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Where does the Eurozone Crisis go from here?
Andrew Lilico
Presentation to CityWire event, Montreux
9 May 2012
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Overview
• Austerity plus limited debt pooling will fail => break-up of €– But austerity is not undeliverable everywhere
• Full debt pooling will fail => break-up of €– Eurobonds etc. would be even worse than
austerity alone
• Disorderly break-up of € would be disastrous• Euro doesn’t need to collapse, just lose a
couple of members (and it probably will)
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The Eurozone Crisis: Different crises in different countries
2010 figures (Eurostat)
Govt debt to GDP
Govt deficit Bank assets to GDP
Avg Growth 2000-2010
“Unsalvageable”
Greece 143% 11% 173% 2.4%
Cyprus 61% 5% 586% 2.8%
“Banking crisis”
Belgium 97% 4% 182% 1.4%
Spain 60% 9% 335% 2.1%
Ireland 96% 32% 328% 2.4%
“Competitiveness Crisis”
Italy 119% 5% 163% 0.2%
Portugal 93% 9% 240% 0.7%
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Austerity Plans are Large in Scale
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Program Change in tax revenues as %
of GDP
Change in public expenditure as %
of GDP
Change in fiscal balance as % of
GDP
Change in expenditures peak to trough as % of total
expenditure in peak year
1920s UK -1.9% -5.6% 3.7% -11.4%1930s UK -0.1% -3.7% 3.6% -5.8%1960s UK 3.7% -2.0% 5.7% -0.4%1970s UK -2.2% -5.1% 2.9% -4.0%1980s UK -4.9% -9.2% 4.3% -3.3%1990s UK 3.2% -6.3% 9.5% -2.8%1990s Sweden 7.0% -7.8% 14.8% -3.1%1990s Finland 5.3% -6.7% 12.0% -2.0%1990s Canada 3.7% -5.8% 9.5% -4.3%1990s Ireland -3.7% -14.3% 10.6% -8.7%1990s Germany 0.7% -3.9% 4.6% -3.1%1990s Neth -2.5% -3.9% 1.4% -0.7%Portugal 0.8% -6.7% 7.4% -13.2%Ireland 0.7% -5.8% 6.6% -5.6%Italy 1.4% -2.8% 4.2% -1.3%Greece 1.2% -11.6% 12.7% -23.6%Spain 2.4% -4.7% 7.1% -5.7%Belgium 0.8% -1.8% 2.6% No fallFrance 1.9% -4.3% 6.2% No fallAustria -0.8% -2.8% 2.0% No fallUK 2010s 1.1% -8.1% 8.6% -5.5%
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Austerity Plans are Long in Duration
Number of years
spending was cut until
trough
Number of years
spending remained less than peak year
1920s UK 3 61930s UK 2 41960s UK 1 11970s UK 2 41980s UK 4 61990s UK 2 4Sweden 2 3Finland 1 3Canada 2 2Ireland 2 3Germany 1 1Netherlands 1 1
Number of years
spending to be cut until
trough
Number of years
spending to remain less than peak year
Portugal 3 >6Ireland 3 >5Italy 3 6Greece 5 >7Spain 3 >7Belgium 0 No fallFrance 0 No fallAustria 0 No fallMemo UK 2010s
5 >6
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Austerity Plans are to be Implemented without an External Depreciation
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-4
-3
-2
-1
0
1
2
3
4
-400
-300
-200
-100
0
100
200
300
400
Belgium (1982-97)
-4
-3
-2
-1
0
1
2
3
4
-400
-300
-200
-100
0
100
200
300
400
Spain (1981-97)
-4
-3
-2
-1
0
1
2
3
4
-400
-300
-200
-100
0
100
200
300
400
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
Portugal (1986-97)
Change in fiscal balance (% of GDP)
-400
-300
-200
-100
0
100
200
300
400
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
-4
-3
-2
-1
0
1
2
3
4
Italy (1988-97)
Change in exchange rate vs DM relative to underlying change 1981-2003
-4
-3
-2
-1
0
1
2
3
4
-6000
-4000
-2000
0
2000
4000
6000
Ireland (1981-97)
-4
-3
-2
-1
0
1
2
3
4
-400
-300
-200
-100
0
100
200
300
400
Greece (1981-97)
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Debt Dynamics are Challenging
Greece Portugal Ireland Spain Italy Belgium
Model Assumptions
2011 Debt / GDP 140% 102% 108% 70% 121% 97%Average inflation 4% 4% 2% 2% 2% 2%Average GDP growth 2012-15 -1.3% 0.2% 2.0% 1.0% 1.0% 1.7%Average GDP growth 2015 on 4.0% 2.0% 2.5% 2.5% 1.75% 2.0%Yield on new debt 10% 8% 6% 6% 6% 6%Average debt maturity 7 5 6 6 7 6
Primary surplus (% of GDP) 6.8% 3.0% 4.0% 2.0% 5.0% 3.0%
Debt to GDP (2020) 120% 99% 87% 65% 99% 87%
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Some, but not all, Fiscal Programmes are Implausible
• Do-able:– Italy, Ireland (2010s programmes no tougher
than delivered 1990s programmes)
• Not do-able:– Greece, Portugal (too big, too long)
• Intermediate:– Spain (just about doable if nothing goes
wrong, but vulnerable to events)
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Could EU Instruction Make the Difference?
Country Year of most recent
introduction of
democracy*
Year of Acc-
ession to EEC
Years demo-cratic
outside EU/EEC
PIIGS Greece 1974 1981 7Ireland 1832[?]/1922 1973 141[?]/51Italy 1948 1952 4Portugal 1975 1986 11Spain 1978 1986 8Others Austria 1945/1955 1995 40/50Belgium 1944 1952 8Bulgaria 1991[?] 2007 16[?]Cyprus 1974 2004 30Czech Republic
1989/1993 2004 15
Denmark 1945 1973 38
Country Year of most recent
intro-duction of
democracy*
Year of Acc-
ession to EEC
Years democratic
outside EU/EEC
Estonia 1991 2004 13Finland 1906 1995 89France 1944 1952 8Germany 1949 1952 3Hungary 1990 2004 14Latvia 1990 2004 14Lithuania 1992 2004 12Luxembourg 1945 1952 7Malta 1964 2004 40Netherlands 1945 1952 7Poland 1989 2004 15Romania 1990 2007 17Slovakia 1998 2004 6Slovenia 1990 2004 14Sweden 1907 [?] 1995 88 [?]UK 1832 [?] 1973 141[?]
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Real Unit Labour Costs
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 201190
100
110
120
130
140
150
GreeceItalyPortugalSpainIrelandFranceBelgiumAustriaGermany
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Degrees of Internal Devaluation Still Required
Greece Ireland Italy Portugal Spain0
5
10
15
20
25
30
35
Peak
2011
Pe
rce
nta
ge
in
tern
al
de
va
lua
tio
n t
o
rea
ch
Ge
rma
an
RU
LC
le
ve
ls
Likely threshold of sustainability
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OK – What About Debt Pooling?
• Problems are:– Cost to France & Germany– Lost Growth for France & Germany– Absent conditionality, result would be debt
more than 30% higher– Conditionality => Reduction of receivers to
economic vassals
• Will not be sustainable
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Scale – Total Requirement
Greece Portugal Ireland Italy Spaineurobonds current requirement (€m)
eurobonds total requirement (€m)Budget
surplus (€m)
Budget surplus
(€m)
Budget surplus
(€m)
Budget surplus
(€m)
Budget surplus
(€m)2012 -14,922 -7,658 -13,842 -38,181 -57,600 441,865 574,0682013 -11,402 -5,259 -11,374 -19,036 -50,700 259,185 356,9562014 -6,344 -4,254 -7,736 -18,477 -48,600 212,757 298,1682015 -6,596 -3,618 -7,540 -19,862 -50,600 174,104 262,3202016 -6,753 -3,299 -7,209 -20,765 -52,500 122,258 212,784
Total 1,704,296
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Burden of Eurobonds to Donors
Germany Austria Netherlands FinlandLuxem-bourg
France Total
2012 257,290 30,589 61,190 19,799 4,586 200,614 574,068
2013 158,777 19,199 38,043 12,497 2,873 125,568 356,956
2014 131,661 16,147 31,768 10,543 2,420 105,630 298,168
2015 114,796 14,289 27,990 9,371 2,148 93,728 262,320
2016 92,231 11,640 22,716 7,674 1,762 76,759 212,784
Total 754,754 91,867 181,704 59,886 13,789 602,296 1,704,296
2010 Public Debt 2,100,000 205,000 370,000 90,000 8,000 1,600,000
Addntl “virtual” debt as % of 2010 level
36% 45% 49% 67% 172% 38%
“Virtual” Debt / GDP incl addtnl burden
114% 104% 94% 82% 53% 114%
Rating downgrade (notches)
2 2 1 0 0 2
Addtnl debt serv burden (bps)
100bps 100bps 50bps 0 0 100bps
Addtnl annual debt serv burden (€bn)
€21bn €2bn €1.9bn 0 0 €16bn
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Growth implications of Eurobonds
• Italy: PLUS 0.3-0.4% per year• France, Germany: MINUS 0.2-0.3% per year• Austria: MINUS 0.1-0.2% per year• Ireland, Spain, Netherlands, Finland,
Luxembourg: Growth unaffected
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Debt pooling, Conditionality and Vassaldom
• Without conditionality:– In academic studies
(Gneezy, Haruvy and Yafe, Economic Journal 2004), splitting the bill => 36% higher bill
• With conditionality:
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Implications of Disorderly Collapse
– Massive disorderly capital flows– Multiple sovereign and private sector defaults– Sov. defaults+capital flight => banking sector collapses– Shortages of essential goods– Considerable social disorder
• This could rapidly result in constitutional overthrows in multiple Member States.
– The collapse of trade within the EU– In the event that there were a sovereign default by Italy,
the collapse of much of the French, UK, and hence US banking sectors
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Italy is very unlikely to default within the euro
• In early 1990s Italy– Had 10-year bond yields of 8-14% (vs <6 now)– Had debt to GDP 120% (= now)
• Memo: Italian peak deficit: 5.4% (e.g. France 7.5%)
– Did not inflate away debts (CPI was around 4% and falling in early 1990s)
– Had real growth of just 1.3% per annum– Spent >11% of GDP on debt servicing– Did not default
• Also, there is no euro without Italy
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It is euro collapse that threatens Italian default, not other way around
• Italy has only ever defaulted (briefly) in 1940– Very good record at paying debts back a key reason
why able to accumulate so much debt!
• If euro were to collapse (e.g. Germany leaves) Italian default risk becomes high
• Consequences v serious
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Cross-border exposures
Banks of… Austria Belgium Greece Portugal Spain Ireland Italy France
Exposure to
Hungary 26 11 0 0 1 0 16 4
Greece 2 1 0 6 1 1 2 35
Cyprus 2 0 8 0 0 0 1 2
Portugal 1 2 0 0 57 1 3 19
Spain 5 15 0 18 0 9 21 105
Ireland 2 17 0 4 6 0 12 21
Italy 16 16 0 2 26 8 0 270Tot of selected countries 52 63 9 30 91 19 55 456All international exposures 363 263 91 90 1043 247 645 2215
Selected as % 14% 24% 10% 33% 9% 8% 9% 21%
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Cross-border exposures as % of GDP
Banks of… Austria Belgium Greece Portugal Spain Ireland Italy France
Exposure to
Hungary 9.4% 3.1% 0.1% 0.1% 0.1% 0.0% 1.1% 0.2%
Greece 0.7% 0.3% 3.8% 0.1% 0.4% 0.2% 1.9%
Cyprus 0.6% 0.1% 3.7% 0.1% 0.0% 0.0% 0.1% 0.1%
Portugal 0.3% 0.7% 0.0% 5.6% 1.0% 0.2% 1.0%
Spain 1.6% 4.5% 0.1% 10.7% 6.1% 1.4% 5.6%
Ireland 0.6% 5.0% 0.2% 2.2% 0.6% 0.8% 1.1%
Italy 5.6% 4.7% 0.2% 1.1% 2.5% 5.5% 14.5%
Tot selected countries 18.8% 18.4% 4.2% 18.0% 8.9% 13.0% 3.7% 24.5%
All int exp 131.7% 77.2% 42.0% 53.9% 101.9% 170.3% 43.3% 119.1%
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Italian Default would Threaten France
• French cross-border banking exposures to Italy at 14.5% of GDP even higher than– Portugal to Spain– Austria to Hungary
• Tough to set out scenario in which Italy defaults but not France– Would rely on Germany standing behind
France but not Italy
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How to save the euro
• Work backwards from solution to members– Can have euro without Greece but not without Italy
• Three kinds of solutions:– Spain: “Don’t be Ireland” => debt-equity swaps for
bank debt– Italy (+ Portugal?): Structural funds => growth– Greece, hence Cyprus (+ Portugal?): leave euro
• Probably bad for Greece; Good for everyone else because can save Italy
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Reject any form of debt pooling!
• “Debt pooling” = any arrangement under which Germany, France, Finland, etc. become responsible for current Italian, Spanish etc. debts– “Eurobonds”; “leveraged EFSF”; “ECB
purchases of €trs of PIIGS bonds” are all debt pooling
• Fiscal union ≠ debt pooling– Collective debt issuance ≠ responsibility for
legacy debt
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Solution for “banking crisis” countries
• Disentangle state from banking sector• Banks distressed => impose debt-equity swaps
– Bring forward EC “bail-in” proposals to now from 2013• Part of more general special resolution regime for banks
• Do not cast good money after bad (“recapitalisation”)– Not
• an irrational market error• a “speculator attack”• simply insolvency from past losses
– Banking bailouts• Immoral (tax the poor to spare rich the consequences of their errors)• Economically destructive (moral hazard; financial instability)• Failed strategy, even in own misguided terms
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Solution for “competitiveness crisis” countries
• Raise growth rate enough for countries to service own debts
• How? Eurozone-only structural funds (“Eurozone competitiveness funds”)– Monies spent by Brussels (so no lobster problem)– Monies spent by Brussels (so no vassal problem)
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Amounts required
– Ireland in 1990s: 0.5% of GDP on structural funds– Italian + Portuguese GDP = €1.8tr => 0.5% = €9bn
• Might need twice this level in early years to be credible• cf structural & cohesion funds budget = ~€58bn per year
– Key: spend on investments => GDP growth effect, not just levels• Might need to rise over time, even with some growth effect
• cf cost of debt pooling– Effectively taking German and French debt exposures
to current Italian levels– add ~ 100bps to funding costs => ~€36bn per year
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Curlicues
• Real money, not “guarantees”• Initiative principle would be different
– Structural funds match funding to govt projects
• Match funding abandoned– Brussels initiative to spend => spending sovereignty
centralised
• Accompanied by tighter fiscal policy constraints– Probably any budget running a deficit above 2% of
GDP to be approved by Brussels– => fiscal sovereignty centralised
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Longer term
• Funding for Eurozone competitiveness funds:– Initially fund with Eurozone member contributions– Later impose special Eurozone taxes– With a funding stream in place, could issue own debt
• Call these “Eurobonds” if you like, but they aren’t debt pooling (no legacy debt)
• Eurozone taxes + spending sovereignty, and curtailed Eurozone Member fiscal sovereignty => need for democratic mechs– Eurozone finance minister, perhaps directly elected?