Fri, Jul 16, 2010 - Page 9 News List

EU policies will lead to a much deeper recession

By Mario Blejer , EDUARDO LEVY YEYATI

The countries on the so-called “periphery” of the eurozone (Greece, Spain, Portugal, Ireland and perhaps some others) need to carry out complementary adjustments that are often discussed separately, but actually need to be tackled jointly.

Indeed, to restore these economies to health, three distinct types of adjustment are needed — between the eurozone and the world, between the eurozone’s periphery and its core, and between debt and income in the heavily indebted peripheral countries, particularly Greece.

The solutions in each case are as clear as their implementation is complex.

First, in order to relieve pressure on the peripheral countries (at least in part), the eurozone must export some of the needed adjustments through a significant depreciation of the euro, which is already taking place. This is the adjustment between the eurozone and the world.

Second, to regain competitiveness the adjustment between the eurozone’s periphery and its core requires closing the inflation differential that built up during the pre-2008 capital-flow bonanza. In countries such as Greece and Spain, this amounted to roughly 14 percent of GDP following the launch of the euro.

Last but not least, the adjustment between debt and income may be helped, over time, by higher overall eurozone inflation.

However, it is becoming increasingly clear that bringing the debt burden in line with distressed countries’ payment capacities requires, at least in some of them (particularly Greece again), an ordered process of debt restructuring.

So far, European policymakers have chosen to do precisely the opposite on each front. They have tried to talk up the value of the euro, though currency markets have dismissed this as mere political rhetoric and are rapidly bringing the euro closer to equilibrium.

Likewise, the EU has tried to dispel doubts about the imminence of Greek and other sovereign-debt restructurings by putting together a reasonably large stability fund (and throwing in 250 billion euros [US$319.2 billion] of still non-existent IMF commitments). This was designed not so much to shield the peripheral countries from a market run as it was to “bail in” private lenders.

Predictably, lenders saw through the announcements and understood the unfeasibility of the underlying fiscal cuts. Bloomberg reports that, in a recent survey of global investors, 73 percent call a Greek default likely. In these circumstances, postponing the restructuring only perpetuates distrust of European banks with opaque sovereign exposures and of financial markets in general — in much the same way that uncertainty about exposure to collateralized debt obligations led to a confidence crisis in late 2008.

Why not use the much-heralded stability fund as collateral for a European Brady bond plan that puts an end to the sovereign debt saga?

It might sound extreme, but it certainly would be more efficient than a slow hemorrhage of EU funds, which would lead to an official and multilateral debt hangover that could only deter junior private lenders.

Such a plan would also clarify, once and for all, the size of the contagion to EU banks, which could ultimately be ring-fenced. All that is required is the same resources that the European Central Bank is squandering today on at-par debt purchases from distressed peripheral sovereigns — an effort that does not seem to be impressing the markets. In fact, spreads on Spanish and Italian bonds are higher today than before the central bank’s program was put in place.

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