From Greek to Irish to Euro Crisis

Barry Eichengreen Project Syndicate December 10, 2010

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BERKELEY "“ What once could be dismissed as simply a Greek crisis, or simply a Greek and Irish crisis, is now clearly a eurozone crisis. Resolving that crisis is both easier and more difficult than is commonly supposed.

The economics is really quite simple. Greece has a budget problem. Ireland has a banking problem. Portugal has a private-debt problem. Spain has a combination of all three. But, while the specifics differ, the implications are the same: all must now endure excruciatingly painful spending cuts.

The standard way to buffer the effects of austerity is to marry domestic cuts to devaluation of the currency. Devaluation renders exports more competitive, thus substituting external demand for the domestic demand that is being compressed.

But, since none of these countries has a national currency to devalue, they must substitute internal devaluation for external devaluation. They have to cut wages, pensions, and other costs in order to achieve the same gain in competitiveness needed to substitute external demand for internal demand.

The crisis countries have, in fact, shown remarkable resolve in implementing painful cuts. But one economic variable has not adjusted with the others: public and private debt. The value of inherited government debts remains intact, and, aside from a handful of obligations to so-called junior creditors, bank debts also remain untouched.

This simple fact creates a fundamental contradiction for the internal devaluation strategy: the more that countries reduce wages and costs, the heavier their inherited debt loads become. And, as debt burdens become heavier, public spending must be cut further and taxes increased to service the government's debt and that of its wards, like the banks. This, in turn, creates the need for more internal devaluation, further heightening the debt burden, and so on, in a vicious spiral downward into depression.

So, if internal devaluation is to work, the value of debts, where they already represent a heavy burden, must be reduced. Government debt must be restructured. Bank debts have to be converted into equity and, where banks are insolvent, written off. Mortgage debts, too, must be written down.

Policymakers are understandably reluctant to go down this road. Contracts are sacrosanct. Governments fear that they will lose credibility with financial markets. Where their obligations are held by foreigners, and by foreign banks in particular, writing them down may only destabilize other countries.

These are reasonable objections, but they should not be allowed to lead to unreasonable conclusions. The alternatives on offer are internal and external devaluation. European leaders must choose which one it will be. They are united in ruling out external devaluation. But internal devaluation requires debt restructuring. To deny this is both unreasonable and illogical.

The mechanics of debt restructuring are straightforward. Governments can offer a menu of new bonds worth some fraction of the value of their existing obligations. Bondholders can be given a choice between par bonds with a face value equal to their existing bonds but a longer maturity and lower interest rate, and discount bonds with a shorter maturity and higher interest rate but a face value that is a fraction of existing bonds' face value.

This is not rocket science. It has been done before. But there are three prerequisites for success.

First, bondholders will need to be reassured that their new bonds are secure. Someone has to guarantee that they are adequately collateralized. When Latin American debt was restructured in the 1980's under the Brady Plan, these "sweeteners" were provided by the United States Treasury. This time around, the International Monetary Fund and the German government should fill that role.

Second, countries must move together. Otherwise, one country's restructuring will heighten expectations that others will follow, giving rise to contagion.

Finally, banks that take losses as a result of these restructurings will need to have their balance sheets reinforced. The banks need real stress tests, not the official confidence game carried out earlier this year. Where realistic debt-restructuring scenarios indicate capital shortfalls, across-the-board conversion of bank debt into equity will be necessary. And where this does not suffice, banks will need immediate capital injections by their governments.

Again, making this work requires European countries to move together. And, with banks' balance sheets having been strengthened, it will be possible to restructure mortgage debts, bank debts, and other private-sector debts without destabilizing financial systems.

Now we get to the hard part. All of this requires leadership. German leaders must acknowledge that their country's banks are dangerously exposed to the debts of the eurozone periphery. They must convince their constituents that using public money to provide sweeteners for debt restructuring and to recapitalize the banks is essential to the internal devaluation strategy that they insist their neighbors follow.

In short, Europe's leaders "“ and German leaders above all "“ must make the case that the alternative is too dire to contemplate. Because it is.

Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley.

Copyright: Project Syndicate, 2010. www.project-syndicate.org For a podcast of this commentary in English, please use this link:http://media.blubrry.com/ps/media.libsyn.com/media/ps/eichengreen25.mp3

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Username Password New registration Forgotten password ccz1 04:51 09 Dec 10

I will try to use facts, only facts:

"But, since none of these countries has a national currency to devalue, they must substitute internal devaluation for external devaluation. They have to cut wages, pensions, and other costs in order to achieve the same gain in competitiveness needed to substitute external demand for internal demand."

A decrease of 5% on wages of export companies in Portugal would reduce the final cost, on average, only 1.35%. Your solution would require a cut of 20 to 30% to be meaningful.

Portuguese exports are growing this year at more than 17%.

There are sectors, like the shoe industry, that is working at full capacity exporting more than 95% of their production.

Furniture exports are growing more than 26%

Textiles exports are growing more than 5%

Machinery exports are growing more than 14%

Do you still think that Portuguese exports have a competitiveness problem?

Our problem is a BIG STATE that sucks everything from private sector in taxes and more taxes.

I agree with you a hair cute is needed as a first step to stop STATE endebtment, followed by a second step: reduce the size of the STATE.

mattus 06:18 09 Dec 10

Brilliant analysis, Professor, and a feasible plan if the countries are really unable to service their debt. It will become clear in the next five years.

However, lets give them a chance to pay the money back first. Here is why:

(1) They are all wealthy countries, Ireland about as wealthy as the US (GDP per person), Portugal about half as rich, Greece and Spain in between. They also have relatively equal income distributions, so broad shoulders to carry the debt. Their citizens have net wealth of around 3 or 4 times GDP, which could be taxed/mortgaged if external credit dries up. The total indebtedness (private plus public sector debt) of each country is not higher than the US (as percentage of GDP), and nobody suggests that there should be haircuts on US debt.

(2) These countries are highly interlinked to others in Europe whose growth prospects are better. As wages fall, exports will rise. That is already happening in Ireland, for example, and will happen in other countries. Tourism to southern european countries will rise. About a fifth of the economy is made up from tourism in the case of Greece. As the northern european economies grows, their citizens get richer and will have more money to spend on holidays on the Mediterranean beaches.

(3) Internal devaluation has recently worked in Estonia, where GDP is now growing again after a severe contraction. (Estonia is not yet in the Euro, but its currency is linked to the Euro, so devaluation was not an option.) Unemployment is down, and the current account deficit has been turned into a current account surplus.

Lets not forget that the higher indebtedness in the European periphery countries financed real higher living standards in the past ten years throughout the region. They got wealthier relative to the countries at the centre, financed by debt from the centre. A re-adjustment is in order before creditors take any haircuts.

belgradetokyo 10:01 10 Dec 10

The alternative is too dire to contemplate? It's unfolding as we speak (write.)

RicardoSmithKeynes 07:42 10 Dec 10

Hegel famously asserted that the history of mankind is that men do not learn from history...

The global response to the events of September 2008 refuted Hegel. G-20 governments avoided the three key policy mistakes of the Great Depression by:

1. providing ample liquidity in response to a global financial crisis;

2. avoiding pro-cyclical fiscal policies; and

3. eshewing protectionist beggar-thy-neighbour policies.

Yet, having avoided a catestrophic collapse of global output in 2008-09, some now seem determined to return to the economic stagnation of the 1930s by recreating the dysfunctional international monetary arrangements of the inter-war period. Fixed and managed exchange rates supported by foreign exchange intervention, currency unions in non-optimal monetary areas that are pursued for political objectives and without the needed supporting legal and policy frameworks, and the adoption of "prudential" capital controls to stem currency appreciation all combine to create an international monetary "non-system" that, like the monetary disorder of the 1920s, sucks aggregate demand from the global economy and propogated defalation.

In these circumstances we risk losing sight of Keynes' insight (derived from his vantage point at Versailles) that inernational monetary cooperation on the rules of the game is required to secure a felicitious balance between financing and adjustment. Attempts to enforce contracts (or treaties) that impose insufferable adjustment burdens on sovereign states, he argued, will only result in the adoption of policies to shift the burden of adjustment to others. Such policies are "injurious to national and international prosperity"; ultimately all are made worse off.

Keynes worked tirelessly to create an international monetary system that would secure the monetary cooperation needed to ensure an appropriate balance of financing and adjustment. For the first 25 years or so of the Bretton Woods system he co-founded (with his Treasury counterpart, Harry Dexter White), private capital flows were limited by the widespread use of capital controls (and the memory of the losses incurred in the 1930s!). Balance of payments crises orginated in current account; from imbalances between private sector savings and investment and government dissaving. And, because saving and investment decisions reflect long-term intertemporal otpimization, the first rule of international finance was: adjust to permanent shocks; finance temporary shocks.

In this environment, the IMF literally had the resources close gaps in the balance of payments. Eventually, however, countries sought the benefits that access to private captial markets provided and liberalized their capital accounts. But this evolution of the system did not elicit a corresponding change in international arrangements for dealing with financial crisises--the rules of the game to support financial globalization. For the past 15 years we have witnessed the consequences of this asymmetry, as we have lurched from international financial crisis to crisis.

In the wake of the Asian finacial crisis efforts were made to erect a framework for the timely, orderly restructuring of private sector claims. Progress was made; particularly the widespread use of collection action clauses. But these efforts were incomplete and attempts to complete the process were styimed by complacency bred of the surfeit of liquidity that followed the dot.com bubble, which was masked by the "Great Moderation". How ironic it is that M. Trichet played a critical role in emasculating these efforts with his voluntary codes of behaviour!

Pity him, however. Had more progress been made in braodening the definiton of "adjustment"--from the Bretton Woods, fixed exchange rate notion of "domestic absorption", to "adjustment of private claims"--the outlook for the European project would not, perhaps, be so bleak as it is today. To be sure, the people of Ireland and Greece would still face difficult decisions and painful adjustments, but the social and political fabric of society would not be under the same stress as they are because the burden of adjustment would be more broadly shared with the investors that funded speculative real estate investments.

The second great age of globalization is looking far less unassailable than it did a few years ago. If efforts are not made to restore Keynes' vision, by securing a felicitous balance between financing and adjustment (including of private sector claims), we are likely to see it founder--just as the first great age failed. We will not only prove Hegel right, but also validate Santayanna's famous warning that those who fail to learn from history are doomed to repeat it.

Ricardo Smith-Keynes (Tilton on the Rideau)

AUTHOR INFO Barry Eichengreen Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley. MOST READ MOST RECOMMENDED MOST COMMENTED New Rules for Hot Money Nouriel Roubini Europe's Monetary Cordon Sanitaire Simon Johnson and Peter Boone The Retreat of Macroeconomic Policy J. Bradford DeLong The Irrepressible 1930's Robert Skidelsky Alternatives to Austerity Joseph E. Stiglitz A New World Architecture George Soros No Time for a Trade War Joseph E. Stiglitz Avatar and Empire Naomi Wolf The Risky Rich Nouriel Roubini Let A Hundred Theories Bloom George Akerlof and Joseph E. Stiglitz The Retreat of Macroeconomic Policy J. Bradford DeLong Land for Peace in Kosovo Charles Tannock Europe's Inevitable Haircut Barry Eichengreen India or China? Jagdish Bhagwati The Irrepressible 1930's Robert Skidelsky ADVERTISEMENT PROJECT SYNDICATE

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