The contagion from the Greek and Irish crises has spread to Portugal, Spain and possibly Italy. Unless the eurozone undertakes radical reform there is a risk of disorderly defaults by fiscally stressed member states and even – eventually – of a break-up of the monetary union.
The current muddle-through approach to the crisis is to “lend and pray”: ie, provide financing to member states in distress (conditional on such states implementing fiscal adjustment and structural reforms) in the hope that their problems are of liquidity rather than solvency. But this could lead to disorderly defaults and a break-up of the European Monetary Union (EMU), unless institutional reforms and other policies leading to closer integration and restoration of growth in the eurozone’s periphery are implemented soon.
The periphery members all suffer from a loss of competitiveness, low economic growth (Italy, Portugal) or contraction (Spain, Ireland, Greece), and large private and/or public debts. Spain’s and Ireland’s problems started with too much debt in the private sector (due to a debt-financed housing bubble) and morphed into a public debt problem once the losses from the housing bust were socialised. Greece had a reckless fiscal policy for more than a decade, which led to a public debt crisis. Portugal and Italy have lower levels of private debt but large stocks of public debt. Distressed sovereigns that have already lost market access (Greece and Ireland) were bailed out by the IMF and the EU, but no one will come from Mars to bail out these super-sovereigns if the sovereigns end up insolvent. Thus, a new plan is needed to save the eurozone.
First, Europe needs policies that restore competitiveness and growth to the eurozone’s periphery. Without growth, it becomes mission impossible to restore fiscal sustainability by stabilising public and private debts and deficits as a share of GDP. And without growth, painful belt-tightening will lead to a political backlash against fiscal austerity and structural reforms, both of which are initially recessionary and deflationary.
To restore growth one has to implement other policies. The European Central Bank (ECB) should pursue a much looser monetary policy; this would weaken the euro, which is necessary to restore the periphery’s competitiveness. Moreover, Germany should postpone its fiscal consolidation or even increase its fiscal stimulus – to boost its growth and restore that on the periphery.
Second, while current resources are sufficient to bail out Greece, Ireland and Portugal, they are not enough to stop a run on the sovereign and banks’ liabilities of Spain and other potentially distressed eurozone members. An increase of official resources would nonetheless be needed to prevent a self-fulfilling run. Trigger-happy investors don’t want to be last in line in case of a run – thus, a destructive run is likely when official resources are insufficient.
Providing more official resources implies some form of a fiscal union, where the tax revenues of the core of the EMU (mostly Germany) are used to backstop not only the public debt of the core but also that of the periphery. One variant of this quasi-fiscal union would be the issuing of eurozone bonds; otherwise, the increase in official resources could occur through a much larger European Financial Stability Facility.
If these options fail to obtain the support of Germany, the ECB would be forced into long-term bond purchases and liquidity operations to support banks, thus dragging the ECB further into a quasi-fiscal role. Since any type of quasi-fiscal union implies that the eurozone’s core economies could end up bailing out those on the periphery, Germany and the core would accept taking such a risk only if the periphery bows to credible commitments to permanent fiscal discipline.
Moreover, super-sovereigns such as the IMF and EU cannot and should not continue to bail out distressed sovereigns that are insolvent rather than illiquid. Thus, a third necessary reform pillar is for Europe to implement early, orderly restructurings of distressed sovereigns’ public debt. Waiting until 2013 to implement these policies (as recently agreed by the EU) would be a recipe for disorderly defaults, as it would imply a much larger haircut (or losses) on residual private claims on sovereign borrowers, once more senior super-sovereign claimants have replaced the lucky private creditors whose claims come to maturity before 2013.
Orderly, market-based restructurings – via market-based exchange offers that replace older debt with new debt that has different financial terms – need to occur in 2011. Such exchange offers can limit the private creditors’ losses if they are done early, while formal haircuts on the face value of debt can be avoided via new bonds that include only a maturity extension and interest rates set below current unsustainable market rates. Waiting to restructure unsustainable debts would only lead to disorderly defaults and much larger haircuts for some private creditors.
Finally, a fourth set of reforms requires that all unsecured creditors of banks and other financial institutions, even senior ones, must accept losses on their claims when a financial institution is severely financially distressed. This is needed to prevent even more private debt being put on government balance sheets. If orderly treatment of unsecured senior creditors requires a new, Europe-wide regime to close down insolvent European banks, such a regime should be implemented soon.
At the European summit last December, the EU decided that the much-needed reforms can be postponed until after 2013. But the markets’ reaction suggest that such reforms cannot wait any longer. What is at stake is the survival of the monetary union and the risk of disorderly defaults on public and private debts.
Nouriel Roubini is chairman of Roubini Global Economics, professor at the Stern School of Business at New York University, and co-author of “Crisis Economics”