Download Marco Pagano 15 May 2010, VOX.EU

Fiscal crisis, contagion, and the future
of euro
Marco Pagano
15 May 2010, VOX.EU
The Eurozone has been swept up in turmoil that has ranged from stock and bond markets to
exchange rates, government spending, and tax rates. Marco Pagano, Professor at the University
of Naples Federico II and CEPR Research Fellow, explains events, how they hang together, and
what needs to be done. This challenge facing Europe could be a historical turning point.
Fiscal crisis, contagion, breakdown of the euro... Let’s try to understand what is going on. In the
past few days, the scenarios discussed in the media have been changing so rapidly and
dramatically that for many it may be hard to grasp the reason behind them. But in emergencies
such as the one we are currently experiencing, the way to escape the worst-case scenarios and
find an exit strategy is to stick to clear-headed thinking.
What happens when sovereign states accumulate large debts?
First, investors start worrying that this debt may not be sustainable: concerns rise over the ability
of the state to pay back capital and interests by generating budget surpluses in the future (that is,
fiscal revenues in excess of expenditures). In this case, investors require higher interest rates to
subscribe new public debt as a compensation for the risk of insolvency. This in turn increases the
risk of insolvency as it worsens public sector balance sheets. At some point, there may no longer
be an interest rate able to compensate investors for the risk of insolvency; then they just stop
subscribing the public debt. This is a situation of fiscal crisis and has only two possible (and not
mutually exclusive) outcomes:
1.
government default followed by a renegotiation of the debt (as in Argentina’s case),
2.
monetisation of the debt, which is effectively bought by the central bank. This represents
an injection of money in the economy and thus generates inflation and exchange-rate
depreciation.
From Greece to Italy
Second, in the case of Greece, the second option – monetisation - was ruled out by Greece’s
membership in the European monetary union: the Greek government could not force the ECB to
buy its own bonds. For this reason, the only option was insolvency and renegotiation of the debt,
unless other countries were willing to lend to Greece at an interest rate lower than the market
rate. Why did euro-area countries choose to do so? In the past few days it has been clear that,
following a substantial dose of indecision, they did it mainly for fear of “contagion”.
But what is contagion?
Here we come to the third and most interesting part of the story. As the Greek crisis unfolded,
investors started to suspect that other countries with high levels of public debt, namely Portugal,
Spain and Italy, would find themselves in a similar situation. But as governments of these
countries rushed to point out, their fiscal position is not as dramatic as the Greek one.
So why are investors so concerned? Because, as economists say, in this game between
sovereign states and investors there can be “multiple equilibria”. Even if the government is not
highly indebted, investors might start questioning its willingness to raise taxes above a level
considered “politically sustainable”. In the future, it might seek a renegotiation of the debt, its
monetisation, or both. Fear that this will happen can push interest rates to a level so high that the
investors’ prophecy will eventually come true. At the prevailing interest rates a country which
would have otherwise been able to service its debt ends up needing a renegotiation or a
monetisation of the debt to avoid full repayment (see for example Calvo 1988).
So the outcome depends on investors’ confidence. If there is confidence, the “good equilibrium”
with moderate interest rates and stable markets prevails; when confidence disappears, the
economy jumps to a “bad equilibrium”, where a fiscal crisis occurs. The contagion generated by
Greek crisis has been exactly of this type. It has weakened investors’ confidence in countries
which would have otherwise been in a safe situation. Moreover, the burden of Greek bail-out itself
is affecting negatively the fiscal position of Portugal, Spain, and Italy. This too may have
contributed to weaken confidence in their ability to service the debt.
Stock exchanges and speculation
The fourth element that has played a role in the crisis is “roll-over risk”. Countries involved are
exposed to a fiscal crisis (the “bad equilibrium”) to the extent that they are forced to rely on the
market to roll-over their debt. Thus, much depends on the amount of public debt coming to
maturity in the next months. This in turn depends on the maturity structure of the public debt. If
public debt mainly has a long-term maturity, then the amount of debt to be rolled-over in a certain
time interval is small and the burden of a high interest rate might be sustainable. In these cases,
the risk of a fiscal crisis is ruled out. If instead the debt has mainly a short-term maturity so that
the amount to be rolled-over is large, then a fiscal crisis can occur, as illustrated in my paper with
Francesco Giavazzi (Giavazzi and Pagano 1988). The argument is similar to the one used by
banks to assess companies’ solvency. There, the roll-over risk arising from short-term maturity
debt is one of the main factors in determining bankruptcy risk.
Why is the euro depreciating?
Fifth, in the last few days we have witnessed the sudden depreciation of the euro. Why is the
euro depreciating? A possible answer is that as the crisis spreads to other large Eurozone
countries, the risk of monetisation of the public debt becomes more concrete. Even if Greece can
be bailed out by other countries in the Eurozone, this would not be feasible for the much larger
public debts of Italy, Spain, and Portugal. In the scenario of a widespread crisis, the possibility
that the ECB will monetise the debt of weak Eurozone countries exists, and fear of the implied
inflation can explain the depreciation of the euro. However, a massive monetisation is an unlikely
scenario, as it would eventually undermine price stability in the Eurozone and imply a substantial
transfer of resources from strong to weak Eurozone countries.
A breakdown in the euro?
An alternative explanation for the depreciation of the euro is the fear of a breakdown of the single
currency itself, a scenario that was unthinkable even a few months ago. In order to avoid having
to bail-out weak Eurozone countries through debt monetisation, the strong countries might push
the weak ones outside the Eurozone. Obviously, this would be a dramatic scenario, as redrawing
the borders of the common currency could hardly happen without generating a financial
earthquake. Meanwhile, such a crisis could degenerate into the insolvency on the public debt of
several Eurozone countries, with devastating effects on the global economy. Given that the public
debt of these countries is massively present in the balance sheets of banks and insurance
companies all over the world, and in the Eurozone in particular, instability would spread
throughout the financial system. Contagion would become really global. In comparison, the subprime crisis would almost pale into insignificance (see a similar discussion in Eichengreen 2007).
This explains why last week stock exchanges collapsed and why governments on both sides of
the Atlantic are very concerned. However, governments’ invectives against speculators and
markets are childish. The word “speculator” comes from the Latin word “specula” (watchtower)
and indicates someone who tries to “look far away” and thus metaphorically “look ahead”, in other
words to foresee future events. Whenever a saver decides whether to subscribe public debt
bonds he also tries to “look ahead” and, in this sense, we are all speculators. And we all
contribute to determine market outcomes, even when we decide to abstain from participating in
them. Rather than blaming them, governments have to demonstrate that speculators and markets
got their forecasts and bets wrong.
Restoring market confidence
Can the markets’ confidence be restored? As the origin of the problem lies in fiscal policy,
confidence needs to be re-established there: strong and coordinated signals must be sent about
the ability of the weak states in the Eurozone to put their fiscal situation in order, accepting the
imposition of strong monitoring and discipline on fiscal policy by the Union’s institutions.
This implies a significant limitation on the fiscal sovereignty of member states, which comes on
top of their delegation of monetary sovereignty to the ECB. But much more is needed than the
fragile discipline imposed by the Maastricht treaty and by the stability pact, such as binding
constraints on budget laws of member states and institutions able to enforce them.
It is not an easy task. Such a monitoring and enforcement system is difficult to put in place and
politically painful to accept, as the riots and deaths in Athens demonstrate. Will governments and
national parliaments be willing to do it? If the answer is “yes”, then Europe will re-emerge stronger
from this crisis and will move toward completing its supranational structure with the gradual
introduction of fiscal federal institutions, the natural counterpart of the ECB.
This may also offer the opportunity to finally fill the “democratic deficit” of the EU, since it is
natural that binding fiscal decisions be taken by representative political bodies. In this way, the
necessary limits to national fiscal sovereignty would not be seen as coming from the diktat of
some technical and bureaucratic organism or ministers’ committee, as they have a supranational
democratic legitimacy. If Eurozone countries have the courage to embrace this great challenge,
not only will confidence be restored on security markets, but this crisis will become the occasion
for a historical turning point in the development of Europe as political entity.
References
Calvo, Guillermo (1988), “Servicing the Public Debt: The Role of Expectations”, American
Economic
Review,
September.
Eichengreen, Barry (2007), “The euro: love it or leave it?”, VoxEU.org, 17 November.
Francesco Giavazzi and Marco Pagano (1988), “The Management of Public Debt and Financial
Markets,” in L Spaventa and F Giavazzi (eds.), High Public Debt: the Italian Experience,
Cambridge University Press.
Comments
Greek Restructuring or Bankruptcy
On May 19th, 2010 Rustylink says
Damaging as it might have been Greece should have been allowed to go bankrupt within the
Eurozone. The recent naive actions of the ECB and Euroepean 'leaders' have indicated panic
and short-term thinking, rather than thoughtful, measured actions contributing to long-term
stability. The survival of Eurozone policitical and monetary Instituions are now threatrened by the
implied open-ended committment to support and finance PIIGS's debts and junk government
bonds. The bankruptcy of the Greek government and subsequent restructuiring of Greek
debts would only have directly affected some three percent of the Euro economy, True the
contagion effects would have been considerable, but they could not in themselves threaten the
financial viability of the ECB and Eurozone governments. European 'leaders' and the ECB have
irresponsibly succeded in turning a Greek crisis into a Euro crisis by staking their credibility on the
behaviousr of those they are providing incentives to behave badly... Few believe that Greece can
avoid the need to restructure its debts. This implies continuing need for generous donors willing
to overlook profligate incompetence. All this is an unacceptable incentive for others to follow
Greece's appalling example.
Unfortunately the motives of some politicaians seeking to bail out Greek deficits are also suspect
as their national banks are deeply involved in high-risk loans to the Greek government (for which
they recieved high-interest rates) that are now threatened with a haircut. At least the Dutch and
German Central Banks had the wit to oppose the ECB's purchase of junk governemnt bonds.
One thing that must be learnt from the present euro-crisis is that politicians should be kept at arm
length from euro-monetary decisions. A second lesson to be learnt is that politicians cannot
change economic realities by actions that do not address the fundamental problems. As for
German attempts to restrict hedge fund activities, it is simply like trying to cut a hole in water with
a short dagger. Once again we are witnessing valiant attempts by politicians to control the
symptoms rather than tackle uncomfortable causes of the present difficulties.
On May 17th, 2010 t.brodzicki says
Dear Marco Pagano
I strongly agree with your opinion stated in article. Significant limitation of the fiscal sovereignty of
eurozone member states, will be necessary. We have known that from the very beginning.
Europe has in my opinion three options: deeper economic and political integration leading to
some-kind of United States of Europe (USE), the status-quo which implies marginalization or
disintegration with adverse economic and political effects. Only the first option is feasible though
hard to implement - is there enough political willingness in Europe?
Limiting the fiscal sovereignty will require the reform of the SGP with newharsh, strict and
automatic excessive deficit procedure of some kind, some new automatic fiscal transfer
mechanism (structural funds?) and reform of the EU budget. I would not stop here though - much
deeper competitiveness-restoring structural reforms are a prerequisite for growth (the growth
which could allow the amelioration of this present worst-case scenario) - labor market
deregulation, the fall of the European social market model etc.
Despite of the challenges I sincerely hope that EU pushed against the wall will be able to reform
itself. We just have to accept it.
Best regards
Tomasz.