The muddle-through approach to the eurozone crisis has failed to resolve the fundamental problems of economic and competitiveness divergence within the union. If this continues the euro will move towards disorderly debt workouts, and eventually a break-up of the monetary union itself, as some of the weaker members crash out.
The Economic and Monetary Union never fully satisfied the conditions for an optimal currency area. Instead its leaders hoped that their lack of monetary, fiscal and exchange rate policies would in turn see an acceleration of structural reforms. These, it was hoped, would see productivity and growth rates converge.
The reality turned out to be different. Paradoxically the halo effect of early interest rate convergence allowed a greater divergence in fiscal policies. A reckless lack of discipline in countries such as Greece and Portugal was matched only by the build-up of asset bubbles in others like Spain and Ireland. Structural reforms were delayed, while wage growth relative to productivity growth diverged. The result was a loss of competitiveness on the periphery.
All successful monetary unions have eventually been associated with a political and fiscal union. But European moves toward political union have stalled, while moves towards fiscal union would require significant federal central revenues, and also the widespread issuance of euro bonds — where the taxes of German (and other core) taxpayers are not backstopping only their country’s debt but also the debt of the members of the periphery. Core taxpayers are unlikely to accept this.
Eurozone debt reduction or “reprofiling” will help to resolve the issue of excessive debt in some insolvent economies. But it will do nothing to restore economic convergence, which requires the restoration of competitiveness convergence. Without this the periphery will simply stagnate.
Here the options are limited. The euro could fall sharply in value towards – say – parity with the US dollar, to restore competitiveness to the periphery; but a sharp fall of the euro is unlikely given the trade strength of Germany and the hawkish policies of the European Central Bank.
The German route — reforms to increase productivity growth and keep a lid on wage growth — will not work either. In the short run such reforms actually tend to reduce growth and it took more than a decade for Germany to restore its competitiveness, a horizon that is way too long for periphery economies that need growth soon.
Deflation is a third option, but this is also associated with persistent recession. Argentina tried this route, but after three years of an ever deepening slump it gave up, and decided to default and exit its currency board peg. Even if deflation was achieved, the balance sheet effect would increase the real burden of private and public debts. All the talk by the ECB and the European Union of an internal depreciation is thus faulty, while the necessary fiscal austerity still has – in the short run – a negative effect on growth.
So given these three options are unlikely, there is really only one other way to restore competitiveness and growth on the periphery: leave the euro, go back to national currencies and achieve a massive nominal and real depreciation. After all, in all those emerging market financial crises that restored growth a move to flexible exchange rates was necessary and unavoidable on top of official liquidity, austerity and reform and, in some cases, debt restructuring and reduction.
Of course today the idea of leaving the euro is treated as inconceivable, even in Athens and Lisbon. Exit would impose big trade losses on the rest of the eurozone, via major real depreciation and capital losses on the creditor core, in much the same way as Argentina’s “pesification” of its dollar debt did during its last crisis.
Yet scenarios that are treated as inconceivable today may not be so far-fetched five years from now, especially if some of the periphery economies stagnate. The eurozone was glued together by the convergence of low real interest rates sustaining growth, the hope that reforms could maintain convergence; and the prospect of eventual fiscal and political union. But now convergence is gone, reform is stalled, while fiscal and political union is a distant dream.
Debt restructuring will happen. The question is when (sooner or later) and how (orderly or disorderly). But even debt reduction will not be sufficient to restore competitiveness and growth. Yet if this cannot be achieved, the option of exiting the monetary union will become dominant: the benefits of staying in will be lower than the benefits of exiting, however bumpy or disorderly that exit may end up being.
Nouriel Roubini is chairman of Roubini Global Economics, professor of economics at the Stern School of Business NYU and co-author of ‘Crisis Economics’ that has been recently published in its paperback edition.
A ‘Plan B’ for Europe is possible
European Union leaders are getting their knickers in a twist over Greece, again. The facts are well-known: a debt spiralling up to 170 per cent of gross domestic product, a stubborn double-digit deficit, the collapse of private investment and a shrinking economy. Plan A – liquidity support and structural reform under an EU-IMF programme – has run aground. But instead of accepting a wider crisis as inevitable, as Nouriel Roubini seems to do in his article above, what Europe now needs is a credible Plan B.
At present Greece cannot repay its debt in full, but asking European taxpayers to share the burden through a write-off is politically toxic. Simply restructuring debt owed to the private sector will bankrupt the Greek banking system, and trigger contagion. Increasing public support to Greece also makes little economic sense. Instead the new path must move between the constraints of what is economically sensible and politically feasible.
This means haircuts on Greek government bonds are arithmetically unavoidable, and that any Plan B must differentiate between the various creditors. EU loans and European Central Bank support provided after Greece landed into trouble must be treated preferentially. Another category of creditors, Greek banks, will also need to be protected. This is not because of fairness or political expediency, but because a haircut will bankrupt all Greek banks, imposing enormous economic costs on Greece and its foreign creditors, and triggering contagion.
Next, Greek bonds held by the ECB and Greek banks should be swapped for new par bonds that are excluded from restructuring. Changes to Greek domestic law will also be needed to smooth restructuring and target a debt stock of just below the psychologically important 100 per cent threshold. Here the burden would fall mostly on private external holders of Greek debt, of which German and French banks are the biggest. Well-capitalised French banks, such as BNP Paribas, can comfortably absorb the 50 per cent haircut needed. German banks can also handle the haircuts.
Finally, contagion to Ireland and Portugal can be avoided through the introduction of a European stability mechanism clause that allows debt restructuring only when the debt/GDP ratio and debt servicing/GDP ratios exceed 110 per cent and 6 per cent respectively, levels that neither Ireland nor Portugal are expected to breach. The markets recognise that Greece is different. It will still need to work very hard to cut deficits and restore growth. For that there is no Plan B.
The writer is managing director of Re-Define, an International Think Tank. This is an extract of a longer article which will be published in the FT on Tuesday, June 14.