Thu, Dec 23, 2010 - Page 9 News List

A survival strategy for the eurozone

In the next few months it will become clear whether European policymakers can implement reforms to ease the threat of a eurozone breakup

By Nouriel Roubini

ILLUSTRATION: MOUNTAIN PEOPLE

After the Greek and Irish crises and the spread of financial contagion to Portugal, Spain and possibly even Italy, the eurozone is now in a serious crisis. There are three possible scenarios: “muddle through,” based on the current approach of “lend and pray”; “break-up,” with disorderly debt restructurings and possible exit of weaker members; and “greater integration,” implying some form of fiscal union.

The muddle-through scenario — with financing provided to member states in distress (conditional on fiscal adjustment and structural reforms), in the hope that they are illiquid, but solvent — is an unstable disequilibrium. Indeed, it could lead to the disorderly breakup scenario if institutional reforms and other policies leading to closer integration and restoration of growth in the eurozone’s periphery are not implemented soon.

The crisis started with too much private debt and leverage, which became public debt and deficits as crisis and recession triggered fiscal deterioration and private losses were mostly socialized via bailouts of financial systems. Then, distressed sovereigns that had already lost market access — Greece and Ireland — were bailed out by the IMF and the EU.

However, no one will bail out these super-sovereigns if the sovereigns prove to be insolvent. Thus, the current strategy of kicking the can down the road will soon reach its limits, and a different plan will be needed to save the eurozone.

The first institutional reform takes the form of a larger envelope of official resources, which would mean a quasi-fiscal union. Official resources currently are sufficient to bail out Greece, Ireland and Portugal, but not to prevent a self-fulfilling run on the short-term sovereign and financial liabilities of Spain and other potentially distressed eurozone members.

So, even if these countries were to implement the necessary fiscal and structural reforms, an increase of official resources would nonetheless be needed. Because nervous investors don’t want to be last in line in case of a run, a disorderly rush to the exits is likely when official resources are insufficient.

Short of full fiscal unification — or a variant of it in the form of eurozone bonds — this increase in official resources would occur through a much-enlarged European Financial Stability Facility and a much greater commitment by the European Central Bank (ECB) to long-term bond purchases and liquidity operations to support banks. Since quasi-fiscal union implies that the eurozone’s core economies could end up systematically bailing out those on the periphery, only a formal loss of fiscal sovereignty — a credible commitment by the peripheral countries to medium- and long-term fiscal discipline — could overcome the current political resistance of Germany and others.

However, even a larger envelope of official resources is not sufficient to stem the insolvency problems of Greece, Ireland and, possibly, Portugal and Spain. Thus, a second set of policies and institutional reforms requires that all unsecured creditors of banks and other financial institutions need to be “treated” — that is, they must accept losses (or “haircuts”) on their claims. This is needed to prevent even more private debt being put on government balance sheets, causing a fiscal blowout. If orderly treatment of unsecured senior creditors requires a new cross-border regime to close down insolvent European banks, such a regime should be implemented without delay.

This story has been viewed 1890 times.

Comments will be moderated. Keep comments relevant to the article. Remarks containing abusive and obscene language, personal attacks of any kind or promotion will be removed and the user banned. Final decision will be at the discretion of the Taipei Times.

TOP top