When discussing the euro crisis, it makes sense to distinguish between the long-term future of the eurozone and its current plight. When it comes to the long term, one dominant school of thought advocates a eurozone with more centralized powers and a mutualisation of government debt.
In principle, this arrangement could work, but there are significant doubts whether it can ever be achieved. As one example, member states of the eurozone would need to cede significant powers to European institutions, especially the right to issue public debt.
Germany today is an example of a country that has such an internal arrangement, but it is imperfect in the sense that, while liability for debt is fully centralized, control is only partially so. The consequence is that several German states are unable to pay off their debts and have little incentive to change this. Another important feature of Germany is that it has implemented a fiscal equalization scheme between its states, but I cannot imagine a similar approach being right for Europe.
I am not convinced Plan A will succeed or that it is even intelligent to proceed in such a mannerOf course, we need more integration and coordination, but the crucial question is: who will ultimately be liable for public debt? In his book, , Michael Heise, chief economist of Allianz, wrote that liability should remain at the member state level, thus placing the costs of excessive debt on the shoulders of private creditors. I think this is the right approach, but at the same time we need to ask ourselves whether the announcement that private creditors will now be “bailed in” is credible. Emerging from the Euro Debt Crisis
Ultimately, this leads to the question of the stability of the financial sector and if it is robust enough to endure a restructuring of government debt. I believe this can be achieved. We are slowly, hesitantly working towards the goal of developing a eurozone that will feature more economic cooperation, especially in the financial sector, but also decentralized responsibility for sovereign debt. Whether this will work, in particular for bigger countries, is an open question.
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What is equally important and relevant is what we will do in the short term. That is, how will we lift ourselves out of the current crisis? The strategy currently pursued by the eurozone governments amounts to what I call “Plan A.” This is a slow reduction of private debt, a consolidation of government finances and adjustments in the labor market, in particular wage reductions that will continue in peripheral countries for years to come. In countries like Spain and Portugal, the debt to GDP ratio will continue to increase for at least another four or five years before a turnaround seems realistic, even if the country maintains strict fiscal discipline. So “Plan A” avoids restructuring either government debt or banks.
If you look at International Monetary Fund (IMF) forecasts for the next 10 years, economic growth is expected to be between 2% and, in the case of Greece, close to 4%. If that holds for a decade, despite the debt overhang, then things are fine, all debts can be repaid. Now, I do not think this is completely impossible, but I do not think the probability of it happening is very high, either. The trouble is that if these forecasts turn out to be too optimistic, we will be confronted with public debt levels even higher than today and countries on the brink of bankruptcy.
But is there a “Plan B” and what would that be? A key characteristic of an alternative would be to act much more decisively on recapitalizing the banking system. This would include a write-down of nonperforming loans. The question is: Who would soak up the losses and capital shortfalls? It is clearly economically wrong and politically difficult to let taxpayers foot the bill. This, however, implies that private bank creditors would have to take losses which would lead to financial market turmoil.
More critical, should there be more restructuring of public debt? In the case of Greece, some form of restructuring, at least concessions on interest and maturity, is inevitable. But whether countries like Portugal or Spain are able to stabilize their debt is an open question.
In any case, it is crucial that we sit down and think realistically about the state of public and private debt in the eurozone. We need to assess what levels of debt will allow Europe to recover economically. And by this I mean real recovery, not just stabilization – as we are witnessing at the moment – where we linger on in a twilight zone of the lowest growth rates.
I am not convinced “Plan A” will succeed or that it is even intelligent to proceed in such a manner. The danger is that we could end up “Japanifying” Europe. Economic policy as pursued by Japan in the early 1990s erroneously treated solvency issues as mere liquidity problems. Consequently, the economy suffered from a huge debt overhang which prevented recovery. Two decades of economic stagnation followed. I see a risk of Europe ending up in that same situation.
There is no easy way out. “Plan B,” which involves restructuring both public and private debt, involves the risk of creating financial market turmoil and hurting investor confidence. On the other hand, investors are perfectly aware of Europe’s economic predicament and anticipate a degree of restructuring at least in the banking sector. It is time to get on with it.
This article was originally published in November 2013.