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December 2010

Can the Euro Survive?Desmond Lachman



Cn e Euo Suvive?

Desmond LcmnResident FellwAmerican Enterprise Institute



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CoNTENTS

Abut the Authr 4

Eecutive Summar 5

Intrductin 7

Chapter I A Flawed Idea Frm the Start 9

Chapter II A Highl Unbalanced Peripher 13

Chapter III Eurzne Banks at Risk 23

Chapter IV The End Game 29



4

ABoUT THE AUTHoR

Desmond Lcmn is a Resident Fellw at American Enterprise Institute (AEI). Previusl,

he served as a managing directr and chie emerging market ecnmic strategist at Salmn

Smith Barne. He als served as deput directr in the Internatinal Mnetar Fund’s (IMF)

Plic Develpment and Review Department and was active in sta rmulatin IMF

plicies. Dr Lachman has written etensivel n the glbal ecnmic crisis, the U.S. husing

market bust, the U.S. dllar, and the strains in the eur area. At AEI, Dr Lachman is cused n

the glbal macrecnm, glbal currenc issues, and the multilateral lending agencies. He

hlds a PhD in ecnmics rm the Universit Cambridge and a BA rm the Universit

Witwatersrand.



5

ExECUTIVE SUMMARy

• The Eur cnrnts an eistential challenge as a svereign debt crisis rages acrss

Greece, Ireland, Prtugal, and Spain. In Ma 2010, this crisis rced the Eurpean

Cmmissin t abandn its earlier “n bail ut” plic and t establish, tgether with

the IMF, a massive saet net r the Eurpean peripher . Despite this saet net, b

end-Nvember 2010 markets demanded recrd high interest rates n the Eurpean

peripher’s svereign debt.

• Failure ver man ears the Eurzne’s members t pla b the budget rules

the Stabilit and Grwth Pact makes a svereign debt deault at least ne the

peripheral cuntries almst inevitable. A deault b an member cuntr is mre than

likel t trigger cntagin t the rest the peripher and t lead t the eventual eit

rm the Eur Greece, Ireland, Prtugal, and Spain.

• The essence the peripher’s present ecnmic predicament is that the cuntries

in the peripher have all run up ver large internal and eternal imbalances. These

imbalances will be etrardinaril dicult t crrect within the Eur-zne straitjacket.

Since, within that straitjacket, these cuntries cannt resrt t currenc devaluatin

either t restre cmpetitiveness r t bst eprts as a cushin t set the highl

negative impact n their ecnmies rm majr scal retrenchment.

• The majr part the peripher’s budget decits cnstitutes “primar” r nn-interest

pament transactins. As such, even a ar-reaching debt restructuring can at best be

viewed as a partial slutin t the peripher’s budget prblems in the sense that it

will nt bviate the need r urther substantial budget retrenchment. Cuntries in the

peripher might d well t cnsider the advantages an earl eit rm the Eur, which

might acilitate the needed scal adjustment withut prvking the deepest dmestic

ecnmic recessins.



Legum Insiue

6

• Althugh Eurpe’s peripheral ecnmies are relativel small in size, their verall public

and private sectr debt is large. A substantial prtin that debt sits n the balance

sheets West Eurpe’s banking sstem. As such, the present debt crisis in the Eurpean

peripher has the ptential t precipitate a majr Eurpean banking crisis that wuld

almst certainl reverberate thrughut the glbal nancial sstem. It wuld d s inmuch the same wa as the 2008 sub-prime crisis in the United States precipitated a

glbal banking crisis.

• The Eurzne’s peripher has mre a slvenc prblem than a liquidit prblem. It

has a slvenc prblem in the sense that, absent a debt restructuring and an eit rm

the Eur, the crrectin the peripher’s public nances cannt be achieved withut

prvking the deepest and mst prlnged dmestic ecnmic recessins. Papering

ver these slvenc issues b simpl advancing these cuntries large amunts EU-IMF

cial nancing will nt address their underling slvenc prblem.

• Eurpean plicmakers understand ull well that a deault in an peripheral cuntr

is almst cer tain t precipitate a ull-blwn banking crisis in West Eurpe. This makes it

highl unlikel that Eurpean plicmakers in the nrth will lightl turn the nancing

spigt that presentl keeps the peripher, and thereb the Eurpean banking sstem,

afat. Rather, ne must epect that Eurpean plicmakers will cntinue t kick the can

rward b repeated bailut peratins in the rlrn hpe that smething might turn

up t rescue the peripher.

• The mre likel trigger r the Eur’s eventual unravelling will be in the peripher itsel.

The Greek, Irish, Prtuguese, and Spanish gvernments alread all have the mst tenuus

hlds n plitical pwer. A deepening in their ecnmic and nancial crises culd ver

well result in the ascendanc mre ppulist gvernments, which might be less willing

t hew t the hair-shirt austerit prgrams being dictated b the IMF.



7

INTRoDUCTIoN

In Januar 2009, amid much anare, Eurpe celebrated the tenth anniversar the Eur’s

launch. yet, almst tw ears later, the Eur cnrnts an eistential challenge as a svereign

debt crisis rages acrss the Eurzne’s peripher. In Ma 2010, this crisis rced the Eurzne

t abandn its earlier “n bail ut” plic and t establish tgether with the IMF a EUR750

billin saet net r the Eurzne’s weakest members. Despite this massive saet net,

hwever, b the end Nvember 2010 markets were still demanding recrd high interest

rates n the svereign debt Greece, Ireland, Spain, and Prtugal.

Until ver recentl, the idea the Eur nt surviving in its present rm was regarded

as a ringe idea mainl entertained b a small grup suppsedl ill-inrmed and biasedUS academic ecnmists. yet tda, markets are pricing in a cnsiderable prbabilit that at

least ne the Eurzne’s peripheral member cuntries will deault n its svereign debt

within the net three ears. And markets are increasingl cming t cnnect the dts rm

a svereign debt deault t a break-up the Eur in its present rm.

5 Ye Cedi Deul Sw Seds

1.0

400

800

1000

1200

600

200

Date

B a s i s p o i n t s

N o v 0 5

D e c 0 5

J a n 0 6

F e b 0

6

M a r 0

6

A p r 0

6

M a y 0

6 J u n

0 6

N o v 0

6

O c t

0 6

S e p 0

6

A u g 0

6 J u l

0 6

ECBpurchasesbegin

Greece

Ireland

Portugal

Surce: Blmberg



Legum Insiue

8

The main purpse this mngraph is t eplre hw likel it is that at least ne the

Eurzne’s peripheral members will indeed be rced t deault within the net three ears.

It als cnsiders what wuld be the implicatins such a deault r the survival the Eur

in its present rm and r the health the Eurpean banking sstem. The main cnclusin

this mngraph is that the ailure ver man ears the Eurzne’s members t pla b its rules makes a svereign debt deault at least ne the Eurzne’s peripheral

cuntries almst inevitable. It is als argued that a deault b an Eurzne member is mre

than likel t trigger the eit rm the Eur Greece, Ireland, Prtugal, and Spain.

The main thesis this mngraph is that the Eurzne’s peripher has mre a

slvenc prblem than a liquidit prblem. It has a slvenc prblem in the sense that, absent

a debt restructuring and an eit rm the Eur, the crrectin the peripher’s public

nances cannt be achieved withut prvking the deepest and mst prlnged dmestic

ecnmic recessins. Papering ver these slvenc issues b simpl advancing these cuntries

large amunts EU-IMF cial nancing will nt address their underling slvenc prblem.

All that it will d is t saddle the peripher with even mre public debt, which will cmplicate

the eventual and inevitable reslutin these cuntries’ public debt prblems.

This mngraph als draws attentin t the act that the majr part the peripher’s

budget decits cnstitutes nn-interest paments r “primar” transactins. As such, even a

ar-reaching debt restructuring can at best be viewed as a partial slutin t the peripher’s

budget prblems in the sense that it will nt bviate the need r urther substantial budget

retrenchment. This mngraph suggests that cuntries in the peripher might d well t

cnsider the advantages an earl eit rm the Eur which might acilitate the needed

scal adjustment withut prvking the deepest dmestic ecnmic recessins.

At the utset it shuld be stressed that the crisis presentl aficting the Eurzne’s

peripher has prund implicatins r the verall Eurpean ecnm and r the glbal

ecnmic utlk. Althugh Eurpe’s peripheral ecnmies are relativel small in size, their

verall public and private sectr debt is large and a substantial prtin that debt sits n

the balance sheets West Eurpe’s banking sstem. As such, the present debt crisis in the

Eurpean peripher has the ptential t precipitate a majr Eurpean banking crisis that wuld

almst certainl reverberate thrughut the glbal nancial sstem. It wuld d s in much the

same wa as the 2008 sub-prime crisis in the United States precipitated a glbal banking crisis.

The remainder this mngraph is rganised in ur main sectins. An intrductr

sectin discusses hw right rm the ver star t the Eurzne lacked thse cnditins requiredr the successul unctining an ptimum currenc area and hw the Eurzne lacked

the apprpriate institutinal arrangements t make it wrk. This is llwed b an analsis

the reasns wh unusuall large dmestic and eternal imbalances maniested themselves

in the Eurzne’s peripheral ecnmies and wh the crrectin these imbalances will

prve t be erbitantl cstl within the straitjacket Eurzne membership. A third

sectin discusses hw, in rder t avid a Eurpean banking crisis, the Eurzne’s strnger

member cuntries will cntinue t keep kicking the can rward b repeatedl bailing ut its

weaker members but hw these erts will end in tears. A nal sectin this mngraph

discusses the implicatins that a svereign debt deault wuld have n bth the Eurpean

and glbal ecnmies.



9

ChaptEr I

A FLAWED IDEA FRoM

THE START

In 1997, with a cnsiderable degree prescience, Grdn Brwn, then the UK Chancellr

the Echequer, devised an eective strateg t keep the United Kingdm permanentl

utside the Eur eperiment.1 B s ding, he revealed that he had a better understanding

the dangers giving up ne’s wn dmestic currenc r the Eur than apparentl did his

cunterparts in Athens, Dublin, Lisbn, and Madrid. Rather than succumbing t the allure

lwer gvernment brrwing csts and better infatinar discipline that Eur membership

held ut, he cused mre n the dangers the lss mnetar and echange rate plic

feibilit that was necessaril entailed in Eur membership. Drawing the right lessns rm

the United Kingdm’s unrtunate Eurpean Echange Rate Mechanism (ERM) eperience

in 1992, he understd ull well that adpting the single currenc wuld mean giving up the

UK’s abilit t set its wn interest rates.2 He als understd that it wuld mean reging

an use currenc depreciatin as an instrument t regain lst cmpetitiveness and t

bst eprt grwth.

At the time that the Eur was launched in Januar 1999, a number prminent US

ecnmists, mst ntabl Miltn Friedman and Martin Feldstein, epressed the gravest misgivings abut the Eur eperiment.3 The argued that Eurpe simpl lacked the

macrecnmic cnditins needed t make the Eur wrk and the cndentl predicted

that the Eur wuld nt survive its rst majr ecnmic recessin. Drawing n the ptimum

1 In 1997, Grdn Brwn drew up 5 ecnmic tests that the UK had t pass bere it wuld agree t jin the Eur. The main

principle behind these tests was whether r nt the cnditins were such that the UK culd cpe with a cmmn mnetar

plic. The main test was whether the UK had an adequate degree ecnmic harmnisatin with the rest Eurpe t

allw it t give up mnetar plic independence.

2 The Eurpean Echange Rate Mechanism was a semi-ed echange rate mechanism with narrw ed echange rate

margins 2.25 percent. It was intrduced in 1979 t reduce Eurpean echange rate vlatilit and t achieve mnetar

stabilit in preparatin r Eurpean Mnetar Unin and the adptin a single currenc. The UK jined the ERM in

octber 1990 but was rced t eit the prgram n “Black Wednesda,” 16

th

September, 1992, under majr pressure rmcurrenc speculatrs.

3 See r eample Feldstein, Martin, (1997a), “The plitical ecnm the Eurpean Ecnmic and Mnetar Unin: Plitical

surces an ecnmic liabilit”, NBER Working Paper Series, n. 6150.



Legum Insiue

10

currenc ther pineered b Nbel Laureate Rbert Mundell, the nted that Eurpe

diered rm the United States in a number imprtant respects, which made the ntin

a currenc unin r Eurpe a bad idea. The drew particular attentin t the llwing

ur cnsideratins:

•

Eurpe des nt enj nearl the degree wage feibilit that characterises the USecnm. Its igid lbou mkes and legislative prtectins mean that wages in Eurpe

are ver slw t adjust t rising unemplment and t declining prductin. This lack

wage feibilit, in the cntet a currenc unin, makes it dicult r individual

Eurpean ecnmies t regain lst internatinal cmpetitiveness as needed thrugh

dwnward mvements in wages. This lack wage feibilit als makes the Eurpean

cuntries vulnerable t sharper declines in utput and emplment than is the case r

the individual states in the United States.

• Cnsiderable language and cultural barriers, cmbined with pr husing inrastructure,

makes lbou vey muc less mobile in Eurpe than in the United States. Unlike the

United States, where labur readil mves rm states in recessin t states enjing a

bm, Eurpean labur des nt readil mve twards jb pprtunities in ther parts

the Eurzne.

• Unlike the United States, Eurpe is et t develp an eective sysem o scl edel

nses. Lacking the same sense shared natinal purpse as in the United States,

there is a strng reluctance the mre prsperus Eurpean cuntries t have their

ta revenues be transerred t cuntries eperiencing scal shrtalls.

• The Eurpean ecnmies are characterised b a great degree diversit which makes

them particularl susceptible t dvese symmeic socks. This vulnerabilit can prve

t be impr tant in a currenc unin where the central bank can nl set ne interest

rate t satis the needs all the unin’s member states. The greater susceptibilit t

asmmetric shcks in Eurpe als highlights its greater need r labur market feibilit

and labur mbilit in a currenc unin.

At the launch the Eur in Januar 1999, Eurpean plitical leaders were nt unaware

that the Eurzne did nt enj all the cnditins that wuld make r a well-unctining

currenc unin. Rather, the believed that the plitical imperatives r rming a mnetar

unin t maintain rward mmentum in Eurpean plitical integratin trumped cncerns

mre strictl ecnmic in nature. It was their view, which sadl has nt been brne utb the Eurzne’s subsequent histr, that nce a mnetar unin had been rmed the

ecnmic cnditins wuld llw. It was als their view, which nce again prved t be

illusr, that strict institutinal cnstraints and nancial market discipline wuld be impsed

n individual member cuntr ies’ actins, which wuld prevent undue ecnmic imbalances

rm develping in the Eurzne.

Tthless Institutinal Arrangements

The unders the Eur were all t aware the ecnmic plic challenges that cuntries

wuld ace within the straitjacket Eurzne membership. Fr this reasn, the insisted



11

Cn e Euo Suvive?

that cuntries meet stringent cnditins bere being accepted int the eclusive Eurzne

club. The basic idea these prir cnditins t entr was t ensure that cuntries jining

the Eurzne did s in sucientl sund ecnmic and nancial health t allw them t

endure the discipline a ne-size-ts-all Eurpean mnetar plic. These cnditins were

enshrined in the 1993 Maastricht Treat and the included the llwing ve criter ia:• Successul applicants r Eurzne membership were required t reduce their infion

e t n mre than 1.5 percentage pints abve the average infatin rate the three

EU member states with the lwest infatin rate ver the previus ear.

• Budge decis were required t be reduced t three percent GDP r belw.

• Applicant cuntries’ ublic deb levels were t be reduced t belw 60 percent GDP,

althugh a cuntr with a higher debt level culd still adpt the eur prvided its debt

level was alling steadil.

• Long-em inees es appling cuntries were t be n mre than tw percentage

pints abve the rate in the three EU cuntries with the lwest interest rates ver the

previus ear.

• Appling cuntries were required t enter e ErM excnge e mecnism tw

ears prir t entr.

In 1997, in an ert t create stable cnditins r the new currenc, the Eurpean

Cuncil decided t etend the public nance principles the Maastricht Treat t appl

t member states ater Eur membership. It did s b adpting a Stabilit and Grwth

Pact (SGP) whse primar purpse was t keep public sectr spending and brrwing in

individual member cuntries ater Eurzne membership under cntrl. Mre specicall,

the SGP required that cuntries aim at keeping their budget decits belw three percent

GDP and their public debt levels belw 60 percent GDP. It als stipulated that, i a

cuntr brke the rules, it had t present a remedial plan t the Eurpean Cmmissin

and take measures t reduce its decit. Furthermre, the SGP

prvided that i a cuntr brke the rules in three cnsecutive

ears, the Eurpean Cmmissin culd impse a ne up t 0.5

percent GDP n the ending cuntr.

Sadl, time has prved the SGP t be nthing mre than a

paper tiger. This became all t apparent as earl as 2003 when

France and German, the Eurzne’s tw largest ecnmies,fagrantl breached the SGP’s budget limits. Rather than take strng

actin against these tw cuntries, the Eurpean Cmmissin

lamel accepted withut an punitive actin France and German’s prmises t reach the

Pact’s targets as sn as pssible. In 2005, in an ert t restre a mdicum credibilit

t the SGP, the Eurpean Cuncil agreed upn a rermed SGP with mre feible rules.

Hwever, even these were sn challenged in 2007, when President Sarkz lked t

revitalise the French ecnm utside the ramewrk the SGP.

The srr saga Greece’s egregius and serial under-reprting its budget decit

has ur ther seriusl tarnished the Eurzne’s reputatin as having the abilit t mnitr, let

alne t plice , its member cuntries’ public nance perrmance. In octber 2009, newl

Eurpe diered rm the

United States in a number

imprtant respects,

which made the ntin

a currenc unin r Eurpe a bad idea



Legum Insiue

12

elected Prime Minister Gerge Papandreu eectivel triggered the Eurzne svereign

debt crisis, b wning up t the act that Greece’s budget decit r the ear wuld nt

be the si percent GDP that Greece had earlier reprted but wuld rather be the

rder a staggering 12.5 percent GDP.4 It was subsequentl revealed that Greece had

sstematicall succeeded in duping EURoSTAT, the Eurzne’s cial budget scre keeper, thrugh the use budget reprting sleight hand. Aided b Gldman Sachs, Greece

had made etensive use cmplicated derivative instruments t disguise its true budget

psitin.5 And, in octber 2009, Greece nall came clean b admitting that right rm the

ver start it had resrted t creative budget accunting t gain entr int the Eurzne at

a time when its true budget decit signicantl eceeded the Maastricht Treat’s entr limit.

I the Stabilit and Grwth Pact has prven t be a paper tiger, s t has the

Eurzne’s suppsed “n bailut clause”. Enshrined in Article 125 the Lisbn Treat,

the Eurpean Cmmissin was suppsed t rerain rm bailing ut member cuntries in

budget dicult.6The basic idea this prvisin was t ensure that markets wuld eercise

discipline n errant Eurzne members b dening them access t market nancing at

reasnable terms in the event that their budget decits mved t an unsustainable path.

Hwever, as we were t learn n 9 th Ma, 2010, the Eurpean Cmmissin wuld buckle

when the chips were dwn as the Eurpean svereign debt crisis came t biling pint. As

described mre ull belw, ar rm reraining rm bailing cuntries ut, in Ma 2010 the

Eurpeans, tgether with the IMF, put in place a EUR750 billin bailut und that wuld be

used r the Eurzne’s weakest members.7

4 In Nvember 2010, EURoSTAT urther revised upwards its estimates Greece’s 2009 budget decit t 15.3 percent GDP.

At the same time, it revised upward the estimate Greece’s end 2009 public debt t GDP rati rm 115 percent t 127

percent.

5 Fr a discussin hw Gldman Sachs helped Greece hide its budget decit the reader is reerred t “Hw Gldman Sachs

Helped Greece t Mask its True Debt”, Der Spiegel, 28 th Februar, 2010.

6 Article 125 the Lisbn Treat prvides that “the Unin shall nt be liable r r assume the cmmitments central

gvernments, reginal, lcal r ther public authrities, ther bdies gverned b public law, r public undertakings an

Member State, withut prejudice t mutual nancial guarantees r the jint eecutin a specic prject. A Member

State shall nt be liable r r assume the cmmitments central gvernments, reginal, lcal r ther public authrities,

ther bdies gverned b public law, r public under takings anther Member State , withut prejudice t mutual nancial

guarantees r the jint eecutin a specic prject”.

7 In setting up the Eurpean Financial Stabilizatin Facilit, the Eurpeans have legalisticall appealed t Article 122 the Lisbn

Treat t justi their eective abandnment the n bail ut clause. Article 122 prvides that nancial assistance can beprvided t a member cuntr “which nds itsel in diculties r which is seriusl threatened with severe diculties caused

b natural disasters r eceptinal ccurrences bend its cntrl”.



13

ChaptEr II

A HIGHLy UNBALANCED

PERIPHERy

At the launch the Eur in Januar 1999, Miltn Friedman epressed the gravest

misgivings as t hw the Eurzne wuld perate in practice.8 Hwever, it is highl

imprbable that, even in his darkest mments, he wuld have anticipated hw prl

the Eurzne’s internal plicing member cuntries’ macrecnmic plic wuld have

wrked and hw miserabl the markets wuld have ailed t eert discipline ver waward

scal behaviur. Nr wuld he have anticipated the staggering degree t which dmestic

imbalances wuld have been allwed t build up particularl in these cuntries’ public

nances. Accrding t the Eurpean Cmmissin’s estimates, b 2009 Greece and Ireland

registered public decits the rder 14 percent GDP. At the same time, the public

decits in Spain had reached 11.5 percent GDP, while that in Prtugal was the rder

nine percent GDP.

The Eur’s Prblem Children

Govenmen Deci pojecion o 2010 (s ecenge o GDp )

Spain

Greece

Portugal

Italy

Ireland-11.7

-9.8

-9.3

-8.5

-5.3

Surce: Eurpean Cmmissin

8 Miltn Friedman’s skepticism is epressed well in “An interview with Miltn Friedman. Interviewed b Jhn B. Talr, Ma 2000”, chapter 6 in P. Samuelsn and W. Barnett, eds., Inside the Economist’s Mind; Conversations with Eminent Economists,

Blackwell, ord 2007.



Legum Insiue

14

public Deb pojecion o 2010 (s ecenge o GDp )

Italy

Portugal

Ireland

Spain

Greece 124.9

118.2

85.8

77.3

64.9


Unemloymen pojecion o 2010 (s ecenge o GDp )

8.8

13.8

11.8

19.7

9.9

Italy PortugalGreeceIrelandSpain


The emergence massive decits in Eurpe’s peripher has placed the public nances

the peripher n a clearl unsustainable path that has created great diculties r these

cuntries in the nancial markets. Decits in the peripher are nw a large multiple the

three percent GDP Maastricht limit and the are arund twice the size the peak level

that the public decit reached in Argentina prir t its spectacular 2001 svereign debt

deault. The un-sustainabilit the per ipher’s public nances is mst apparent in the Greek

case where the cuntr’s public debt t GDP has alread reached 127 percent r mre

than twice the Maastricht 60 percent GDP limit. Hwever, as will be discussed mre ull

belw, the public nances Ireland and Spain are als n unsustainable paths that als

require the earliest remedial actins. Althugh the public debt t GDP ratis in Ireland

and Spain are presentl at reasnable levels, ne has t epect that these ratis will be

substantiall increased b the public supprt that the ver trubled Irish and Spanish bankswill require ver the net ear r tw.

A secnd area where etrardinaril large imbalances have emerged in Eurpe’s

peripher has been in the husing markets Ireland and Spain. Fuelled b eas access t

glbal credit, as well as b an ECB whse ne-size-ts-all interest rate plic kept interest

rates t lw r t lng r Eurpe’s peripher, Ireland and Spain eperienced husing

bubbles that make that eperienced in the United States pale.9 Whereas husing prices in

9 A cmbinatin lw ECB interest rates and epansinar scal plicies cntributed t a situatin ecess aggregate

demand in the peripher, which was refected in persistentl higher infatin in the peripher than in the Eurzne’s cre

cuntries. Ireland and Spain, which ver the past decade generall eperienced signicantl higher gds and asset price

infatin than did the Eurzne’s cre cuntries, needed higher plic interest rates than did France and German t reignin dmestic gds and asset price infatin. Hwever, the ECB having nl ne interest rate instrument set its interest rates

mre t meet the needs France and German than the Eurzne’s peripher.



15

Cn e Euo Suvive?

the United States increased b arund 80 percent between 2000 and 2006, thse in Ireland

and Spain apprimatel trebled.10 And whereas emplment in the cnstructin sectr

peaked at arund si percent the labur rce in the United States, that in Spain reached

as high as 18 percent. The bursting the husing bubbles in Ireland and Spain has been

a primar driver in the dramatic deteriratin in their public nances. It has als been theprimar actr in the rise in unemplment in Ireland and Spain t their present levels

arund 13 percent and 20 percent respectivel.

Cumuled Cnges o home pices

400%

300%

250%

0%

200%

350%

450%

150%

100%

50%

Q 2

1 9 9 6

Q 2

1 9 9 7

Q 2

1 9 9 8

Q 2

1 9 9 9

Q 2 2 0

0 0

Q 2 2 0

0 1

Q 2 2 0

0 2

Q 2 2 0

0 3

Q 2 2 0

0 4

Q 2 2 0

0 5

Q 2 2 0

0 6

Q 2 2 0

0 8

Q 2 2 0

0 9

Q 2 2 0

0 7

Ireland

Spain

15

0

20

25

10

5

1 9 9 5

1 9 9 6

1 9 9 7

1 9 9

8

1 9 9

9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 7

2 0 0 9

2 0 0

8

2 0 0 6

Ireland

Spain

Construction investment: as percentage of GDP

Surce: EURoSTAT

The lack macrecnmic discipline in Eurpe’s peripher has als given rise t

the emergence acute eternal vulnerabilit. over the past decade, a generall t eas

mnetar and scal plic stance has caused wage and price infatin in the Eurpean

peripher t be cnsistentl higher than that in the Eurzne’s mre scall cnservative

10 See “Husing Prices mre Rm t Fall”, IMF Finance and Develpment, March 2010.



Legum Insiue

16

members. As a result, ver the past decade, Greece, Spain, Prtugal, and Ireland have all

eperienced a lss in internatinal cmpetitiveness at least 20 percentage pints. This

lss cmpetitiveness, tgether with a wrsening in public sectr savings perrmance,

has maniested itsel in gaping eternal current accunt decits that in 2009 were well int

duble digits as a percentage GDP r Greece, Spain, and Prtugal.

Greece’s Rad t Deault

The essence the Eurzne peripher’s present ecnmic predicament is that the

cuntries in the peripher have all run up ver large internal and eternal imbalances that

will be etrardinaril dicult t crrect withut the benet having their wn separate

dmestic currencies. Stuck within the Eur-zne straitjacket, these cuntries cannt resrt

t currenc devaluatin t restre the ver sizeable lsses that the have registered in

internatinal cmpetitiveness.11 Nr can the devalue their currencies t bst eprts

as a cushin t set the highl negative impact n their ecnmies rm the majr scal

retrenchment that the IMF and the EU are requiring as a cnditin r their nancial

supprt. Attempting t adjust under these cnditins must be epected t entail man

ears painul defatinar and recessinar cnditins r these cuntries that will nl

cmpund their indebtedness prblems.12

The Greek case, where the ecnmic imbalances are the greatest, illustrates mst vividl

the utilit tring t hew t the IMF’s prescriptin painul budget adjustment withut

resrt t either currenc devaluatin r debt restructuring. Greece’s tw basic prblems

are its etrardinaril bad public nances and its large lss in internatinal cmpetitiveness.

As alread mentined abve, despite the Eurpean Stabilit and Grwth Pact’s strictures,

b 2009 Greece’s budget decit had ballned t arund 15 percent GDP, while ver

the past decade it has managed t lse ver 20 percent in wage and price cmpetitiveness.

Nt wishing t cuntenance the idea either debt restructuring r Eur eit as part

its Ma 2010 US$140 billin supprt package r Greece, the IMF and the Eurpean

Unin are presentl prescribing dracnian scal retrenchment as a cure-all t Greece’s

man ecnmic ills. Indeed, the are requiring Greece t cut its budget decit b n less

than 11 percent GDP ver the net three ears, with hal that adjustment t ccur

in the prgram’s rst ear. And recgnising that scal retrenchment will entail a signicant

recessin that will erde Greece’s ta base, the IMF is insisting that Greece implement ta hikes and public spending cuts that ttal as much as 10 ull percentage pints GDP

11 The sizeable lss in internatinal cmpetitiveness eperienced b the Eurzne’s peripher ver the past decade has

rendered its eprts t be uncmpetitive in internatinal markets and it has acilitated a great degree imprt penetratin

in the dmestic market. The net result has been a substantial widening in these cuntries’ eternal current accunt decits. In

the absence an echange rate devaluatin that might help restre internatinal cmpetitiveness, crrecting these eternal

decits is likel t entail man ears painul wage and price defatin.

12 There are a number cuntries like Belgium, Canada, New Zealand, and Sweden, which in the past tw decades all have

successull reduced ver large public sectr decits withut eperiencing undul painul dmestic ecnmic recessins and

withut eperiencing a meaningul pick-up in infatin. Hwever, all these cuntries perated under fating echange rate

sstems that acilitated large echange rate depreciatins, which created the cnditins r substantial eprt bms. The

were als helped b ver much mre avrable internatinal ecnmic envirnments than presentl cnrnts the Club-Med

cuntries. In this regard, it is als wrth recalling the eperience cuntries under the gld standard in the 1930s. As Barr Eichengreen has nted, thse cuntries that let the gld standard rst eperienced less severe ecnmic recessins than

thse cuntries that remained n the gld standard lnger.



17

Cn e Euo Suvive?

in 2010.13 Adjustment this rder magnitude, and in s shrt a space time, ges

cnsiderabl bend what the IMF has ever prescribed bere r an ther its ecnmic

clients under a ed echange rate sstem.

B nw ne wuld have thught that the IMF wuld have learnt that undertaking a

Herculean sized budget adjustment, withut the benet a currenc depreciatin t bsteprts, will plunge the Greek ecnm int a majr ecnmic recessin that will sap

Greece’s plitical willingness t endure man ears painul austerit. one wuld als have

thught that this wuld be par ticularl the case at a time when Greece’s brrwing csts

have sared, its banks are lsing depsits, and labur disturbances have becme the rder

the da. It is dicult t understand hw the IMF can be seriusl thinking that the Greek

ecnm can pssibl avid the deepest ecnmic recessins. Ater all, its ecnm is

being subjected t 10 ull percentage pints scal measures in a

single ear. And this is ccurring at the ver time that the markets

have in eect brutall tightened mnetar plic r Greece b

raising brrwing csts since the beginning the ear b ver si

percentage pints.

I there was ever an dubt that the IMF prgram wuld lead

t a cllapse the Greek ecnm, all ne need d is lk at the

srr eperience Argentina under the IMF’s tutelage in the late

1990s.14 Argentina, like Greece tda, gt itsel int deep ecnmic

and nancial truble, thugh nt nearl t the etent that Greece

has dne s tda.15 And, like Greece tda, it did s b prfigate

public spending within the cntet an “immutable” currenc peg t the US dllar. yet,

ver much smaller might Argentina’s ecnmic imbalances have been than thse in Greece

tda, it subsequentl und that attempting t address thse imbalances thrugh IMF-stle

scal austerit, while maintaining its currenc peg, was an eercise in utilit. Since, withut

the benet a currenc depreciatin t bst epr ts, scal austerit prduced a deep

ecnmic recessin that undermined its plitical willingness t stick with austerit plicies.

The ensuing dmestic nancial crisis plunged the Argentine ecnm int an ecnmic

depressin that saw the cuntr’s GDP decline b 25 percent in the earl 2000s.

Clser t hme, ne wuld have thught that bere embarking n an IMF stle hair-

shirt adjustment prgram, Greece might have wanted t take a clse lk at the mre recent

adjustment eperiences in Latvia and Ireland. over the past tw ears, utput has cllapsedb ver 20 and 12 percent in Latvia and Ireland, respectivel. It has dne s precisel as a

result IMF-stle budget decit reductin in the cntet a ed echange rate sstem

n a ver much lesser scale than that nw being prpsed r Greece. Given the ver much

larger scal adjustment nw being required Greece than was the case in Ireland and Latvia,

etraplating rm the Irish and Latvian eperience ne must epect that Greece’s ecnm

13 Cutting public spending and increasing taes in the midst an ecnmic recessin is almst certain t deepen that recessin

b reducing verall aggregate demand. This is particularl the case i husehlds are in the prcess deleveraging and i

cmpanies are reluctant t invest at a time clse t recrd levels spare capacit.

14 Fr an ecellent accunt the IMF’s invlvement in Argentina, the reader is reerred t the Reprt n the Evaluatin the

Rle the IMF in Argentina, 1991–2001 b the IMF’s Independent Evaluatin oce, Jul 2004.15 At its peak, Argentina’s dmestic imbalance were arund hal thse Greece tda. Argentina’s budget decit did nt eceed

6 percent GDP while its public debt t GDP rati did nt eceed 65 percent.

Stuck within the Eur-

zne straitjacket, these

cuntries cannt resrt

t currenc devaluatin

t restre the ver sizeable

lsses that the have

registered in internatinal

cmpetitiveness



Legum Insiue

18

culd ver well cntract b 15 percent ver the net tw ears. Such a cntractin wuld be

mre than duble the si percent cntractin that the IMF is targeting in its Greek stand-b

arrangement, which wuld almst certainl put the IMF prgram well track.

At the same time that the IMF is prpsing dracnian budget adjustments r Greece, it is

als urging Greece t restre the 20 percent that it has lst in internatinal cmpetitivenessver the past decade thrugh an “internal devaluatin.” Given the limitatins n Greece’s abilit

t increase labur prductivit thrugh structural rerm, the IMF wuld like t see wages

and prices all in Greece ver a prlnged perid time s as t restre its cmpetitiveness.

The basic faw in the IMF spnsred Greek adjustment prgram is that i successull

implemented it will have the unwanted eect substantiall increasing rather than reducing

Greece’s public debt t GDP rati. Since, i Greece’s nminal GDP were t decline ver the

net ew ears b 20 percent as a result a deep recessin and price defatin, Greece’s

public debt t GDP rati wuld arithmeticall rise rm its present level arund 127

percent twards 180 percent.16 It is calculatins this srt that have recentl led Standard

and Pr’s t warn Greek bnd hlders that the might eventuall retrieve nl 30 t 50

cents n the dllar n their bnd hldings. It is als calculatins this srt that are inducing

markets t assign a 75 percent prbabilit t a Greek svereign restructuring within the

net ve ears despite the massive IMF-EU Greek bailut package.

It is dicult t understand wh the Greek gvernment is allwing the IMF t lead it

dwn a path that ailed s spectacularl in Argentina. This is all the mre s the case when

ne cnsiders the ver much larger scal adjustment that the IMF is requiring Greece than

it did Argentina. I Argentina’s eperience is an guide, ver the net ew ears Greece’s

ecnm will be put thrugh the severest wringers as the brutal IMF scal adjustment

takes uller eect in the cntet ver high dmestic interest rates. At the same time, the

cuntr will be saddled with a muntain IMF and EU debt as cial nancing replaces

private nancing thereb making Greece’s svereign debt all the mre dicult t restructure.

yet, in the end, it is all t prbable that Greece will be rced t deault n its svereign debt

and t eit the Eur as a means t imprve its cmpetitive psitin.

What makes Greece’s ecnmic utlk all the mre tragic is that the Greek gvernment

des have viable plic ptins, which, ineplicabl, it is chsing nt t eercise. Principal

amng these is Greece’s ptin t restructure its US$420 billin svereign debt in an

rderl wa as a means reducing the scal adjustment required t restre scal plic

sustainabilit. Unlike the 2001 Argentina case, where almst the entiret Argentina’s debtwas cvered b American r English law, arund 90 percent Greece’s debt is cvered b

Greek law.17 B changing its dmestic law, Greece can restructure the verwhelming majrit

its svereign debt withut ear having t pa Argentina’s price r irrespnsible public

sectr brrwing b being shut ut the internatinal capital market.

This is nt t sa that there wuld nt be a ver large cst rm a Greek deault. Rather,

it is t sa that the cst such a deault wuld be shited b Greece mainl t the Eurpean

16 It might be nted that with all its ptimistic assumptins abut ecnmic grwth and budget adjustment in Greece, the

IMF’s stand-b arrangement r Greece cncedes that b 2012 Greece’s public debt t GDP rati will have risen t the

neighbrhd 150 percent GDP.17 Fr an interesting discussin hw ver much mre amenable Greece’s svereign debt is t restructuring than was the case

in Argentina, see “Hw t Restructure Greek Debt” b Lee Buchheit and G. Mitu Gulati, 7 th Ma, 2010.



19

Cn e Euo Suvive?

banks, the largest hlder thse bnds. And ultimatel that burden wuld be shited t the

Eurpean tapaer, wh in all prbabilit wuld be needed t bail ut the Eurpean banks.

T be sure, having the IMF prlng the status qu in Greece thrugh large scale cial

nancing might be in the immediate interest the Eurpean banks. Hwever, it remains

dicult t understand wh Greece is allwing the IMF t put the Greek ecnm thrugh the severest recessins when the mst that is being achieved is the dela an inevitable

Greek debt restructuring and an all t likel Eur eit.

Ireland’s Hangver

In a number imprtant respects, ater Greece, Ireland appears t be the Eurzne

member cuntr mst likel t deault n its svereign debt. As was the case in Greece,

Ireland’s budget decit increased sharpl t 14 percent GDP b 2009. And despite the

earl adptin bld scal measures t address the cuntr’s public nance imbalances,

the Irish budget decit (ecluding the ne- 20 percentage pints GDP supprt t the

banks) is still epected t remain at an unsustainabl high 12 percent GDP in 2010 r at

the highest level in the Eurzne. Hwever, unlike the Greek case, Ireland’s public nance

prblems were nt the result budget prfigac. Rather the have been the prduct a

hangver rm an uncntrlled credit binge.

In the earl part this decade, an rg Irish bank lending bth helped t uel the

Celtic Tiger’s ecnmic miracle and gave rise t ne the wrld’s mst prnunced

prpert speculative bubbles.18 In the tw ears since that bubble burst in earl 2008,

the Ir ish ecnm cntracted b a cumulative 12 percent and unemplment rse t 14

percent.19 Meanwhile, the cuntr’s public nances deterirated sharpl as the gvernment’s

prpert-based ta revenues cllapsed and as incme ta cllectins were severel

impacted b rising unemplment and declining incmes.

Mre minusl et r Ireland’s uture public nance utlk, at the end September

2008 the gvernment annunced a blanket guarantee n all the liabilities the main Irish-

cntrlled banks. It did s in respnse t the inabilit Angl-Irish Bank, a majr Irish bank,

t rllver its debt and t ears a cntagius reactin nt the ther banks. Subsequent

revelatins balance sheet windw-dressing at the Angl-Irish bank and sme dubius

transactins related t share purchases, cntributed t the gvernment’s decisin t take

ull wnership cntrl Angl-Irish in earl 2009. Since the grss bank liabilities guaranteedb the gvernment amunted t well ver twice Ireland’s GDP, the pen-ended nature

the pssible bank lsses cnstituted a ver large ptential charge n the Irish gvernment’s

nances. That blanket guarantee is nw prving t have been a ver cstl plic mistake and is

raising serius plitical questins as t wh the gvernment agreed t guarantee all creditrs,

including unsecured creditrs, as ppsed t nl depsitrs in the Irish banking sstem.

18 Between 2000 and 2007, Irish bank credit grew at an average annual rate 25 percent and this credit bm was ueled t a

cnsiderable degree b large scale eternal brrwing. This rapid credit grwth ed a husing price bubble, which in turn ed

back int mre credit grwth and resulted in a mre than 250 percent increase in huse prices. This led t a disprprtinatel

large cntributin b bth the cnstructin and the nancial sectrs t the Irish ecnm and cnsequentl t real Irish GDP

grwth rates well abve the cuntr’s ptential.19 Fr an ecellent descriptin recent Irish ecnmic develpments, the reader is reerred t the IMF’s Sta Reprt n its

Article IV Cnsultatin with Ireland, Jul 2010.



Legum Insiue

20

Until ver recentl, markets turned a blind ee t Ireland’s highl cmprmised public

nances and t the massive ptential cst t the Ir ish echequer the blanket bank liabilit

guarantee prgram. Instead markets lavished praise n the Irish gvernment r the bld

and timel scal measures that it tk in an ert t crrect its rapidl erding public

nances. Markets were particular l impressed with the deep public spending cuts, especiall in the area public wage and benet cuts, as well as with the gvernment’s capacit t

withstand cnsiderable ecnmic pain. Ireland was ampl rewarded r its erts b the

market as is refected in the relativel lw interest rates that the market demanded r

purchasing Irish gvernment bnds.

In August 2010, there was an abrupt turnarund in market sentiment twards Ireland

as dubts began t surace as t whether Ireland was anmre slvent than was Greece.

These dubts were refected in a widening in the spreads n Irish bnds relative t

thse n German bnds t as wide as 400 basis pints r t their widest levels since

Ireland jined the Eur. The actr triggering the sea change in the market’s attitude was a

urther dwngrading Ireland’s svereign debt b the S&P rating agenc. The market was

particularl taken aback b S&P’s estimate that Ireland’s blanket guarantee culd in the end

cst the Irish gvernment between a staggering EUR80 billin and EUR90 billin, r the

equivalent between 50 and 58 percent Ireland’s GDP. 20 The market was als shcked

b S&P’s estimate that Ireland’s banking sectr prblem culd raise the cuntr ’s public debt

level t 130 percent GDP b 2012, r t a level nt ver dierent rm that presentl

prevailing in Greece.

The Irish gvernment is hping that Ireland will smehw grw its wa ut its

public nance and public debt prblems ater having seen its GDP cntract s sharpl

ver the past tw ears. Hwever, such hpes wuld seem t be anciul in light bth

the substantial amunt budget decit cutting that lies ahead as well as the eective

mnetar plic tightening being rced n Ireland b the munting nancial market

scepticism abut Ireland’s lnger-run slvenc. The IMF estimates that Ireland needs ur ther

scal tightening at least 6.5 percentage pints GDP ver the net tw ears i the

cuntr is t hpe t regain scal plic sustainabilit. At the same time, since the start

the ear Irish interest rates have increased b mre than 250 percentage pints while credit

has becme cnsiderabl mre dicult t btain. Further cmpunding Ireland’s ecnmic

prblems is the act that defatin has nw taken hld in the Irish ecnm, which bth

increases the real cst brrwing and aggravates Ireland’s real debt burden.21

Spain’s Balance--Paments Prblem

Spain pses a much greater threat t the lng-term survival the Eurzne in its present

rm than des Greece r Ireland. Ater all, its ecnm is ve times larger than Greece’s,

while at arund US$1 tr illin, its svereign debt is three times larger. In additin, the Spanish

20 “Republic Ireland Lng-Term Rating Lwered t ‘AA-’ on Higher Banking Sectr Fiscal Csts; outlk Negative”, Standard

and Pr’s, 24 th August, 2010

21 over the past ear, Ireland’s cnsumer price inde has declined b arund 2 percent. Since Ireland’s unemplment rate isalmst certain t remain unusuall high ver the net ew ears, there is the real danger that the pace Ir ish defatin culd

accelerate.



21

Cn e Euo Suvive?

ecnm is burdened b an ecessivel high level public- and private-sectr eternal

debt, which makes it vulnerable t the whims the internatinal capital market.

Unlike the Greek case, the parlus state the Spanish ecnm is nt the result

ears gvernment prfigac. Rather, it is the result a massive husing bm, which

ver the past decade saw a trebling in Spanish hme prices as well as an increase in itscnstructin sectr t a staggering 18 percent the Spanish ecnm. It is als the result

an assciated 20 percent lss in internatinal cmpetitiveness that cntributed t a

ballning eternal current-accunt decit and an increase in Spain’s grss eternal debt t

arund 135 percent GDP.

Snis Deb

60

140

100

20

0

40

80

120

160

Total external debt

Government debt

180

2002 2003 2004 2005 2006 2007 2008 2009

%

o f G D P

Year

Surce: Wrld Bank, Wrld Develpment Indicatrs, and Spanish Natinal Bank.

Since September 2008, the bursting the Spanish husing bubble, tgether with

the nset a deep dmestic recessin, has revealed the weak underbell the Spanish

ecnm. As husing-related ta cllectins plummeted, Spain’s budget psitin swung

dramaticall rm a small surplus t a decit 11.5 percent GDP b 2009. At the same

time, in large measure due t structural rigidities in the labur market, unemplment

surged rm less than 10 percent bere the crisis t ver 20 percent in 2010.

Mre disturbing still, the incipient husing market bust has drawn attentin t the

act that Spain’s banks in general, and its savings and lans (cajas) in particular are verl

epsed t its crumbling husing sectr. Cnstructin lans made b the Spanish banking

sstem are estimated t be the equivalent 45 percent the cuntr’s GDP. Unsettled

b this large epsure, reign banks virtuall have stpped lending t Spanish banks and

crpratins. This has rced the ECB t rediscunt arund €125 billin in Spanish bank

lans t restall a ull-blwn Spanish unding crisis.

Spain nw nds itsel in a similar predicament t that Greece and Ireland. It is rced

t engage in severe budget cutting t bring its budget decit dwn t a mre sustainable

level withut the benet a cheaper currenc t bst eprts t cushin the ecnmic

blw. Similarl, Spain is rced t g dwn the painul path price defatin t restre



Legum Insiue

22

cmpetitiveness, even thugh that path will cmpund the cuntr’s public- and private-

debt prblems. Further cmplicating Spain’s daunting ecnmic challenges is the prspect

that it will have t engage in serius budget tightening at a time when unemplment is

alread arund 20 percent and when the husing bust still has a lng wa t g. Ater

increasing threeld, Spanish hme prices have nl declined b arund 15 percent t date.

Precarius Dmestic Plitics

The Eurpean svereign debt crisis is plaing ut against the backdrp the mst tenuus

hlds n plitical pwer b the varius gvernments in the peripher. The cnsequent lack

plitical stabilit is hardl cnducive t retaining market cndence that cuntries in the

peripher will stick the curse scal austerit. This has been vividl illustrated b recent

plitical develpments in Prtugal. At the end octber 2010, nancial markets were

rattled b the reusal the Prtuguese ppsitin parties t supprt the 2011 budget

prpsal Jse Scrates, the prime minister Prtugal’s minrit scialist gvernment.

onl ater prtracted negtiatins, which raised basic questins as t Prtugal’s plitical

willingness t sta the curse, did the Prtuguese gvernment

nall secure apprval r a budget aimed at reducing the budget

decit rm an estimated 7.3 percent GDP in 2010 t 4.6

percent GDP in 2011.

Recent plitical develpments in the rest the peripher

raise urther questins abut the peripher’s plitical willingness

t persevere with painul adjustment measures. In Ireland, the

ppsitin parties have made n secret abut their ppsitin t

the 2011 budget prpsals the minrit Fianna Fail gvernment,

raising the prspect that the Irish gvernment will sn all. In earl Nvember 2010, Greek

vters n bth the let and the right registered cnsiderable unease in lcal electins

abut the plic directin Gerge Papandreu’s scialist gvernment. Meanwhile, in

Spain, the scialist-led minrit gvernment Jse Luis Rdriguez Zapater remains highl

dependent n the supprt Spain’s ractius reginal parties t secure passage its

legislative agenda.

Recent plitical develpments

in the rest the peripher

raise urther questins abut

the peripher’s plitical

willingness t persevere with

painul adjustment measures



23

ChaptEr III

EURoZoNE BANKS AT RISK

In 2007, Ben Bernanke, the Chairman the US Federal Reserve, spent mst the ear

reassuring markets that the sub-prime mrtgage lan prblem wuld be cntained and that

it wuld nt materiall impact the verall US ecnm. Nw, in a manner all t reminiscent

Mr Bernanke’s hllw reassurances 2007, Jean-Claude Trichet, the President the

Eurpean Central Bank keeps asserting that the Eurzne’s svereign debt crisis will nt

pse a signicant threat t the verall Eurzne ecnm. He des s b emphasising that

the peripheral ecnmies cnstitutes nl a relativel small part the verall Eurzne

ecnm. In particular, he keeps reminding us that Greece cnstitutes less than tw percent

the verall Eurzne ecnm while, including even Spain, the peripher accunts r less

than 15 percent the verall regin’s GDP. As such, Mr Trichet wuld want us t believe

that a deepening in Eurpe’s svereign debt crisis shuld be a relativel cntained matter.

The crucial pint that Mr Trichet disingenuusl glsses is that while the Eurzne’s

peripheral ecnmies might be relativel small, their gvernments are highl indebted. 22

Indeed, Greece’s svereign debt alne amunts t ver US$420 billin. As a result, were

Greece t deault n its debt, it wuld cnstitute the largest svereign debt-deault n

recrd. It wuld als be ver ur times the size the Argentine svereign debt deault

2001, the largest svereign debt deault t date, which sent ripples thrugh the glbalnancial sstem. A Greek deault might als be epected t accentuate the svereign debt

diculties in Ireland, Prtugal, and Spain, which between them have a cmbined svereign

debt ttalling arund US$1.5 trillin. In shrt, a Greek svereign deault, r r that matter

an Irish svereign debt deault, culd bring int serius questin the serviceabilit arund

US$2 trillin Eurpean svereign debt, a magnitude that ne wuld think shuld nt be

lightl dismissed r its ptential impact n the Eurzne’s verall ecnm.

22 Mr Trichet als glsses ver the act that between 2000 and 2008, the Eurpean peripher was the majr engine Eurpeanecnmic grwth and a principal market r German’s epr t machine. over this perid, the Irish and the Spanish ecnmies

cnsistentl registered GDP grwth rates cnsiderabl abve the Eurzne average.



Legum Insiue

24

Bnk Exosue o pIGS by Nionliy in 2010 Q1

Spain

Germany *

Other Euro area

UK

Italy

Rest of World

Spain

USA

Japan

France

0 20 40 60 80 100 120

Greece

Ireland

Portugal

Billions of USD

* Statistics r German are n an immediate risk basis, while that thers are n an ultimate risk basis

Surce: BIS Quarterl Review, September 2010

Consolided oeign clims o eoing bnks, end o 04 09 (% o GDp)

Lending ombnks in:

Lending o:

Geece pougl Sin Ielnd Ily tol pIIGS

ausi 1.3 0.8 2.5 2.4 7.2 14

Belgium 0.8 0.7 5.0 14.1 6.9 28

Denmk 0.1 0.1 0.8 7.3 0.2 8

Fnce 3.1 1.8 8.9 2.5 20.8 37

Gemny 1.5 1.5 6.2 6.0 6.2 21

Geece 0.0 0.0 0.1 0.3 0.2 1Ielnd 4.0 2.6 14.5 0.0 22.1 43

Ily 0.4 0.3 1.6 0.9 0.0 3

Neelnds 1.6 1.7 16.4 4.2 9.4 33

pougl 4.7 0.0 13.4 10.3 2.5 31

Sin 0.1 6.4 0.0 1.2 3.5 11

Sweden 0.2 0.1 1.6 1.3 0.7 4

Swizelnd 0.8 0.9 4.0 3.6 3.6 13

UK 0.8 1.2 5.7 9.4 3.8 21

Euoen bnks 1.3 1.7 6.0 4.5 7.3 21

Nte that the numbers must be interpreted with cautin as there are large changes in the gures rm quarter

t quarter in sme cuntries (e.g. Switzerland rm Q3 t Q4). Surce: BIS Quarterl and Danske Markets

A urther incnvenient truth that Mr Trichet chses t dwnpla is that a majr part

the peripher’s debt is held b the Eurpean banking sstem. This necessaril implies

that a wave svereign debt deaults in the peripher wuld deal a serius blw t the

Eurpean banking sstem at the ver time that the Eurpean banks are et t ull recver

rm their 2008-2009 lan lsses.23 The ptential severit this prblem is underlined b

23 In its April 2010 Glbal Financial Stabilit Reprt, The Internatinal Mnetar Fund nted that the Eurpean banks have been

much slwer than their American cunterparts t recgnise the lan lsses sustained rm sub-prime mrtgage lending.



25

Cn e Euo Suvive?

the disturbingl high epsure a number individual cuntr ies t the Eurzne debt

crisis. Accrding t data rm the Bank r Internatinal Settlements, the Eurpean banking

sstem’s epsure t Greece, Ireland, Ital, Prtugal, and Spain eceeds 20 percent the

Eurzne’s GDP, while that the Dutch and French banks eceeds 33 percent their

respective GDPs. This wuld suggest that the Eurpean banking sstems wuld need t bebailed ut at a high cst t these cuntries’ echequers in the event that cuntries in the

peripher were t deault.

In August 2010, Eurpean plicmakers under tk a stress test Eurpe’s 91 mst

imprtant banks, in rder t address the rising market cncerns abut the ptential

damage that wuld ccur as a result a svereign debt crisis. Their hpe was that

cnducting such a test might alla market cncerns abut the state the Eurpean

banking sstem in much the same wa as US Secretar Treasur Timth Geithner’s

stress test in March 2009 succeeded in deusing the US banking crisis. on cmpleting

the test, the Eurpean plic makers annunced that the Eurpean banking sstem was

adequatel capitalised t withstand a “wrst case” scenari and that nl ve relativel

small banks, mainl in Spain, culd be judged t be inadequatel capitalised. Judging b the

market’s ver lukewarm reactin t the annuncement, it appears that the markets were

nt particularl cnvinced b the stress test results. A requent criticism viced b market

analsts was that these tests were ar rm realistic. In particular, there was disappintment

that the tests ecluded the pssibilit an cuntr deaulting n its svereign debt and

that, where haircuts n svereign debt were cnsidered, the were applied nl t the

banks’ svereign debt hldings in their relativel small trading bks as ppsed t their

mre imprtant banking bks.

Bailing out the Peripher

Amng the mre imprtant the earl casualties the svereign debt crisis has been

the Eurzne’s suppsedl immutable “n bailut clause”. Enshrined in Article 125 the

Treat Lisbn, this clause was suppsed t preclude an individual Eurzne svereign

gvernment rm being bailed ut b ther Eurpean cuntr gvernments. The basic

ratinale this clause was t create the cnditins that wuld subject individual cuntries

t the ull rce nancial market discipline. I nancial markets knew that the Eurzne

gvernments wuld in n circumstances be bailed ut, the wuld be etremel careulin lending t thse gvernments and the wuld demand higher interest rates the mre

prfigate a gvernment became.

The Greek svereign debt crisis in the rst hal 2010 revealed in n uncertain terms

hw much a paper tiger the “n bailut clause” was. Ater several mnths insisting

that the Greek crisis culd be managed withut the need r utside nancial supprt,

b earl Ma 2010 the Eurpean Cmmissin annunced a bailut package r Greece

epic prprtins. Under this plan, the Eurpean Unin cmmitted itsel t prviding

EUR80 billin t Greece ver the net three ears. And it did s in cnjunctin with the

Internatinal Mnetar Fund, which cmmitted itsel t prviding Greece an additinal

EUR30 billin in the cntet a three ear IMF stand-b arrangement.



Legum Insiue

26

The cmbined EUR110 billin EU-IMF nancing prgram was sucient t ull cver

Greece’s public nancing needs ver the net three ears and t ensure that the Greek

gvernment wuld nt need t return t the capital market bere 2013. At the insistence

the German gvernment, which aced strng dmestic plitical ppsitin t bailing

Greece ut, the disbursement mne under the Plan was t be dne in a strictl phasedmanner and was nl t be made available subject t Greece’s cmpling with the strict

terms an IMF stand-b arrangement. The German gvernment als insisted that Greece

be charged a ve percent interest rate r the mne brrwed under this prgram, which

culd be sld dmesticall as being a lan etended t Greece at a market related rate.

on 9 th Ma, 2010, the nal death knell was sunded r the Eurzne’s “n bailut clause”.

In the cntet ears that cntagin rm the Greek crisis wuld sn envelpe Ireland,

Prtugal, and Spain, the Eurpean Cmmissin and the IMF put in place a EUR750 billin

saet net r the Eurzne’s peripheral cuntries. The basic idea this saet net was t

assure the markets that cial mne was available in the event that it was needed t ull

cver the public nances the Eurzne’s peripher ver the net three ears. once again,

mnies made available under this plan were t be made subject t strict IMF cnditinalit

and the cuntries drawing n this saet net were t pa market related interest rates. While

the annuncement the saet net did have the immediate desired eect deusing the

crisis at least tempraril, it did nt succeed in reducing the high interest rates spreads that

markets demanded the peripher. B September 2010, market interest rate spreads r

Greece, Ireland, Prtugal, and Spain were again back clse t their pre-9th Ma, 2010 highs.

A central plank the EU-IMF saet net is the creatin a EUR440 billin Eurpean

Financial Stabilit Fund (EFSF). In essence, the EFSF is a special purpse vehicle that wuld

brrw in the markets as needed t prvide nancing t the peripheral cuntries, which

might require access t the saet net. The brrwing that the EFSF wuld undertake

wuld be guaranteed b thse Eurzne cuntries nt accessing the saet net and thse

guarantees wuld be prvided in prprtin t thse cuntries’ relative psitin in the

Eurpean Central Bank. Thse guarantees were set t ttal 20 percent mre than the

EUR440 billin size the EFSF in rder t secure r the EFSF an AAA rating rm all

three majr rating agencies. A glaring weakness the EFSF is that it is reling r arund

20 percent the ttal guarantees rm Ireland, Prtugal, and Spain, the ver cuntries

which might themselves sn need t tap the saet net. This weakness has the ptential t

jepardise the EFSF’s AAA rating since markets will cme t questin whether the EFSF isadequatel back stpped b the member cuntries.

Bailing ut thrugh the backdr

Anther serius casualt the svereign debt crisis has been the integrit the Eurpean

Central Bank as a suppsedl independent pillar Eurzne mnetar stabilit. At the time

that the ECB was set up in 1999, its unding statutes precluded the ECB rm directl

subscribing t member gvernment bnd issues in rder t saeguard the integrit the

ECB and t avid mral hazard. This preclusin was t be a cmplement t the Eurzne’s

n bail ut clause in the sense being a ur ther means t subject member gvernments t



27

Cn e Euo Suvive?

the ull rce nancial market discipline. Hwever, nthing in the ECB’s charter prevented

that institutin rm engaging in rediscunt peratins with member cuntr’s banks,

even thugh thse banks ma n-lend the prceeds such peratins t their dmestic

gvernments.24 Nthing in the ECB’s charter als prevented it rm supprting member

cuntr gvernments b buing their paper in the secndar market.over the past tw ears, the ECB has liberall availed itsel the lphles in its charter

in rder t prvide massive supprt t thse gvernments in the Eurzne’s peripher that

encuntered cnsiderable dicult in raising private sectr nancing. The ECB has als

substantiall relaed the standards the paper that it accepts as cllateral r its rediscunt

peratins in a urther ert t supprt the banks in the Eurzne’s peripher. While the

initial prvisin unlimited liquidit t Eurzne banks was intrduced in June 2008 in

respnse t the glbal nancial crisis, in the past ear, it has mainl been the banks in the

Eurzne’s trubled peripher that have availed themselves the ECB’s discunt windw.

As an indicatin the degree t which the peripher has used the ECB’s windw is the

act that b August 2010 the peripher, which nl accunts r

15 percent the Eurzne’s verall ecnm, accunted r a

ull 37 percent the ECB’s cnsiderabl epanded lan bk.

25 The ECB’s lending t Spain alne rse t EUR125 billin b

August 2010 as the ECB stepped in t ll the gap created b the

virtual dring up private reign lending t Spanish banks and

crpratins during the summer 2010.

In the heat the Spring 2010 Eurzne debt crisis, the ECB

gave up an pretence maintaining its lending standards t aid

trubled peripheral gvernments. Ater weeks indicating that the

ECB wuld nt purchase gvernment bnds member cuntries in the secndar market,

n 9th Ma, 2010, in a dramatic abut ace in cnjunctin with the EU-IMF annuncement

the nancial saet net r the peripher, Jean-Claude Trichet annunced that the ECB

wuld begin such purchases as need be t stabilise nancial markets. B September 2010,

the ECB had purchased a ttal EUR60 billin gvernment bnds in the secndar

market althugh the pace such purchases has tapered t a trickle.

Clsing the Stable Dr ater the Hrse has Blted

Rather than cntemplate hw the peripheral cuntries might eit the Eur in an rderl

ashin, Eurpean plicmakers are nw prpsing t rti the Eurzne’s architecture

thrugh treat mdicatin. At a recent Eurpean Summit, agreement was reached t

etend the Eurpean Financial Stabilit Fund when it epired in 2013 and t require that

private bndhlders bear their share the burden uture bailut eercises. In additin, it

was agreed t intrduce real penalties r cuntr’s that were in repeated vilatin the

budget limits the Stabilit and Grwth Pact.

24 The ECB’s rediscunt peratins are essentiall lans etended b the ECB at a discunt t a member cuntr’s banks against the cllateral high qualit paper tendered b the bank requesting the lan.

25 See “Eurzne: Standing out”, BNP Paribas, 7 th Jul, 2010.

Anther serius casualt

the svereign debt crisis

has been the integrit the

Eurpean Central Bank as

a suppsedl independent

pillar Eurzne mnetar

stabilit



Legum Insiue

28

While the treat mdicatins nw being prpsed wuld have had great merit when

the Eur was launched in Januar 1999, hw relevant the are tda at a time when the

peripher’s public nances have been cmprmised bend repair and when there is ever

indicatin that the peripher’s crisis is deepening is questinable. While the peripher’s

svereign debt crisis is plaing ut in real time, past eperience wuld suggest that treat mdicatin, which requires unanimus raticatin b all Eurpean Unin members, will

take ears t eect. In additin, it wuld appear that the prpsed rerms verlk the

act that the majr part the peripher’s budget decits is primar in nature. As such,

even i the debt the peripher were t be substantiall written dwn, the peripher

wuld still be let with ver large budget decits. And reducing these ver large budget

decits t sustainable levels wuld still invlve ver deep recessins i such an eercise were

attempted within the straitjacket cntinued Eur membership.



29

ChaptEr IV

THE END GAME

The late Herb Stein, a well-knwn American ecnmist, was nd bserving that i

smething cannt g n rever it will stp. This aphrism appears t be particularl apt r

the current Eurzne situatin. Since it wuld seem unreasnable t epect that vters in

the Eurzne’s nr th, and especiall in German, will indenitel acquiesce t the transer

large amunts bailut mne t the Eurzne’s suth in an ert t keep thse

cuntries afat. And it wuld seem even mre unreasnable t epect vters in the suth

t indenitel endure the severe ecnmic and scial pain assciated with the austerit

measures attached t the nancing that the receive rm the nrth. This wuld seem t

be especiall true i vters in the suth were t perceive (a) that the were being taed

s that nerus debt repaments culd be made t reign banks; and, (b) that there was

little prspect their ecnmies emerging antime sn rm depressin like cnditins

withut the benet either a debt restructuring r an eit rm the Eur straitjacket.

In Ma 2010, a cautinar warning was sunded r Eurzne plicmakers in the

Westphalian state electins. The vters Westphalia, German’s largest state, handed Angela

Merkel’s Christian Demcratic Unin a crushing deeat largel in prtest at Mrs Merkel’s

active rle in the Greek bailut package. It wuld seem that electral cnsideratins this

srt wuld make it all but impssible t enlarge r t etend the EFSF when it epires in three ears time.

As recent ECB eperience ampl attests, in principle Eurpean plicmakers can

use ECB nancing t the peripher as a ver much less transparent rm keeping the

peripher afat. The bvius advantage using the ECB r that purpse is that the ECB’s

rediscunt peratins are nt subject t the same clse parliamentar scrutin as are the

budgetar apprpriatins required r the Eurzne’s ther bailut peratins. Hwever,

ne wuld think that there have t be limits as t hw much urther the ECB can bend

its rules. There als have t be limits as t hw much urther the ECB might be prepared

t cntaminate its balance sheet b accepting mre cllateral lesser qualit rm the

peripher’s banks. Alread serius vices within the ECB, mst ntabl that Ale Weber



Legum Insiue

30

the President German’s Bundesbank, have been publicl raised abut the lnger term

advisabilit urther cmprmising the ECB’s balance sheet and using the ECB t

cnduct what are essentiall budgetar peratins.

Eurpean plicmakers understand ull well that a deault in an peripheral cuntr is

almst certain t trigger cntagin t the rest the peripher. The are als highl cgnisant the act that a wave deaults in the peripher wuld mre than likel precipitate

a ull-blwn banking crisis in West Eurpe. These cnsideratins wuld make ne think

that Eurpean plicmakers in the nrth will nt l ightl turn the nancing spigt that

presentl keeps the peripher, and thereb the Eurpean banking sstem, afat. Rather, ne

must epect that Eurpean plicmakers will cntinue t kick the

can rward in the rlrn hpe that smething might turn up t

rescue the peripher. The might als d s in the hpe that time

might allw the West Eurpean banks t strengthen their balance

sheets in a manner that wuld allw them mre easil t absrb

the shck a svereign debt deault in the peripher.

The mre likel trigger r the Eur’s eventual unravelling

will be in the peripher itsel. The Irish, Prtuguese, and Spanish

gvernments alread all have the mst tenuus hlds n plitical

pwer. A deepening in their ecnmic and nancial crises culd ver well result in the

ascendanc mre ppulist gvernments which might be less willing t hew t the hair-

shirt austerit prgrams being dictated b the IMF. This is essentiall what precipitated

the demise Argentina’s Cnvertibilit Plan in 2001. Mre recentl, the new Hungarian

gvernment’s spurning the IMF in September 2010 wuld seem t be a pignant

reminder that cuntries in the Eurzne’s peripher might ver well als be tempted t

turn their backs n IMF austerit. Anther plausible trigger r the Eur’s eventual unravelling

culd be a heightening the capital fight that alread is underwa in Greece and Ireland.

Ample eperience in earlier ed echange rate regimes suggests that capital fight can

reach such prprtins that cuntries are let with little alternative but t restructure their

debt and t eit their ed echange rate arrangement.26

The Eur in a pst-deault wrld

At the Eur’s launch in 1999, Eurpean plicmakers understandabl did nt negtiate a PlanB t deal with the cntingenc that the Eur might eventuall unravel. The ver idea the

Eur was t ster a permanent ecnmic and plitical unin, whse attainment wuld have

been seriusl undermined b an cial suggestin that the bld mnetar eperiment

n which Eurpe was embarked might eventuall unravel. This nw leaves the greatest

uncertainties as t what might happen t the Eur shuld an the peripheral cuntries

be rced t eit the Eur. In a recent legal paper, the mst that the ECB has indicated n

this tpic is that individual cuntries ma vluntaril chse t leave the Eur but that n

26 Capital fight rm the Eurzne’s peripher can be epected t intensi as dmestic bank depsitrs increasingl ear that their depsits might be rzen and rcibl cnverted rm Eurs int a newl issued dmestic currenc at an unavrable

echange rate.

The departure an

individual peripheral cuntr

rm the Eur wuld almst

certainl result in severecntagin t the ther

cuntries in the peripher



31

Cn e Euo Suvive?

individual cuntr can be rced t leave the Eur b ther member cuntries.27 Further the

ECB has indicated that its interpretatin the Treat Lisbn is that shuld an individual

cuntr chse t leave the Eur, it will als be bliged t leave the Eurpean Unin.

over the past ew ears, a clear pattern has emerged as t hw the Eurzne applies

its rules at a time stress. In the event a real crisis, the rules have been bent cnsistentl in an ert t nd a plitical slutin t deuse the crisis. As discussed abve, this has

certainl been the case with the Stabilit and Grwth Pact, the “n bailut clause”, and

the ECB’s adherence t pursuing strictl mnetar plic bjectives. on this basis, it wuld

seem reasnable t epect that were an individual cuntr t leave the Eur, the same

pragmatism wuld be applied t nding a plitical slutin that wuld limit the damage t

the rest the Eur area.

In cnsidering what might happen t the Eurzne in the event that an its peripheral

member cuntries were t lse the plitical willingness t persevere with IMF-stle scal

austerit measures, it is well t recall the nature their public nance prblem. A striking

eature the public nances Greece, Ireland, Prtugal, and Spain, is hw ver large are

the “primar” r nn-interest pament cmpnents their budget decits. This eature

their public nances limits the degree t which these cuntries might rebalance their public

nances thrugh debt restructuring. Fr an such restructuring wuld nt aect the nn-

interest part their budgets which cnstitutes the majr part their public nance prblem.

As an illustratin the limits debt restructuring, ne might cnsider that had Greece

and Ireland successull managed t halve their public debts thrugh restructuring in 2009,

the wuld have still been let with budget decits ver 10 percent GDP. This wuld

have let these cuntries with the basic prblem ater debt restructuring still having

t undertake a ver sizeable amunt scal adjustment within a ed echange rate

sstem in rder t restre scal sustainabilit. It is cnsideratins this srt that must

make ne epect that, in the event that an the peripheral cuntries were t lse the

plitical willingness t stick t IMF-stle austerit measures, nt nl wuld the substantiall

restructure their debt but the wuld als chse t eit the Eur. The wuld d s in the

hpe that a cheaper currenc wuld allw them t bst their epr ts as a cushin t the

negative eects n their ecnmies the still needed scal plic tightening.

The departure an individual peripheral cuntr rm the Eur wuld almst

certainl result in severe cntagin t the ther cuntries in the peripher . This wuld ccur

as the result an unleashing severe market pressure n thse cuntries, which wuldnw be viewed as mre likel than bere, t leave the Eur, sharing as the d the same

basic structural weaknesses as the cuntr that chse t eit. It wuld als ccur as a result

the ver likel intensicatin dmestic capital fight. The prhibitive interest rates that

these cuntries wuld nw have t pa r their market brrwing wuld create the ver

cnditins that wuld make it all but impssible r these cuntries t cntinue servicing

their svereign debt.

Since the Treat Lisbn is silent n the matter, it is ar rm clear what wuld happen

t the Eur in the event that several the peripheral member cuntries were rced t

27 “Withdrawal and Epulsin rm EMU and the EU, Sme Refectins”, Phebus Athanassiu, ECB Legal Wrking Series Paper,

December 2009.



Legum Insiue

32

eit the Eur. A ver prbable scenari is that the Eur wuld survive, albeit in a reduced

rm. While Greece, Ireland, Ital, Prtugal, and Spain might all be epected t leave the

Eur, ne culd envisage a scenari where the Eurzne’s strnger nrthern member

cuntries, including France, German, and the Benelu cuntries wuld remain in the

currenc arrangement. Hwever, ne cannt eclude the pssibilit that the breakup the Eur wuld prmpt German t rethink its cntinued Eurzne membership. The Eur

was never ppular with the German public, wh retain nd memries the rle that

the Deutsche Mark and the Bundesbank plaed in German’s pst-war ecnmic miracle.

The turmil in the Eurzne’s peripher will nl have served t validate the German

public’s initial grave misgivings abut Eur membership at the time that German gave up

its treasured Deutsche Mark.28

A Eur cmprised nl Eurpe’s strnger nrthern member cuntries culd be

epected t be a ver strng currenc in the lng term. Hwever, in the near term, ne

shuld epect that the Eur will eperience cnsiderable weakness. A series svereign

debt deaults in the Eurzne’s peripher wuld almst certainl cause a majr Eurpean

banking crisis that in turn wuld seriusl undermine the Eurpean ecnm. At the same

time, ne must epect that markets wuld becme ver unsettled in an envirnment where

it was ar rm clear as t the rm in which the Eur wuld survive in the atermath the

eit its peripheral member cuntries.

Plic Implicatins

Eurpean plicmakers seem t be in denial abut the peripher’s slvenc prblem.

Sadl this state denial can lead t serius plic mistakes that culd cst the Eurzne

ecnm dearl. This wuld certainl seem t be the case r the peripheral cuntries

themselves. Fr i Argentina’s 2001 eperience is an guide, these cuntr ies will nd that

the will eperience the deepest ecnmic recessins ver the net ear r tw as

the appl IMF-stle scal austerit while still within the Eur. yet in the end, the will nd

that the will still be rced t restructure their public debt and t eit the Eur as deep

recessins bth erde their ta bases and sap their plitical willingness t persevere with

austerit. I debt restructuring and eiting the Eur is indeed inevitable r the peripheral

cuntries, it wuld be better r them t d it sner rather than later. This wuld seem t

be clearl preerable t their prlnging the agn and delaing the putting in place thsecnditins that culd er hpe an eventual ecnmic recver.

In cnsidering plic ptins r the cuntries in the peripher, it is imprtant t

recgnise that the majr part their budget decits is “primar”, r nn-interest related

pament transactins, in nature. As such, even a large write dwn in their svereign debt,

while helpul, will nt bviate the need r majr scal adjustment t bring the primar

budget back int balance. T illustrate this pint, ne might cnsider that in 2009 nl

arund 6.5 percentage pints Greece’s 15.3 percent GDP budget decit cnstituted

28 It might be recalled that in 1999 German jined the Eur as the price it had t pa r France’s acquiescence t Germanreunicatin. Nw that German has been successull reunied, German’s incentive r remaining in the Eur has been

diminished.



33

Cn e Euo Suvive?

interest paments. As a result, even i Greece’s public debt were t have been written dwn

b 50 percent, Greece wuld still have been let with a budget decit 12 percent GDP,

which wuld have still required a majr scal plic adjustment.

Eperience ver a wide range cuntries strngl suggests that large scale scal

adjustment in a ed echange rate sstem generall invlves the deepest and mstprtracted ecnmic recessins. Fr this reasn, ne wuld think that the peripher

cuntries shuld seriusl cnsider the ptin an earl eit rm the Eur as a means

t incentivise their eprt sectrs. Since a strng bst t these cuntries’ eternal

sectrs culd serve as a much needed cushin t the majr scal plic adjustments that

are needed t restre scal sustainabilit. one wuld nt curse want t minimise

the shrt-run csts invlved in eiting the Eur since this wuld necessaril invlve the

rced redenminatin bank depsits and all cntracts at a less avurable echange

rate. Hwever, it wuld seem that i the abandnment the Eur is the inevitable end

game, it wuld be preerable that such an eercise be carried ut in a cntrlled manner,

preerabl with the supprt the IMF and the peripher’s Eurpean partners, rather than

in a disrderl manner in the wake the cllapse these cuntr ies’ adjustment prgrams.

While the dela in the peripher’s inevitable debt restructuring wuld nt be in the

interest Eurpe’s peripheral cuntries, a persuasive case can be made that it wuld be

in the interest the Eurzne’s nrthern member cuntries. Such a dela culd ard

thse cuntries time t strengthen their banking sstems in a manner that wuld allw their

banks t better absrb the large lan lsses that wuld be assciated with debt deaults in

the peripher. This wuld especiall appear t be the case since, as mentined abve, the

Eurpean banking sstem is still relativel weak as it is as et still t ull recgnise the lsses

assciated with the September 2008 Lehman cllapse.

There is the ver real danger that the Eurpean plicmakers’ present state denial

abut the likelihd a wave svereign debt deaults in the peripher will breed a sense

plic cmplacenc. Such a state cmplacenc culd lead them t cntemplate t

hast an eit rm the stimulus plicies that were put in place ver the past tw ears t

supprt the Eurpean ecnmic recver. It culd als induce Eurpean plicmakers nt

t ull avail themselves the breathing rm that the are being arded t strengthen

their banks in anticipatin the all t prbable wave svereign debt deaults that lie

ahead. This wuld be the greatest shames nt nl r the Eurpean ecnm but als

r the glbal ecnm as a whle. As we have painull learnt rm the 2008 Lehmaneperience, the wrld’s nancial sstem is all t inter-cnnected and a majr banking crisis

in Eurpe must be epected t seriusl reverberate thrughut the glbal ecnm.



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