"Dreams Versus Reality" - Former IMF Chief Economist On Europe's Last Stand

Successive plans to restore confidence in the euro area have failed. Proposals currently on the table also seem likely to fail. The market cost of borrowing is at unsustainable levels for many banks and a significant number of governments that share the euro. In three short sentences, the Peterson Institute for International Economics' (PIIE) Simon Johnson introduces the clear and present danger that Europe has become in a comprehensive article on the deepening European crisis. The circular nature of the realization of sovereign credit risk realities and the subsequent effective insolvency of banks exacerbates a credit crunch and exaggerates problems in the real economy - most specifically in the periphery. Johnson outlines five measures that are needed to enable the euro area to survive but the big bazooka of up to EUR5tn just for the PIIGS is what the PIIE senior fellow fears as the ECB is pushed down a dangerous path. The coordination of 17 disaparate nations leaves the former IMF man greatly concerned as the unique nature of this crisis leaves "four economic, social, and political events as possible causes of systemic collapse with each at risk of occurring in the next weeks, months, or years and these risks will not disappear quickly." As European sovereign bonds are now deeply subordinated claims on recessionary economies, it is no surprise that Johnson ends by noting that Europe's economy remains in a dangerous state.


The European Crisis Deepens

Peter Boone and Simon Johnson, Peterson Institute for International Economics


 Successive plans to restore confidence in the euro area have failed. Proposals currently on the table also seem likely to fail. The market cost of borrowing is at unsustainable levels for many banks and a significant number of governments that share the euro.


Two major problems loom over the euro area. First, the introduction of sovereign credit risk has made nations and subsequently banks effectively insolvent unless they receive large-scale bailouts. Second, the ensuing credit crunch has exacerbated difficulties in the real economy, causing Europe’s periphery to plunge into recession. This has increased the financing needs of troubled nations well into the future.


With governments reaching their presumed debt limits, some commentators are calling on the European Central Bank (ECB) to bear the costs of additional bailouts. The ECB is now treading a dangerous path. It feels compelled to provide adequate “liquidity” to avert systemic financial collapse, yet must presumably limit its activities in order to prevent a loss of confidence in the euro—i.e., a change in market and political sentiment that could lead to a rapid breakup of the euro area.


Five measures are needed to enable the euro area to survive: (1) an immediate program to deal with excessive sovereign debt, (2) far more aggressive plans to reduce budget deficits and make peripheral nations hypercompetitive” in the near future, (3) supportive monetary policy from the ECB, (4) the introduction of mechanisms that credibly achieve long-term fiscal sustainability, and (5) institutional change that reduces the scope for excessive leverage and consequent instability in the financial sector.


Europe’s leaders have mainly focused on a potential longterm fiscal agreement, and the ECB under Mario Draghi is setting a more relaxed credit policy; however, the other elements are essentially ignored.


This crisis is unique due to its size and the need to coordinate 17 disparate nations (see chart below). We give four examples of economic, social, and political events that could lead to more sovereign defaults and serious danger of systemic collapse. Each trigger has some risk of occurring in the next weeks, months, or years, and these risks will not disappear quickly.


Key Systemic Problems In The Euro Area

Within the complex sphere of Europe’s crisis, if we had to pick one issue that turns this crisis from a tough economic adjustment into a potentially calamitous collapse, we would argue it is the transformation of Europe’s sovereign debt market.


European Sovereign Bonds Are Now Deeply Subordinated Claims on Recessionary Economies


Once risk premiums are incorporated in debt, Greece, Ireland, Portugal, and Italy do not appear solvent. For example, with a debt/GDP ratio of 120 percent and a 500-basis-point risk premium, Italy would need to maintain a 6 percent of GDP larger primary surplus to keep its debt stock stable relative to the size of its economy. This is unlikely to be politically sustainable.


Crisis Spreads into Europe’s Core Banks and Incites Capital Flight from the Periphery


Europe’s peripheral banks are suffering large deposit losses as capital moves to safer nations. The chart above shows the enormous capital flight that is occurring through the banking sector across the euro area. These Target2 balances show a cumulative transfer of €440 billion from peripheral nations to Germany from early 2009 to October 2011. Were it not for these implicit bailouts through the payments system, the euro area would have already collapsed.


Macroeconomic Programs: Too Timid to Restore Confidence or Growth


The strong core is becoming stronger, while Greece, Ireland, Portugal, and Spain have high unemployment. Italy’s troubles are recent, so with a sharp recession beginning, we anticipate Italian unemployment will soon rise sharply too.

Dreams versus Reality

There is no doubt that European political leaders are highly committed to keeping the euro area together, and so far, there is widespread support from business leaders and the population to maintain it. There is also, rightly, great fear that disorderly collapse of the euro area would impose untold costs on the global economy. All these factors suggest the euro area will hold together.


However, many financial collapses started this way. A far more dramatic creation and collapse was the downfall of the ruble zone when the Soviet Union collapsed in 1991.


Argentina’s attempt to peg its currency to the dollar in the 1990s was initially highly successful but ended when its politicians and society could not make the adjustments needed to hold the structure together. The Baltic nations—Estonia, Latvia, and Lithuania—have managed to maintain their pegs but only after dramatic wage adjustments and recessions.


More relevant, the various exchange rate arrangements that Europe created prior to the euro all failed. With the creation of the euro, Europe’s leaders raised the stakes by ensuring the costs of a new round of failures would be far greater than those of the past, but otherwise arguably little has changed to make this attempt more likely to succeed than the previous one. Small probabilities of very negative events can be destabilizing. A lot of things can go wrong at the level of individual countries within the euro area—and one country’s debacle can easily spill over to affect default risk and interest rates in the other 16 countries.


The euro swap market is based, in part, on interest rates charged by 44 banks in a range of countries; about half of these banks may be considered to be located in troubled or potentially troubled countries. If the euro swap market comes under pressure or ceases to function, this would have major implications for the funding of all European sovereigns—including those that are a relatively good credit risk.


At the least, we expect several more sovereign defaults and multiple further crises to plague Europe in the next several years. There is simply too much debt, and adjustment programs are too slow to prevent it. But this prediction implies that the long-term social costs, including unemployment and recessions rather than growth, attributable to this currency union are serious. Sometimes it is easier to make these adjustments through flexible exchange rates, and we certainly would have seen more rapid recovery if peripheral nations had the leeway to use exchange rates.


When we combine multiple years of stagnation with leveraged financial institutions and nervous financial markets, a rapid shift from low-level crisis to collapse is very plausible.


European leaders could take measures to reduce this risk (through further actions on sovereign debt restructurings, more aggressive economic adjustment, and increased bailout funds). However, so far, there is little political will to take these necessary measures. Europe’s economy remains, therefore, in a dangerous state.