Is the Euro Zone in trouble?

A comprehensive solution for the euro crisis


 
  


It is well over a year since concerns over debt sustainability in Greece began spilling out to the rest of the Euro zone. The crisis continues. This column presents a three-part plan aiming to clean up the banks, reduce Greece’s public debt, and foster growth in the peripheral economies.
 
It is more than a year since the Euro zone crisis began (Baldwin 2010), but the troubles continue. Despite the repeated involvement of the EU and the IMF, markets remain unconvinced that public authorities are tackling the two main problems facing the Euro zone. These are:

• First, the peripheral countries – Greece, Ireland, Portugal, and Spain – face a huge challenge in having to adjust their weak economies so as to avoid a vicious circle of high private and public debts on the one hand and low growth on the other.
• Second, the interdependence between banks and sovereigns not only within peripheral countries but also between these countries and the rest of the Euro zone.

In a recent analysis of these two problems (Darvas et al. 2011 a), we propose a comprehensive strategy comprising three components:

• cleaning up banks;
• reducing the public debt in Greece, the only Euro zone country which has likely become insolvent;
• and fostering adjustment and growth in peripheral countries

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The problem
In many ways the four peripheral countries share common traits. Since the run-up to the euro and especially after joining the Euro zone, they have spent and lived beyond their means by accumulating private and/or public debtand running large current-account deficits. Regaining sustainability will require a combination of lower living standards and higher production levels, especially in the tradable sector. Efforts by the private and the public sectors to pay up their debts will have a negative impact on growth, and low growth will it make more difficult to reduce debt levels. These countries are also confronted with the risk of debt deflation, as restoring competitiveness in the tradable sector will require low price increases and perhaps even deflation.
Given the high level of financial interdependency within the Euro zone, the private and public debt difficulties of the peripheral countries also translate into risks for other Euro zone countries. Our estimates (Table 1) show that peripheral banks hold about €340 billion of peripheral sovereign debts and that banks in the rest of the Euro zone are exposed to peripheral countries to the tune of about €400 billion, 60% via exposure to banks and 40% via the holding of sovereign debt. By far the biggest exposure of Euro zone banks is to Spain (53% of the total exposure), through both sovereign and banking channels. The second largest exposure is to Ireland (18% of the total), mainly through the banking channel, and then Portugal (16%). Exposure to Greece is the smallest (13 %) and is almost entirely through the sovereign channel.
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“The last battle: How Europe is wrecking its currency.” Der Spiegel’s cover story this week is a gloomy forecast of the continent’s future. “Governments decide bailout after bailout, but can’t get to grips with the crisis.” European leaders seem “narrow-minded, at odds and overwhelmed” – hence the increasing likelihood of a financial meltdown far worse than the aftermath of the Lehman Brothers’ fall in 2008. Bailing out one state after another will no longer suffice, so the Eurogroup (eurozone finance ministers) are looking into two other options: a general guarantee for individual states’ sovereign bonds underwritten by all the countries in the eurozone, an idea gaining ground in Germany; or the creation of “euro-bonds” jointly issued by all the eurozone countries (and with the same interest rate for every country), an option championed by Italy and Eurogroup president Jean-Claude Juncker. At all events, Germany will have to foot the bill for the eurozone’s past mistakes. But according to Der Spiegel, there’s no telling whether the electorate will swallow that bitter pill.

Greece Ireland Portugal,Spain, Belgiu and Italy just to name a few