Nouriel Roubini's Global EconoMonitor

A Survival Strategy for the Eurozone

From Project Syndicate:

After the Greek and Irish crises and the spread of financial contagion to Portugal, Spain, and possibly even Italy, the eurozone is now in a serious crisis. There are three possible scenarios: “muddle through,” based on the current approach of “lend and pray”; “break-up,” with disorderly debt restructurings and possible exit of weaker members; and “greater integration,” implying some form of fiscal union.

The muddle-through scenario – with financing provided to member states in distress (conditional on fiscal adjustment and structural reforms), in the hope that they are illiquid but solvent – is an unstable disequilibrium. Indeed, it could lead to the disorderly breakup scenario if institutional reforms and other policies leading to closer integration and restoration of growth in the eurozone’s periphery are not implemented soon.

The crisis started with too much private debt and leverage, which became public debt and deficits as crisis and recession triggered fiscal deterioration and private losses were mostly socialized via bailouts of financial systems. Then, distressed sovereigns that had already lost market access – Greece and Ireland – were bailed out by the International Monetary Fund and the European Union.

But no one will bail out these super-sovereigns if the sovereigns prove to be insolvent. Thus, the current strategy of kicking the can down the road will soon reach its limits, and a different plan will be needed to save the eurozone.

The first institutional reform takes the form of a larger envelope of official resources, which would mean a quasi-fiscal union. Official resources currently are sufficient to bail out Greece, Ireland, and Portugal, but not to prevent a self-fulfilling run on the short-term sovereign and financial liabilities of Spain and other potentially distressed eurozone members.

So, even if these countries were to implement the necessary fiscal and structural reforms, an increase of official resources would nonetheless be needed. Because nervous investors don’t want to be last in line in case of a run, a disorderly rush to the exits is likely when official resources are insufficient.

Short of full fiscal unification – or a variant of it in the form of eurozone bonds – this increase in official resources would occur through a much-enlarged European Financial Stability Facility and a much greater commitment by the European Central Bank to long-term bond purchases and liquidity operations to support banks. Since quasi-fiscal union implies that the eurozone’s core economies could end up systematically bailing out those on the periphery, only a formal loss of fiscal sovereignty – a credible commitment by the peripheral countries to medium- and long-term fiscal discipline – could overcome the current political resistance of Germany and others.

But even a larger envelope of official resources is not sufficient to stem the insolvency problems of Greece, Ireland, and, possibly, Portugal and Spain. Thus, a second set of policies and institutional reforms requires that all unsecured creditors of banks and other financial institutions need to be “treated” – that is, they must accept losses (or “haircuts”) on their claims. This is needed to prevent even more private debt being put on government balance sheets, causing a fiscal blowout. If orderly treatment of unsecured senior creditors requires a new cross-border regime to close down insolvent European banks, such a regime should be implemented without delay.

Similarly, super-sovereigns cannot continue to bail out distressed sovereigns that are insolvent rather than illiquid. Thus, in addition to an orderly resolution regime for banks, Europe must also implement early orderly restructurings of distressed sovereigns’ public debt. Waiting until 2013 to implement these restructurings, as German Chancellor Angela Merkel proposes, will destroy confidence, as it implies a much larger haircut on residual private claims on sovereign borrowers.

Thus, orderly market-based restructurings via exchange offers need to occur in 2011. Such exchange offers can limit private creditors’ losses if they are done early. That way, formal haircuts on the face value of debt can be avoided via new bonds that include only a maturity extension and an interest-rate cap that is set below today’s unsustainable market rates. Waiting to restructure unsustainable debts would only lead to disorderly workouts and severe haircuts for some private creditors.

Finally, Europe needs policies that restore competitiveness and growth to the eurozone’s periphery, where GDP is either still contracting (Greece, Spain, and Ireland) or barely growing (Italy and Portugal). Without growth, it will be difficult to stabilize public and private debts and deficits as a share of GDP – the most important indicator of fiscal sustainability. Moreover, without growth, the social and political backlash against painful belt-tightening will eventually undermine austerity and reform.

Unfortunately, fiscal austerity and structural reforms are – at least in the short run – recessionary and deflationary. So other policies are needed to restore growth. The ECB should pursue a much looser monetary policy to jump-start growth, with a weaker euro to help boost the periphery’s competitiveness. In addition, Germany should delay its fiscal consolidation; if anything, it should cut taxes for a couple of years to boost its own growth and – via trade – that of the periphery.

In the next few months, it will become clear whether European policymakers can compromise and implement reforms that dampen the threat of a eurozone breakup. Either the EU moves in the direction of a more stable equilibrium of closer integration, or the risk of an unstable and disorderly breakup scenario will rise significantly.

2 Responses to “A Survival Strategy for the Eurozone”

Heinrich von LoeschJanuary 10th, 2011 at 3:14 pm

I saw Dr Roubini’s Project Syndicate article in today’s Sueddeutsche Zeitung. While I can agree with most of its conclusions I believe the reality in some peripheral states of Europe differs from what Dr Roubini described.Knowing Italy well, I can tell you that the deflationary effects expected from the current austerity drive of Finance Minister Giulio Tremonti have not materialized. Today’s news is that consumer spending has contracted in2009 and 2010 by over 2 percent p.a. which might be due to rising unemployment, higher propensity to save because of the crisis, or simply because of flat incomes and inflation.No doubt: instead of the feared deflation there is rising inflation. Why?Part of the answer is of course increased cost of energy, driven by oil prices. But in addition there is a good deal of home made inflation, as usual likely to be underestimated by ISTAT. the Italian statistics office.How come that inflation prevails despite a vigorous (yes, really!) austerity drive? Having lived for well over twenty years in Italy I think I have a pretty realistic idea of what is happening.To understand the phenomenon it is important to remember that Italy, like other Mediterranean countries, has experienced decades of inflation at least since World War II. When the euro replaced the lira, Italian mentality did not change at all. Inflation-mindedness, to coin a proper term, continued unabated. Government debt spending and commercial credit expansion provided the additional euro supply needed to balance the domestic economy’s inflationary trend with the available money supply.As a result, wages and prices rose to the point where Italy lost most of its competitive status within the euro zone and outside. Then came the crisis and the government austerity campaign. But good old inflation-mindedness continued. Why and how?First of all: Italian companies, individuals and public entities are accustomed to raise prices, tariffs and fees periodically, say, once a year. With the advent of the crisis and consumer reticence the reaction was not to lower prices, cut margins etc. Instead of trying to maximize sales, many companies resorted to maximizing profit per unit sold by jacking up prices, rates, tariffs, etc.In other countries this might induce consumers to search for lower offers, to refrain from accepting the higher prices etc. Not so in Italy, a country in which prices “age”, and new prices are always higher. Inflation does not cause much concern: it is accepted like the weather. Usually twice a year, during the summer break and around Christmas, Italian media announce for the coming autumn or new year a “stangata”, a unique Italian term for a wave of price and tariff increases. The media also report how much the expected stangata is going to cost the average family annually, usually well above one thousand euro.Stoic consumer behavior makes it easy for producers not only to raise prices but also to limit competition. A major response to austerity and weak consumption is for Italian producers and especially distributors to join forces and regulate the market to their advantage. From leading banks to supermarket chains and mafia contractors there is hardly a sector in Italy in which competition is not limited or excluded by legal and illicit means.This showed, for instance, when during the financial crisis Italian banks – the most expensive in Europe — were scarcely affected and drew the government’s praise for having been so “cautious.” In reality, by avoiding competition they had shaped the domestic market so conveniently that they were happily exploiting their domestic customers and did not need to undertake any investment banking abroad.An inflation-minded population combined with highly monopolistic structures, not to speak of endemic corruption and organized crime, can render even a large economy like Italy’s dysfunctional in the sense that the logic of economics does not always apply. Recommendations for how to shape economic policy in a situation under stress may be helpful in functional economies. In a dysfunctional one the recommendations might backfire and produce perverse results.In the case of Italy, floating the economy with cheap money and incentives could accelerate the inflation to the point of no return and a final cataclysm like Greece’s.Italy is a country that needs psychiatric help to free itself of inflation-mindedness. A brief spell of detox and rehab will not suffice.Sincerely,Heinrich von