There is little doubt that the ongoing crisis in the market for Greek government bonds is a major test for the sustainability of the Eurozone. As such, it is certain to attract, in due course, considerable academic attention shedding light to its origins, mechanics and lessons. But with events still unfolding, time is of essence: Any insights to the crisis’ likely causes, mechanics and outcomes, even imperfect, are bound to be useful for the purpose of managing the crisis. When in unchartered territory academics’ typical initial response tends to be a first-pass assessment using tools available at hand. In a recent paper (Arghyrou and Tsoukalas, 2010a), we do precisely that. More specifically, we use insights from the literature on currency crises to offer the first, to the best of our knowledge, analytical treatment of the crisis’ causes, mechanics and likely outcomes.
We analyse the Greek crisis using a model drawing elements from all existing models of currency crises (first, second, and third-generation) rationalising and capturing all the facts we have observed up to the time of writing (end April 2010). In our model a rational government makes a choice between staying in or exiting the euro by balancing the costs of these options. The cost of exiting the euro (i.e. the loss of long run credibility) is assumed to be equal to a constant value. On the other hand, the cost of staying in the EMU (i.e. the loss of short run macroeconomic flexibility) is a quadratic function of the misalignment of the country’s peg to the euro versus the equilibrium exchange rate. This is the exchange rate the country would have chosen under a floating exchange rate regime. Crucially, the cost of staying in the EMU is also a function of private expectations about the credibility of the country’s future EMU participation. There exist three possible regimes for these expectations. The first is one where the country’s future EMU status is regarded as fully credible and its fiscal liabilities guaranteed by its EMU partners. The second is one of non-credible future EMU participation with guaranteed fiscal liabilities. Finally, the third regime is one of non-credible commitment to future EMU participation and non-guaranteed fiscal liabilities.
Based on the predictions of our model we argue that the Greek debt crisis and its escalating nature, are very likely the result of (a) steady deterioration in Greek macroeconomic fundamentals over the period 2001-2009, to levels inconsistent with long-term EMU participation; and (b) a double shift in markets’ expectations, from a regime of credible commitment to future EMU participation under an implicit EMU/German guarantee for Greek fiscal liabilities, to a regime of non-credible EMU commitment without fiscal guarantees. These shifts, respectively taking place in November 2009 and February/March 2010, transformed what was initially a challenging crisis of fundamentals, first into a crisis of confidence in Greece’s monetary regime, in November 2009, and then into a crisis of confidence in Greece’s ability to service its public debt, in February/Marcy 2010. Under these circumstances, resorting to the agreed EU/IMF mechanism of emergency non-market financing on 23 April 2010 was the only option available for Greece to avert an imminent EMU-exit.
Our analysis suggests that all parties involved in the crisis have contributed, in varying degrees, to the crisis’ creation and/or escalation. First Greek authorities, initially for allowing a deterioration of Greek fundamentals over the period 2001-2009; and then for sending mixed signals regarding their determination to promote structural reforms during the crucial period October/November 2010. This proved to a pivotal point for subsequent events, as for the first time since the crisis’ onset, faced by hesitation and clarity of intention, markets started doubting the commitment of Greece to future EMU participation. This introduced a previously non-existing exchange-rate risk into the interest rate of Greek government bonds, causing a vicious circle involving increasing spreads and further adverse shifts in expectations.
Second, the EMU as a whole, first for not having in place a mechanism supervising effectively fiscal policy in individual member-states and, second, after the crisis erupted, for misjudging markets’ expectations regarding a fiscal guarantee perceived to apply to Greek fiscal liabilities. It now becomes increasingly clear that markets had never believed the no-bail-out clause of the Maastricht Treaty and had been pricing, even well into the crisis, Greek bonds assuming that a bailout would eventually be available. Hence, if a bailout were given, it would not be regarded as news and would not destabilise the Eurozone through the creation of a moral hazard problem; the news actually was that there was to be no bail-out. Therefore, despite its sound ex-ante justification, the mainly German-led policy of “constructive ambiguity” ex-post seems to have backfired: In view of the ballooning Greek public debt, the withdrawal of the assumed implicit fiscal guarantee in February/March 2010 introduced into Greek government bond yields a substantial default risk, additional to the exchange rate risk discussed above. This not only contributed to the collapse of the Greek bonds’ market, thus escalating a crisis it was meant to contain, but has also sown the seed of contagion to the bonds markets of other EMU periphery countries, also operating hitherto under the assumption of guaranteed fiscal liabilities.
Third, the markets for misjudging the commitment of Germany to the no-bailout clause. The closest historical analogy to current events is the ERM crisis of 1992-93. At the time Germany was called to make a choice between two conflicting objectives: On the one hand, maintaining internal price stability and economic restructuring following the German re-unification. These called for higher German interest rates. On the other, maintaining momentum for the European monetary integration project by helping its ERM partners to cope with an economic recession. This called for lower German interest rates. Germany opted for the former, causing the ERM’s collapse and putting in jeopardy the whole EMU project just one year after the signing of the Maastricht Treaty. This event, combined with the consistent post-war nature of German economic policy confirmed that the latter’s Holy Grail is low internal inflation and external currency stability. To this objective Germany’s commitment to European monetary integration, comes second. With this experience available and with German policy announcements traditionally been regarded among the most credible in the world, why markets chose to doubt Germany’s commitment to the no-bailout clause is, to say the least, surprising.
As far as Greece is concerned, there is now a clear binary path regarding future outcomes: Either Greece will introduce the reforms necessary to address the crisis’ initial source, i.e. deteriorating fundamentals, in which case and, assuming a favourable external environment, her economy will gradually regain the markets’ confidence and the country has a good chance of staying in the EMU; or Greece will not promote any reforms, in which case she will have no option other than to leave the euro.
Regarding the possibility of contagion, our analysis suggests that other periphery EMU countries, i.e. Ireland, Italy, Portugal and Spain, appear (at varying degrees) vulnerable. Since their euro-accession in 1999 they have also experienced significant deterioration in key fundamentals. Furthermore, the withdrawal of the implicit EMU/German fiscal guarantee applies to these countries too. Therefore, to avoid the adverse shift in markets’ expectations Greece has sustained, these countries must also pursue, without delay, fiscal consolidation and extensive structural reforms.
What are the institutional lessons drawn from the Greek crisis? To minimise the risk of contagion of the present crisis and avert future ones, it is necessary for the EMU to undertake institutional reforms towards two directions. First, to prevent future crises, improve the effectiveness of fiscal supervision applied to individual EMU-member states. Second, for handling this and future crisis, minimise the risk of default risk. To achieve this, the EMU must develop as soon as possible a mechanism of emergency financing, with clear and transparent rules reassuring markets that no money will be lost on investments involving EMU government bonds. The EU/IMF mechanism put in place for Greece is helpful for handling the present crisis but unlikely to avert future ones, as it is an ad-hoc arrangement involving an external institution, the IMF, to EMU affairs. This is a disadvantage, with the argument made on economic grounds only. The prospect of IMF involvement into the handling of future EMU crises may fail to reduce market uncertainty, as no effective ex-ante guarantee can be given to markets for the possibility of co-ordination failure between the EMU and the IMF. Therefore, without an exclusively EMU-run mechanism of crisis management, the EMU may find it difficult to stabilise market expectations at the crucial initial stages of a future crisis. Defining the rules of a European Monetary Fund will be a challenging task, as these should at the same time reassure markets that no money can be lost without causing moral hazard leading to excessive deficits and lack of reform. This is a topic calling for significant attention from academics and policy-makers alike.
But when all is said and done, ending the current EMU crisis and averting future ones ultimately depends on one single factor: the willingness of societies in the EMU periphery to undertake the significant short-run welfare cost accompanying reforms necessary to remain in the Eurozone. It is therefore vital for EMU periphery governments to communicate clearly to their citizens what are the stakes in not promoting reforms; and convince them that since the latter will have to take place anyway, it will be much preferable for their own long-run welfare to undertake them within the euro rather than outside it.
There is one final risk: This is that over the past decade EMU periphery economies have diverged so much from those of core EMU countries that either they cannot sustain, or markets regard them as not being able to sustain, the cost of reforms necessary to remain in the Eurozone. At this stage it is impossible to know whether this is true; but if it is, it will be extremely challenging for European governments to sustain the euro. We believe that European governments must have a plan to face such as scenario. Allowing individual economies to exit the euro on a unilateral basis is an easy, yet inappropriate response, as one country’s exit from the euro will very likely cause a domino effect, with markets eventually forcing all struggling economies out of the euro. From an EMU perspective such a development will be catastrophic, but is there any alternative?
We believe there is one. In a recent paper (Arghyrou and Tsoukalas, 2010b), we have spelled out a plan of last resort for resolving the present crisis, to be used only if everything else fails. The key ingredients involve a temporary split of the euro into two currencies both run by the ECB. The hard euro will be maintained by the core-EMU members whereas the periphery EMU countries will adopt for a suitable period of time the weak euro. All existing debts will continue to be denominated in strong euro terms. The plan involves a one-off devaluation of the weak euro versus the strong one simultaneously with the introduction of far reaching reforms and rapid fiscal consolidation in the periphery EMU countries. We argue that due to enhanced market credibility the plan will have a realistic chance of success, maintaining the project of European monetary integration and leaving the door open to the periphery countries for a return to the strong euro.
Arghyrou M.G. and Tsoukalas J. (2010a). “The Greek debt crisis: Likely causes, mechanics and outcomes”. CardiffBusinessSchool, Economics Working Papers No E2010/3.
Arghyrou M.G. and Tsoukalas J. (2010b). “The option of last resort: A two-currency EMU”. published on 7 February 2010 at www.roubini.com. Available at:
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