Restoring Stability and Confidence in European Sovereign Debt ...
Restoring Stability and Confidence in European Sovereign Debt Markets Joseph E. Stiglitz Global ARC London, May 18, 2010 Unprecedented Instability Putting the future of the euro into question Raising the possibility of sovereign wealth defaults in Europe Key Questions:
The origins of the problem The adequacy of the responses The origins of the problem Part of the unfolding economic crisis A bubble in the U.S. and in many European economies That helped sustain global growth But which itself was not sustainable Based on excessive leverage On flawed models of risk On flawed incentives structures
In some instances, on practices that bordered on fraudulent It was predictableand predictedthat when the bubble broke, there would be serious consequences A financial crisis An economic crisis (a deep and long recession/downturn) Governments came to the rescue Saving the banks and the financial system
Stimulating the economy Keynesian economics worked A financial collapse was prevented A depression was prevented Automatic stabilizers played a big role But all of this came at a great cost Unprecedented (peacetime) deficits In effect, debts were transferred to the government
Historical pattern After financial crises, there are often sovereign debt crises Hope that this time things would be different Most crises are in developing countries, with limited ability to raise taxes and high debt-to-GDP ratios But European crisis shows that that is not the case Greece had high debt and deficit But many of the countries in Europe face similar problems Slow recovery means that it will be difficult to
reduce deficit Recognition of this leading to financial instability Slow global recovery With the exception of Asia But strong growth in Asia will not suffice to restore growth in Europe and US Anemic growth prospects mean unemployment will not return to normal for years Projected annual percentage change in GDP
Source: IMF, World Economic Outlook, April 2010 Slow US recovery Continuing residential foreclosures
Unfolding problem in commercial real estate Record level of bank closings Tip of iceberg: shows weaknesses in banking system Small- and medium-sized enterprises cant get access to credit
Administration admits previous programs havent worked Havent dealt with mortgages underwater Likely to keep consumer spending depressed, contribute to bank weaknesses Banks constrained both by supervisors and balance sheet Borrowers constrained by lack of collateral (decrease in real
estate values) Fiscal stringency in state and local governments Bank lending collapse (1) Bank lending collapse (2) Source: OECD, Economic Outlook No. 86, 19 November 2009 Reducing the deficits will be difficult Even if economies had no structural deficit
that is, at full employment, they would be in balancewith a weak economy, there will be large deficits Cutting back government spending (or raising taxes) will weaken the economy further So improvement in fiscal position will be smaller than hoped Problem similar to Argentinas death spiral Poor performance leads to higher interest rates, increasing deficit Growing government debts
Sources: IMF, World Economic Outlook, April 2010 [CAN, FR, DE, IT, UK, US]; eurostat, teina220, April 2010 [GR, PT, ES] Though there are some things that Greece can do to offset contractionary effects of reduced spending, much depends on what happens elsewhere Whether German tourists spend more money on Greek vacations Which depends in turn on what happens in Germany
An example of multiple equilibria If markets had confidence in Greece, interest rates would be low, and with low interest rates, Greece would be able to service its debt But if markets lack confidence in Greece, interests rates will be high, and with high interest rates, there will be trouble servicing the debt Justifying the high interest rates
Distinction between Brazil and Argentina Brazil faced a crisis in 1998, it faced the same multiple equilibria problem: it managed its way through that crisisand now has a low debt-toGDP ratio and managed its way through this crisis There was probably no way that Argentina could meet its debt obligations, especially given the fixed exchange rate with the dollar Europe (Greece) is more akin to Brazil The euro frameworks confidence problem
Problem was recognized at the time of the creation of the euro Euroland did not satisfy the conditions for an optimal currency area Especially disturbing was the lack of a common fiscal framework Providing assistance to countries in adverse circumstances There was a solidarity fund for new entrants into EU, but no solidarity fund for stabilization An institutional deficiency which would eventually have to be addressed
Test of euro would come when there was a large shock Had taken away two crucial instruments of adjustment (interest rates, exchange rates) But had put nothing in their place As the crisis in Greece became evident in January, Germany was slow to respond Only when the threat of contagion became imminent was there an effective response
Not just a matter of profligacy Spain had a budget surplus before the crisis Spain had only a 60% debt-to-GDP ratio Spain had better bank regulation (at least in some dimensions) than the US and most other countries Yet today, Spain stands at the precipice Huge deficit (exceeds 10% of GDP) 20% unemployment More than 40% youth unemployment The Response
Combined European and IMF support Ensuring that Greece and (at least some) other European countries can roll over their debt and finance their deficits The question is: Will it work? Market response: Risk of default has gone down considerably, but is still significant Question: Why hasnt the trillion-dollar rescue done a better job at restoring confidence? Structure of rescue may be selfdefeating Heavy demands on austerity, structural
reforms Akin to old-style IMF programs Many suggest that they must do this to avoid charges of a double standard But these programs have often been ineffective Austerity (especially when pursued by many countries in Europe simultaneously) may be self-defeating Europe faces a dilemma
The effect of cutting back spending and/or raising taxes could be massively contractionary The improvement in the deficit will be minimal The small improvement will exacerbate pessimism Further reasons for skepticism of the Program Structural reforms partially misplaced Impact effect of wage cuts will be to further reduce
aggregate demand Across-the-board wage and price cuts are not a feasible substitute for devaluation Political resistance in some countries likely to be high European democracies may be less likely to accept dictated terms (Iceland) Already high unemployment in some countries (Spain) But are there alternatives?
Europe will benefit from the weak euro Europe is winning the contest of which currency is the ugliest New form of competitive devaluation Given overall global weakness, weak euro will not suffice to restore prosperity or even a modicum of normalcy And there appear to be no other tools to restore prosperity Monetary policy has limited effect Trade policy is not an option
With EU average debt level at 73% of GDP, is fiscal policy an option? Yes, if money is spent on high return investments, e.g. in education, technology, and infrastructure Generating stronger growth in the short run and longer run Generating higher tax revenues Even with limited returns (5-6%), long term debt/GDP ratio will be reduced Should not focus on short run deficit (deficit fetishism) But on a countrys balance sheetliabilities and
assets On should take a long term perspective Thinking the unthinkable? Are there enough funds to bail out PIGS plus Italy? Not certain Bailouts are effectively (temporary) transfer of funds from the stronger countries If bailouts restore confidence, they are not really bailouts, just temporary provision of liquidity Lenders will be repaid
But even the stronger countries must effectively borrow to finance bailout Another example of a transfer of liabilities Raising questions of the viability of the entire project, if the downturn lasts long and, as a result, deficit reductions are less successful What matters is not just efforts, but outcomes If markets share these qualms, interest rates may remain high Reinforcing pessimistic perspective Then what?
A default? Part of modern capitalism Financial markets often misjudge creditworthiness Important to give countries/companies/individuals a fresh start Nineteenth-century models (Dickens debt prisons, military force to impose debt repayment) thing of the past IMF often viewed as a modern version of military might by developing countries But European democracies are less likely to accept such stringent terms
Default less likely immediately Many countries still have a large primary deficit Default would choke off ability to borrow to finance deficit Thus they would face austerity in any case But once primary deficit is reduced, incentives change, especially if (a) there are large external payments and (b) severe and unpopular conditionalities are imposed Defaults are disruptive
But Argentina showed that there is life after default averaged 8.5% growth for six years (20032008) Budget deficits forecast Source: IMF, World Economic Outlook, April 2010 Risk of contagion Investors reassess likelihood of other countries defaulting Recognizing this, the rest of Europe has and will be forced to come to assistance
But will Germany provide more assistance if a trillion dollars doesnt work? The dissolution of the euro? The circumstances of different European countries are markedly different, both with respect to fiscal and trade deficits and with respect to debt Limited solidarity to share burden of adjustment Without exchange rate and interest rate mechanisms, there is a need for large fiscal assistance
What is required may be more than those who are capable of providing it are willing to give EU government debts General government consolidated gross debt as a percentage of GDP, 2009 (eurostat) Current account balances Source: IMF, World Economic Outlook, April 2010 The dissolution of the euro?
Inconsistent macro-frameworks Focus has been on countries with too high deficits as the problem Concerns are legitimate Especially as one focuses on long-term problems (aging of population) These long-term problems have continued to fester, but the crisis has diminished the ability of countries to deal with them Markets have recognized this Surpluses are the problem
But equally, countries with too high trade surpluses are a problem Surpluses mean that they are producing more than they are consuming Contributing to an insufficiency of aggregate demand Imposing macro-economic costs on others Keynes recognized this Wanted to impose tax on surplus countries Part of original Bretton Woods initiative US refused
Trade deficits and surpluses If euro were set so that on average, Europe has a trade balance, if part (Germany) has a trade surplus, others have trade deficit Trade deficit requires financing (may be hard to get) and contributes to weak national aggregate demand If exchange rates were flexible, they would adjust to punish trade surplus economy, equilibrate system US is complaining that China is not adjusting its currency, contributing to global imbalances
The euro in effect is doing the same for Germany Three alternatives 1. Europe finishes the euro agenda: Germany recognizes the problem, Europe establishes an effective fiscal and macro coordination framework, and it works 2. The euro comes to an end Weak countries do a cost-benefit analysis and decide that the costs exceed the benefits Market fundamentalist philosophy that underlies much of the
EU project is viewed as wrong Can legitimately blame lack of sufficient solidarity to make project successful Strong countries decide it is not worth subsidizing weak countries Probably myopic view Germany would find it hard to maintain surpluses Critical part of its economic model 3. Muddling through/brinkmanship Strong countries provide just enough assistance and
critical level of conditionalities (enforcement of conditionalities) to keep euro together But because the money is provided reluctantly, late, and in minimal amounts with maximum conditionalities, overall costs may be higher than if an effective program were designed initially Especially because judgments will differsome market participants will think amount insufficient Resulting in higher interest costs The Implication Europe and the world are likely to be going through a
period of high volatility Confidence in sovereign bond markets of certain countries will not be easily restored Which in itself will contribute to weak recovery Managing risk will be especially difficult Market opportunities based not just on underlying economics, but on political judgments For me, remedying the institutional deficiencies that were apparent at the creation of the euro would be the best course of action But it is not clear that this will be the course undertaken
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