereignbondsandthebankingsector.However,ithas alwaysmadeclearthatthiswasnotthedefaultmode.In ordertorestoremarketconfidenceitisnownecessary thattheECBagreestoprovidesupportforaslongandon assufficientascaleasisneeded.

12

reversedofholdingareferendumontheausterity measuresisanunambiguoussignofthedifficultiesfacing thecountryinaddressingthesechallenges.Indeed,the autumnforecastbytheEuropeanCommissionprojectsa substantialincreaseingrossdebtasashareofGDPfrom 162%in2011to198%in2013whileGDPgrowthremains innegativeterritoryinboth2011and2012at5.5%and 18 2.8%respectively. Aswediscussinthispaper,arootcauseoftheproblemsin theeurozoneperipherycountriesistheirlackof competitivenesswithinthesinglecurrencyunionthathas exacerbatedcurrentaccountimbalancesandslowed growth.Inaddition,simultaneousfiscalconsolidationby allpartsoftheeurozonehasmagnifiedtheadverseeffects ongrowth.Smallopeneconomiescanminimisethe contractionaryeffectsofdomesticfiscalconsolidationif theirtradingpartnersareabletosubstituteexternal demandfordomestic.Buteurozonecountrieshavemuch strongertradinglinkswithothereurozonemembers,and theeurozoneasawholeisalargeandrelativelyclosed economywithsubstantialinterconnectionsbetweenits constituents.Soforeachcountrywithintheeurozone,its ownfiscaleffortsarenotonlyaffectingdomesticdemand, butexternaldemandisalsoweakening. Iftheeurosurvivesinitscurrentform,addressingthese competitivenessissuesrequires: asharedsolutionwhereeuroareamemberstates withcriticalfiscalpositionsimplementcredible mediumtermplanstoreducedeficitsanddebtwhile euroareamemberstateswithcurrentaccount surplusestakemeasurestoreducetheirsurpluses; amorestructuredapproachtofiscaltransfers betweenricherandpoorercountrieswithinthe currencyarea; structuralreformstomaximisegrowthpotentialin individualcountries; reformsthatmakeiteasierforcountriestomaintain competitivenesswithinthesinglecurrency,in particulartoensurethatrealexchangeratescan adjust.

3.2APLANFORGROWTHINTHELONGERTERM
InthispaperwearguethatEuropessovereigndebtcrisis ismultifacetedandeveniftheoutcomeissimilarforall countriesacriticalfiscalpositionthatmarketsdeem unsustainablerestoringfiscalhealthshouldnotbeaone sizefitsallpolicygoal,butshouldbeassessedand achievedwithinthespecificcontextofeachcountry.Not onlydoesaonesizefitsallapproachignorefeaturesand conditionsthatarepeculiartoeachcountry,butalso indiscriminatefiscalstrategieswiththeultimategoal simplytobalancethebudgetcanhaveveryadverseeffects oneconomicgrowth(atleastintheshortterm).Lackof growth,inturn,seriouslyhindersfiscalconsolidation becauseofitseffectsontaxrevenueandwelfare spending.Thus,inthelongertermEuropesfiscal problemscanonlybesensiblyaddressedwithareturnto growthbothtoavoidthedebtdynamicsthatcouldput fiscalconsolidationplansatriskandtogeneratethe necessarypoliticalsupportfordifficultpolicydecisions. ThisisclearinthecaseofGreece,wherethe implementationofpublicexpenditurecutsandtax increaseshasalreadycontributedtostrongfallsinoutput, whichinturnaremakingthefiscalchallengeseven greater.Strongpublicoppositionandtherecentchangeof governmentfollowingthedecisionsubsequently

3.3REBALANCINGTHEEUROECONOMY
Thereisafundamentalcontradictionbetweenthetwo equallyimportantandnecessarygoalsoffiscal consolidationandeconomicgrowth,especiallywithinthe constraintsimposedbythefixedexchangerateregimein theeuroarea.Giventhelimitedtimeframeimposedon theeurozonebyfinancialmarkets,fiscalconsolidationcan onlybeachievedthroughapainfulprocessofdomestic deflation.Undertherightcircumstancesthisprocessisa waytoincreasecompetitiveness;itisindeedtheprocess
18.See,EuropeanCommission,EuropeanEconomicForecast Autumn2011,EuropeanEconomy6,2011(provisionalversion), http://ec.europa.eu/economy_finance/ eu/forecasts/2011_autumn_forecast_en.htm.

 thatGermanywentthroughintheyears20032007in ordertoachievetheadjustmentsintherealexchangerate necessarytocompeteinafixedexchangerateregime. However,thesizeofdebtreductionforcountriessuchas GreeceandItaly,andtosomeextentSpainandPortugal, requiresmeasuresoffiscalausteritythatwouldseriously damagegrowthandthreatensocialcohesion.Thesolution isthentogenerateanintraeurorebalancingwherethe burdenofadjustmentissharedbetweendeficitand surpluscountries.

13

monetaryunion,withsharedresponsibilitiesandshared interestinensuringthattheunionflourishes,itshouldbe easiertorebalancethoseresponsibilities.Onemechanism couldbetolinkfiscaltransfersdirectlytobalanceof paymentssurplusesanddeficits(theeurozoneequivalent ofKeynesoriginalnotionfortaxingbalanceofpayments surplusesanddeficits).

3.5CONCLUSION:THEALTERNATIVE
Withoutthesechanges,bothtodealwiththecurrentcrisis andtoaddresssomeoftheunderlyingproblemswhich preventtheeurozonefromeffectivelycoordinatingits policies,itishardtoseetheeurosurvivinginitscurrent form.ThebalanceofcostsandbenefitsfromEMU membershipisspreadunevenlyamongitsmembers.And thestrains,botheconomicandpolitical,placedon individualcountriesonlivingwithintheconstraintsofthe singlecurrencyaresubstantial. Ultimately,ifthecostbenefitequationshiftstoofar,it couldforcethebreakupoftheeuro,eitherbyforcingout someofitsweakermembersorbyencouragingthe strongermemberstoleavebecausetheyarenotprepared toaccepttheconsequencesforthemselves.Butthis wouldbeanuclearoption,andwouldpotentiallyreverse thetrendtowardsgreaterintegrationatalllevelswithin Europe.Forthatreason,itwouldonlycomeaboutasa lastresort.Nevertheless,unlessfurtherchangesaremade tothestructureofthesinglecurrencytoputitona sustainablefooting,itmaystillcometopass. Despitethedifficulties,thebenefitsofmembershipinthe euroarelarge.Itsmembersareabletotradewitheach otherwithoutfacingcurrencyrisk,andtheeconomiccosts ofcurrencyconversionareeliminated.Also,manyofthe peripherycountrieshaveenjoyedsubstantiallylower borrowingcosts,andtheyhavehadsignificantpolitical benefitsfrommembership.

3.4STRUCTURALREFORMS
Inthelongterm,iftheeuroistosurvive,thedesignflaws andthepoliticaltensionsthatthecurrentcrisishave exacerbatedwillhavetobeaddressed. Onemajorflawinthedesignofthesinglecurrencythatis widelyrecognisedisthelackofaneffectivefiscal coordinationmechanism.TheStabilityandGrowthPact (SGP)hasprovedtobeineffectiveinbothofferinga benchmarkformeasuringmemberstatesfiscal performanceandprovidingsurveillanceoncritical situationsandmitigatingaction.Inaddition,itsdesignis structurallyflawedasitonlyconsiderseachmember statesfiscalpolicy,andnotfiscalpolicyfortheeurozone 19 asawhole. ItisnowclearthattheEMUcannotbesuccessfulwithouta degreeoffiscalunionamechanismforformulatingfiscal policyattheunionlevelandamechanismformaking fiscaltransfersfrommorecompetitivetolesscompetitive regionswithinthecurrencyarea.Acrediblesystemof sanctionsforexcessivedeficitsinindividualcountries wouldalsobenecessaryinordertoavoidfreerider problems.TheEUasawholedoesallowlimitedfiscal transfersthroughthestructuralandcohesionfunds.But theseareprimarilyintendedtoencourageconvergence betweenthepoorerandricherregions,nottocompensate forthelossofmonetarysovereignty. Effectivefiscalcoordinationwouldalsohelpavoidthe currentselfreinforcingnatureoffiscalpolicymaking withintheeurozone,whichismagnifyingthe contractionaryeffectsofsimultaneousfiscalconsolidation. Anotherrelatedissueisthebalanceofresponsibilities betweensurplusanddeficitcountrieswithintheeurozone forcorrectingpaymentsimbalances.Asatthegloballevel, theresponsibilitiesareplacedmuchmoreonthedeficit countriesthanonthesurpluscountries.Butwithina
19.Fiscalpolicycoordinationinthesenseofavoidingspillovers andpromotingpeerreviewinordertodetectproblematic situationsbeforetheybecomeunmanageablewasnotamain concerninthemindsofthearchitectsofEMU.TheSGPwas designedasaninstrumenttoprovideameasuretocontroland reprimandfiscallyproblematiccountrieslikeItaly.Itisironicthat theSGPwasbreachedbyGermanyitself(togetherwithFrance)in 2003.ThepreviousyearPortugalwasreprimanded,butnotfined forhavinghadadeficitofmorethan3%ofGDP.

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