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POLICY INSIGHT No.51

Greece and the fscal crisis in theEurozone

Willem Buiter and Ebrahim RahbariCitigroup and CEPR; Citigroup

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To download this and other Policy Insights, visit www.cepr.org

OCTOBER 2010

Introduction

The saga of the Greek public nances continues.

But this time, Greece is not the only country thatsuffers from doubts about the sustainability ofits scal position. Quite the contrary. The publicnances of most countries in the Eurozone arein a worse state today than at any time sincethe industrial revolution, except for wartimeepisodes and their immediate aftermaths. And theproblems are not conned even to the Eurozone,but extend to other EU member states, like theUK and Hungary, and to Japan and the US. Thisessay explains how and why this situation cameabout and how it is likely to evolve during the

rest of this decade.

The origins of this widespread loss of scalcontrol are shared by most countries and canbe traced to pro-cyclical scal policy during theboom period preceding the nancial crisis thatstarted in August 2007, the scal cost of thenancial rescue operations, the revenue lossescaused by the recession and the discretionary

scal measures taken to stimulate economicactivity. But the uniquely serious situation inGreece owes much to country-specic featuresof its economy, its political institutions andits policies. Fiscal sustainability in Greece andelsewhere can only be restored via scal pain(tax increases and/or public spending cuts), byinating away the real burden of the public debt,by economic growth, by sovereign default or bya bailout, and the balance of costs and benetsof these options can vary between differentcountries and over time.

For countries that are part of the Eurozone, thiscost-benet analysis is complicated by the legaland institutional constraints of membership.Nevertheless, we are convinced that any scally-challenged Eurozone member is better off within

the Eurozone than outside it with an independentnational monetary and/or exchange rate policy.We also believe that the Eurozone as a whole

could come out of this crisis stronger than itwent in if it uses this opportunity to remedy thedesign aw at the heart of it the absence of aminimal scal Europe.

The dimensions o the fscal problem

Table 1 shows that the scal troubles arewidespread. In fact, only a limited number ofsmall industrial countries are in reasonablescal-nancial shape, i.e. Australia, NewZealand, Denmark, Norway, Sweden, Finland

and Switzerland. Canada, Germany and theNetherlands, which are widely considered (andconsider themselves) to be in reasonably goodscal-nancial condition, are so only comparedto the truly dire conditions experienced by mostof their peers.

At almost 115% and 14%, respectively, Greeces(gross) government debt and budget decit arecertainly of great concern. But these numbersare somewhat less staggering, even in peacetime, when set against a Eurozone average ofalmost 82% for gross debt and 6% for the budgetdecit. And on the whole, the scal situation of

the Eurozone as a whole still appears to be moresustainable than that of the US, the UK, or Japan.

The roots o the fscal unsustainabilityproblems in Eurozone and Greece

The scal unsustainability problems in mostadvanced economies have four common roots:

First, strongly pro-cyclical behaviour bythe scal authorities during the boom periodbetween the bursting of the tech bubble at theend of 2000 and the onset of the nancial crisis

of the North Atlantic region in August 2007.Second, the direct scal costs of the nancial

crisis, that is, the bailouts and other budgetaryrescue measures directed at propping up thenancial system, starting with the collapse of

In fact, only a limited number of smallindustrial countries are in reasonable

scal-nancial shape.


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Fourth, the end of asset booms and bubbles,especially in real estate markets, plus thenormalisation, from extraordinary heights, of

prots and pay in the nancial sector, are likelyto produce a lasting reduction in the buoyancyof government revenues with respect to GDPin countries with signicant construction andnancial sectors, resulting in an increase in thestructural primary (non-interest) decit of thesovereign.

Together, these four developments causedan unprecedented peacetime deterioration inthe public nances of most of the advancedindustrial countries.2

In Greece, a number of country-specic factors

2 They also caused a sharp deterioration in the publicnances of a number of emerging market economies mainly in Central and Eastern Europe and the countries ofthe Commonwealth of Independent States ( the successorstates of the former Soviet Union minus the three Balticnations).

Northern Rock in September 2007, and expandingmassively with the rescue of Fannie and Freddieby the Federal government on September 7, 2008,

the Lehman Brothers insolvency on September15, 2008, and the last-minute rescue by theFederal government and the Fed of AIG and itscounterparties in a number of interventions thatstarted on September 16, 2008.

Third, the worldwide recession that startedin 2008 and lasted in most of the advancedindustrial countries until the end of 2009.1 Therecession weakened many government revenuesources and boosted certain public expenditurecategories (like unemployment benets) forthe usual cyclical or automatic scal stabiliser

reasons.1 According to the NBER Business Cycle Dating Committee,

the latest US recession started in December 2007 andreached a trough in June 2009. The recovery in the US istherefore 15 months old at the time of writing (September27, 2010).

Table 1. Fiscal troubles around the world

% of 2009 nominal GDP

Gross debt Net debt Budget balance Sturctural balanceCyclically

adjusted primarybalance

Australia 15.9 -5.7 -3.9 -3.3 -2.5

Canada 82.8 28.6 -5.1 -3.2 -2.3

Czech Republic 42.0 -1.0 -5.9 -4.6 -3.7

Denmark 51.8 -5.1 -2.8 0.1 0.7Euro area 78.7 51.7 -6.3 -3.6 -1.2

Austria 66.5 37.2 -3.5 -2.5 -0.4

Belgium 96.7 80.7 -6.1 -2.8 0.4

Finland 44.0 -63.2 -2.7 1.1 0.6

France 77.6 50.6 -7.6 -5.7 -3.7

Germany 73.2 48.3 -3.3 -1.4 0.8

Greece 115.1 87.0 -13.5 -11.7 -7.1

Ireland 64.0 27.2 -14.3 -9.9 -8.2

Italy 115.8 101.0 -5.2 -2.7 1.5

Luxembourg 14.5 -0.7 1.1 -0.2

Netherlands 60.9 28.5 -5.3 -4.6 -3.0

Norway 43.7 -153.4 9.7 -0.8 -3.8Portugal 76.8 57.9 -9.4 -7.4 -4.7

Slovak Republic 35.7 12.4 -6.8

Slovenia 35.9 -5.5

Spain 53.2 34.8 -11.2 -8.3 -7.1

Hungary 84.0 58.0 -3.9 -1.6 2.2

Iceland 122.7 41.0 -9.1 -7.4 -5.0

Japan 189.3 96.5 -7.2 -5.5 -4.5

Korea 34.9 -31.0 0.0

New Zealand 35.0 -8.1 -3.5 -1.4 -2.3

Poland 58.4 22.3 -7.1 -7.3 -5.3

Sweden 51.8 -23.4 -1.1 2.3 2.6

Switzerland 5.5 0.7 1.3 1.7United Kingdom 72.3 43.5 -11.3 -8.6 -7.0

Unites States 83.9 56.4 -11.0 -9.1 -7.6

Notes: Gross Debt: "General Government Gross Financial Liabilites", OECD EO and "General Government Debt", Eurostat; NetDebt: "General Government Net Financial Liabilites", OECD EO; Budget Balance: "Government Net Lending", OECD EO and"General Government: Net Lending/Borrowing", Eurostat; Structural Balance: "General Government Cyclically Adjusted Balances",OECD EO; Cyclically Adjusted Primary Balance: "Cyclically Adjusted Government Primary Balance", OECD EO.

Source: Gross Debt and Budget Balance for Euro Area (and countries in Euro Area) from Eurostat, otherwise OECD EconomicOutlook (EO).



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is only one emerging market amongst the high-government decit countries in 2009 India.And India, with a gross general government debt

to GDP ratio of over 80% during 2009 (see IMF(2010)), is much better able to manage a 10%of GDP general government decit, becauseduring 2009 it had a growth rate of nominalGDP of around 11.5% and most of its publicdebt is denominated in domestic currency andheld domestically by a still nancially represseddomestic nancial system cut off from full accessto the global nancial markets by capital controls.

It remains true, of course, that India, unlikemost other leading emerging markets at themoment, is highly vulnerable to a sudden

weakening of nominal GDP growth, which couldcause its public debt-GDP ratio to rise sharplyunless its underlying government decit isreduced. But the near total absence of emergingmarket economies from the list of sovereignswith scal troubles and the relatively robust stateof public nances in most emerging economies istruly remarkable.

Markets wake up ater an almost decade-longslumber

Prior to the creation of the Eurozone on January

1, 1999, Spain, Portugal, Italy and Ireland all hadsignicant spreads of their 10-year sovereign bondyields over the Bund yield. This reected marketexpectations of ination and exchange ratedepreciation for the currencies of these countries unsustainable scal programs were resolved byopting for an inationary solution and associatedexpectations of currency depreciation vis--visthe D-mark. This was then, prior to Eurozonemembership, an option because each of thesecountries had its own independent currency butno independent central bank committed to price

stability. Greece did not join the Eurozone untilJanuary 1, 2001.

For some reason - perhaps misplaced faith in theability of the Stability and Growth Pact (SGP) toenable the scally-responsible Eurozone member

added to these common causes of the scaltroubles. In October 2009, following the Greekgeneral election and change of government,Greeces general government budget decit wasrevealed by the new government to be 12.7%of GDP rather than the 6.0% reported by theold government, and the 3.7% promised to theEuropean Commission at the beginning of 2009.The most recent estimate from Eurostat puts the2009 general government decit of Greece at13.6% of GDP. And, while the nances of manysovereigns deteriorated strongly as a result of therecent crisis, Greece entered the downturn with alarge underlying public decit already.

Greeces budgetary problems owe much to highentitlement and age-related spending, poor taxadministration and a bloated public sector. Theseweaknesses are compounded by the growinguncompetitiveness of much of its industry, asmeasured for instance by relative normalisedunit labour costs, by any other of a range ofreal exchange rate indices or by Greeces poorshowing in such surveys as the World BanksDoing Business 2010 or the World Economic

Forums Global Competitiveness Report 2009-2010. Spain, Portugal and Italy have similarstructural real competitiveness problems.3

Fiscal unsustainability is not confned to theEurozone

It is clear from Table 1 that the scal deteriorationis not conned to a few Eurozone member states.The deterioration in the structural (or cyclically-adjusted) scal balance of the US and the UKis larger than in Greece, Portugal or Spain.Only Ireland and oil-rich Norway have a larger

cyclically-adjusted budget decit. Rising grossgeneral government debt to annual GDP ratiosare likely to take the US and the UK no later than2011 into the higher-than-90% bracket for whichReinhart and Rogoff (2009b) have identied amarked negative effect on the growth rate of realGDP.

The deterioration in the scal positions of mostindustrialised countries has been spectacular,even more so when set against the remarkablescal restraint demonstrated by most emergingmarkets over the same period (Figure 1). There

3 In the World Banks Doing Business 2010 ranking of183 countries by the easy of doing business, Portugalranked 48th, Spain 62nd, Italy 78th and Greece 109th.The Global Competitiveness Report 2009-2010 ranks 133countries according to their competitiveness. Spain isranked 37th, Portugal 43rd, Italy 48th and Greece 75th.

0

20

40

60

80

100

120

140

2009 2014

Debt%o

fGDP

Emerging MarketsDeveloped Economies

Figure 1 Public debt in emerging economies and 20developed economies

Source: IMF

The deterioration in the scal positionsof most industrialised countries has been

spectacular, even more so when set againstthe remarkable scal restraint demonstrated

by most emerging markets



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(by which we mean the augmented generalgovernment the consolidated generalgovernment (itself the consolidated federal, stateand local, government including social securityetc.) and central bank):1. Fiscal pain, that is, an increase in taxes or a

cut in public spending. Here it makes senseto recall that public debt problems of theadvanced industrial countries are wont payproblems, not cant play problems. Moreprecisely, these countries face the politicaleconomy problem of having to agree on,

design and implement a scal burdensharing agreement one that commandssufcient political and popular support to besuccessfully adopted and implemented overa period of years. Fiscal pain is more likely tobe chosen as the method for addressing scalunsustainability the less polarised are theelectorate and the polity in general. Even if anational consensus on scal burden sharingcan be established, government institutionsand political incumbents capable of swiftand decisive action are also required.

2. Increased recourse to seigniorage or revenuesfrom monetary issuance by the central bank.In addition to the revenues from base moneyissuance (whose real value is likely to rstrise and then decline with the expected rateof ination), there is the reduction in thereal value of long-dated xed-interest ratenominal debt, which is higher the greaterthe unexpected increase in the ination rate.The incentive to use unanticipated inationboosts to reduce the real value of servicingthe public debt will be stronger the larger

the share of the debt that is held externally(foreigners dont vote) and the longer thematurity or duration of the outstandingdebt. The opportunity to have recourse toseigniorage would depend on the extent to

states to discipline the scally-irresponsibleones, or the expectation of de-facto sovereignrisk pooling among the Eurozone member states,either through cross-border scal transfers orthrough bail-outs of tottering sovereigns bythe ECB - the markets believed that joining theEurozone would deliver a lasting improvementin scal sustainability. From 1999 till late 2007(for Greece from 2001 till late 2007), sovereignspreads over Bunds for the ve South-WestEurozone Periphery (SWEAP) countries becamevery small indeed, often only 20 basis points or

less (see Buiter and Sibert 2006). The onset of thecrisis revealed that nothing much had changedas regards the fundamental drivers of scalsustainability (or of its absence). So the sovereignspreads of the SWEAP countries opened up again,but this time they reected not ination andexchange rate depreciation expectations, butdifferential perceptions of sovereign default risk.

Spreads over the 10-year German Bund rateof the sovereign 10-year bonds of Greece,Portugal, Spain, Ireland and Italy (all Eurozonemembers) have uctuated quite wildly around asteadily rising trend since 2008, as can be seen

from Figure 2. Five-year CDS spreads for theseve countries tell a similar story. But the strongincrease in the spreads at the end of 2009 andin early 2010 indicates that nancial marketsbecame extremely nervous at the end of 2009and early 2010, as concerns about sovereign debtsustainability moved to the fore. Since September2009, the markets have clearly perceived Greeceto be in a sovereign risk class of its own, asreected in its sovereign default risk spreads inboth the CDS and the government bond markets.

The political economy o restoring fscalsustainability

There are six ways to achieve a reduction in thenon-monetary debt burden of the government

-2

0

2

4

6

8

10

1995 1998 2000 2003 2005 2008 2010

Portugal

Ireland

Italy

Greece

Spain

%

Figure 2 Selected Eurozone countries 10-Year government bond spread vs. bunds, 1995-Aug 2010

Note: Ination and exchange rate depreciation driving spreads over Bunds before the Eurozone. A lull from 1999/2001 to 2007.Sovereign default risk driving spreads over Bunds in Eurozone after 2007.Source: DataStream.



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concerns about the health of the public andnancial balance sheets in these countries.

In response, three sets of measures wereannounced. First, the EU and the IMF announceda 110 billion support package for Greece. Thefailure of the Greek support package to stop therun on the sovereign debt of Spain, Portugaland Ireland then prompted the creation of abigger sister for the rest of the Eurozone memberstates by the name of the European StabilisationMechanism. This consists of the EuropeanFinancial Stability Facility (EFSF), which can raiseup to 440 billion of intergovernmental money,and a further 60 billion supranational facilityadministered by the European Commission.4 Upto 250 billion of IMF money will be availableto supplement the European StabilisationMechanism. Third, the ECB lent its own supportto prevent major market disruptions, to rule outsovereign defaults it did not consider warranted

by the fundamentals and to prevent anotherbanking crisis in the Eurozone, where manybanks had unknown but potentially signicantexposures to the scally-challenged sovereigns.Until the EFSF became operational on August 4,2010, the 60 billion supranational fund and theECB/Eurosystem were all that stood between theEA member states and a potentially devastatingsovereign debt crisis and banking crisis.

The Greek support package

Details about the joint Eurozone/IMF supportprogram for Greece were presented on May 2.The Eurozone/IMF agreed to provide 110 billionin what are initially three-year loans, with 80billion provided by the Eurozone countriesaccording to their respective paid-up capitalshares in the ECB, with the remainder madeup by the IMF. The loans would be disbursedin tranches and the program would imply thatGreece would not need to have to access marketsagain until 2012. Rates for variable rate loans willbe 3-month Euribor plus 300 basis points (bps)for maturities up to 3 years (400bps for longer

maturities). For xed rate loans, 3-month Euriboris replaced with the swap rate for the loan'smaturity and both xed and variable rate loansalso incur a one-off 50bps charge for operatingexpenses. In addition, Greece agreed to subjectitself to tough conditionality, negotiated andapplied by the IMF. In exchange for external aid,Greece agreed to implement a scal adjustmentworth 30 billion (or 12.5% of 2009 GDP) spreadover the next three years. This tightening comeson top of the measures already announced (andpartly implemented) so far this year, which

amounted to around 3% of GDP. The decitis targeted to decline to 3% of GDP by 2014,

4 The 60 billion supranational facility, which is supposedto be based on Article 122.2 of the Treaty is in principleavailable to all EU members, not just the Eurozonemembers.

which the central bank is independent andcommitted to price stability. The fact thatthe ECB is deemed to be the central bankwith the highest degree of independenceand the strongest commitment to pricestability would seem to weigh against thisoption in the Eurozone. But if a sufcientnumber of national Treasuries are in favourof this option, we are likely to see a Gameof Chicken between the ECB and theTreasuries, with the Treasuries ultimatelyprevailing.

3. A lower interest rate on the publicdebt. Unfortunately, this is not a policyinstrument of the sovereigns, unless thetoolkit of nancial repression (includingcapital controls and mandatory holding ofpublic debt by banks and other nancialinstitutions not motivated by macro-

prudential considerations) though it is ofcourse affected by policy actions and thereality and expectation of external nancialsupport.

4. A higher growth rate of GDP. Again, thegrowth rate of GDP is not a policy instrument.Moreover, growth in the Eurozone is likely tobe weak in the near future, even if growthturns out to be somewhat higher that thevery pessimistic expectations held at thebeginning of 2010 implied. In addition,

history, including very recent history, hasshown that higher growth often raises thepressure for higher spending, thus partlyor completely negating the benign effect ofhigher growth on revenues.

5. Default, which here includes every form ofnon-compliance with the original terms ofthe debt contract, including repudiation,standstill, moratorium, restructuring,rescheduling of interest or principalrepayment etc.

6. A bailout (which can be interpreted eitheras a current transfer payment from abroador a capital transfer from abroad).

EU/IMF/ECB support measuresIn early May 2010, 10-year yields on Greekgovernment debt topped 10%, while the spreadon 5-year credit default swaps exceeded 900 basispoints, and there was substantial doubt to saythe least about the willingness of markets tonance Greeces remaining sovereign funding

needs of around 30 billion for the currentscal year even at these very high rates. At thesame time, spreads versus Bunds on debt of thegovernments of Spain, Portugal and Ireland alsoreached levels not seen since the mid-1990s amid



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the lines of those included in the Greek supportpackage. While the loan terms are only nalisedat the time of disbursement, the formula usedwill presumably also be very similar to thoseagreed on for the Greek facility.

ECB support measures

With only the 60 billion supranational facilityactually approved, and with even that smallfacility not yet operational, there remained arisk on May 10 that contagion from the Greeksovereign could have created a liquidity andfunding crisis for other Eurozone sovereigns,notably Portugal, Spain and Ireland, but possiblyeven Italy or others. Following the weekend of7 May to 9 May, only the ECB had the means tointervene and safeguard the Eurozone sovereignsat risk from a contagion-driven sudden stop andsovereign default.

The ECB chose to act and announced a numberof policy changes, the most important andremarkable of which was its commitment topurchase government securities outright in thesecondary markets - an unprecedented departureboth from its past practice and from its priorview of how an independent central bank oughtto behave. Under its newly-created SecuritiesMarkets Programme, the ECB can purchase anyprivate and public securities outright in secondarymarkets. The ECB then went to great lengths toexplain that this did not amount to quantitative

easing, as it would sterilise these purchases bycollecting term deposits. As sterilisation meansreplacing overnight deposits with the centralbank with one-week term deposits (whichconstituted eligible collateral for borrowingfrom the Eurosystem), the distinction betweenquantitative easing and asset purchases under theSecurities Markets Programme is semantic, notsubstantive. It also stressed that it acted on thebasis of its nancial stability mandate, addressingdysfunctional markets, and not out of a concernfor sovereign liquidity or even solvency.

The modalities o a bailout in the Eurozone/EUIs a bailout legally possible?

One often hears statements, especially fromopponents of bailouts of EU member states byother EU-member states, that the no-bailoutclause of the Treaty (currently the Lisbon Treaty)forbids a bailout of a member state governmentby other member state governments, theEuropean Commission or the ECB. In fact, thereis nothing like a blanket no-bailout clause thatprevents the bailout of an EU or EU sovereign

by another sovereign or by any EU institution,including the ECB. What Article 125.1 of theTreaty forbids, subject to a key qualication,both the EU and member states from engagingin, is to assume the commitments of the public

postponing by two years the deadline previouslyagreed with the EU Commission.

The bulk of the measures will focus on thesame areas as previous austerity packages,imposing higher indirect taxes hikes (the VATrate to move up again from 21% to 23%, and fueland alcohol taxes to increase by 10 percentagepoints) and further public sector wage, pensionand employment cuts. More importantly, achange in the state pension system will also beintroduced to raise the minimum retirement ageto 60 years. Reform of the labour market, endingthe closed shop features of around 90 professionsin the service sectors, privatisation of a numberof state enterprises and tax administrationreform are also part of the program. Finally, a 10billion contingent fund will be set up as part ofthe package to support the Greece banking sectorover the next three years.

The European Stabilisation Mechanism

Over the weekend of Friday, 7 May, to Sunday, 9May, Econ, the Council of the nance ministersof the 27 EU member states, together with theECB and the European Commission, cobbledtogether a nancial rescue package for theEurozone member states.5 The support measuresare made up of three parts, a supranational 60billion EU fund administered by the EuropeanCommission, a 440 billion intergovernmentalfacility, the EFSF (a special purpose vehicle

incorporated in Luxembourg), and 250 billionfrom the IMF. We shall refer to them jointly asthe European Stabilisation Mechanism, eventhough that term strictly refers only to the twoEU components.

The contribution of each Eurzone country tothis facility is supposed to be according to its share

of the paid-up capital of the ECB. In addition, toattract a triple-A rating for its debt, each Eurozonemember state is supposed to guarantee 120% ofits contribution and a cash reserve is supposedto be built up. It has since transpired that theseenhancements are to come out of the 440billion committed by the Eurozone members.The net resources available for disbursementcould therefore end up being no more than 300billion, or even less. In order to access the EFSF,member states need to request a loan and agreeon a memorandum of understanding with the

European Commission. This will include theconditions attached which are presumably along

5 The 27-member Econ consists of the Eurogroup(the nance ministers of the 16 member states of theEurozone) and the 11 nance ministers of EU memberstates outside the Eurozone.

In fatc, there is nothing like a blanket no-bailout clause that prevents the bailout of anEU or EU sovereign by another sovereign orby any EU institution, including the ECB.



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adamant to highlight though, in our view, theseactions, while certainly appropriate, conformmore to the letter than the spirit of the Treaty.

Bailouts by the IMF

It is sometimes argued that the IMF cannotlend to Greece because, according to Article Vof its Articles of Agreement, it can only lend tocountries with balance-of-payments difcultiesand Greece or any other individual memberof the Eurozone no longer has a balance ofpayments only the Eurozone as a whole does.

Since the beginning of the Eurozone, themember countries no longer have a balance ofpayments in the sense of monetary balance,international reserve balance or ofcialsettlements balance measuring the net increasein gold and ofcial foreign exchange reserves(typically held by the central bank). Indeed, onlythe 16-nation Eurozone as a whole has a balance

of payments in this narrow sense.However, it is clear that IMF itself does not use

the term balance of payments in this narrowway, but instead uses it to refer to the balanceof a nations external transactions more broadly.Clearly, Greece has a balance-of-paymentsproblem. Its low private and public sector savingrates have resulted in persistent external currentaccount decits, which have cumulated into alarge negative net external investment position(since 2000 it almost doubled from -38.8% to-69.8% in 2008). The IMF, with its long history

of providing external resources to over-extendedgovernments and nations on a short-term basisand against strict macroeconomic, nancialand budgetary conditionality, is ideally setup to address precisely these kinds of difcultconditions. Its prior absence in dealings withEurozone member countries can mainly be tracedto earlier vehement opposition by the ECB, thePresident of the Eurogroup (Jean-Claude Juncker)and many other Eurozone representatives(notably the French government) for reasons ofpride and prestige.

Does the German constitution allow a bailout ofGreece?

Two court cases remain before the German FederalConstitutional Court in Karlsruhe. The rstaction concerns the law governing Germanyscontribution to the Greek facility and arguesthat Germanys participation would violateGermanys Basic Law (Constitution), specicallythat it would violate the constitutional right toproperty (Article 14 of the Basic Law) and otherfundamental principles of the Constitution, suchas the principle of democracy and the social state

(Articles 20, 23 and 28 of the Basic Law).The second action before the Constitutional

Court, brought by a member of the Bundestag, isbased on the argument that the laws governingGermanys contribution to the Greek facility and

sector of another member state, or to be liable forthem. In plain English, this prevents the EU andmember states from guaranteeing the public debtof other member states. It does not even preventthe EU or member states bilaterally or jointlymaking loans to or giving grants to anothermember state. It does not prevent the EU andmember states from purchasing outright thedebt of another member state sovereign. It doesnot prevent member states from guaranteeingbank loans provided by private banks or state-owned/state-controlled banks to a member statesovereign. Only guarantees of foreign public debtare not permitted, and even (mutual nancial)guarantees are permitted as long as they are forthe joint execution of a specic project.

What is a project? It is not dened in the Treaty.Anything can be a project. To a wife, a husbandis a project. Article 125.2 grants the Council thepower to dene a project to be anything it wants

it to be.Bailout by other EU Member states or by the EC

According to the European StabilisationMechanism Framework Agreement, it wascreated under Article 122.2 of the Treaty whichsays Where a Member State is in difculties or isseriously threatened with severe difculties caused bynatural disasters or exceptional occurrences beyondits control, the Council, on a proposal from theCommission, may grant, under certain conditions,Union nancial assistance to the Member State

concerned.Obviously, Greeces scal predicament isnot due to a natural disaster or some otherexternal event beyond its control, but to aninternal man-made disaster. The same wouldpresumably apply to other applicants to thefacilities though the aficted member statesmay well argue that being cut off from nancialmarkets due to irresponsible policies or not isan event that is beyond their control. Arguably,even solvent and prudent states can becomethe victims of contagion and this would bebeyond their control. The fact that the only

Eurozone member states that have been testedby the markets have been those whose publicnances are clearly unsustainable rather weakensthe case for application of Article 122.2 on thegrounds that Portugal, Spain, Ireland etc. are thehapless victims of blind, irrational contagion. Ajustication of the Council decision to provideUnion nancial assistance based on this articletruly is a bit of a stretch.

Bailouts by the ECB

Article 123 (ex Article 101 TEC) of the Treaty

forbids the ECB (or the Eurosystem) from givingcredit to or purchasing sovereign debt fromsovereigns. However, it does not say anythingabout purchasing sovereign debt on thesecondary markets, a distinction the ECB was



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through changes in ownership, accountabilitymechanisms and incentives. They also increasethe exibility of the wider economy and raise thelevel and possibly the growth rate of potentialoutput. Nowhere in Europe would such changesbe more appropriate than in Greece.

Similarly, scal consolidations achievedmainly through reductions in public spending,and specically through reductions in currentpublic spending (mainly public sector pay andemployment and entitlement spending), tend tobe sustained more effectively than consolidationsachieved principally through tax increases.

The IMF catalogue of conditionality containsa number of measures that fall into the rightbuckets from the perspective of these studies.And so far Greece appears to show some resolvein following through on its commitments. Buteven if all the promised scal tightening isimplemented, and if the Greek economy does notcontract more severely than expected, the generalgovernment gross debt will reach 145-150% ofGDP by 2013. To talk of it being stabilised at that

level is disingenuous. The government interestbill on that debt would be around 8% of GDP,but the primary balance would be in surplus. Ahigh level of debt (with a correspondingly highinterest burden), with small or negative primarydecits, are exactly the circumstances underwhich it would be individually rational for asovereign creditor to default. Since external orthird-party enforcement of contracts involvingthe sovereign is unlikely, the only real penaltyfor default is the temporary exclusion of adefaulting sovereign from the international andpossibly also the domestic capital markets. Since

the collective memory of markets is rather shortand primary budgets will by then be in balance,the present value of access to internationalcapital markets will most likely be less than theburden of interest and principal payments on theoutstanding government debt.

The political economy of scal tightening isalready quite complex and fraught in Greeceand the current fragile consensus for scalconsolidation is highly unlikely to survive until2013 and beyond. These facts and the logic ofstrategic default will not be lost on the markets.

We therefore expect, with a high degree ofcondence, that a restructuring of Greek publicdebt, involving both maturity lengthening andhaircuts for creditors will have to take placerelatively soon. Such restructuring would ideally

to the EFSF are in breach of Article 125 of theTreaty on the Functioning of the EU. This is theArticle that contains what is often referred to asthe no bailout clause. The claimant argues thatthe Act has to be considered as an amendmentof the European Treaties and could only enterinto force if the necessary procedure for suchamendments at the European level had beenrespected. Therefore, the claimant contends,the Bundestag did not have the competence toapprove the guarantees.

We shall not try to argue the legal merits ofthis interpretation, beyond pointing out thatArticle 125 strictly only precludes member statesfrom guaranteeing the debt of governments ofother member states, and even that preclusionis waived provided this takes the form of mutualnancial guarantees for the joint execution ofa specic project, to be dened by the Council.The decision of the Court, like that of Supreme

Courts in other countries, will likely be drivenby political concerns and considerations, ratherthan textual exegesis.

The road ahead or Greece and theEurozone

Greeces debt burden is unsustainable, with orwithout the support package

By early May, Greece had already received

20 billion (14.5 billion from the EU, 5.5billion from the IMF). On August 5, the EU/IMF announced that the second tranche of 9billion would be released as Greece had hit themilestones specied in the initial agreement.So will the Greek consolidation effort succeedin bringing down the public debt burden andrestoring scal sustainability? A reading of theliterature on successful scal consolidations,such as in Canada (1994-98), Sweden (1993-98),and New Zealand (1990-94) or more broadly,suggests some caution. First, the initial debtand decit positions were not as unfavourable

in these countries. Furthermore, studies suchas Ardagna (2004), Alesina and Ardagna (2002),and European Commission (2007) nd that pasteconomic growth, a higher level of the initialdecit to GDP and a lower level of the initialdebt to GDP ratio increase the chances thatconsolidation will succeed. Only the second ofthese favours Greece.

Other lessons from these studies are that forimprovements in the public nances to belasting, signicant public sector reforms andother structural reforms including deregulation,

privatisation, labour market reforms andproduct market reforms are required. Thesetend to reduce the scope and scale of the statesinvolvement in the economy, through publicsector employment, pay and pension cuts and

...even if all the promised scal tightening isimplemented, and if the Greek economy does

not contract more severely than expected,the general government gross debt will reach

145-150% of GDP by 2013. To talk of itbeing stabilised at that level is disingenuous.



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(the bond holders) to the tax payers and thebeneciaries of public spending that would becut in the absence of a default. These competingclaims carry different weight in different timesand circumstances. With Greece likely to have ageneral government gross debt not much below150% of annual GDP by mid-2013 (if the debtis not restructured before that time), even a lowestimate of the annual interest bill of around7% of GDP would represent a signicant scalburden. The cost to the sovereign of exclusionfrom the international and possibly even thelocal capital markets following default dependson the current and prospective future path of thegovernments primary surplus and the durationof the exclusion.

Most examples of countries discussed inCottarelli et. al. (2010) that worked off highpublic debt burdens without sovereign defaultinvolved countries that either used the

unanticipated ination tax, and/or achieveda signicant real exchange rate depreciationthrough a nominal exchange rate depreciationand the fortunate combination of real wageexibility and either nominal wage rigidity(the Keynesian conguration) or nominalwage exibility. High real GDP growth wasalways part of the process. Greece does nothave independent national monetary policy ornominal exchange rate exibility. Even if it did,the fact that Greece is more likely to have realwage rigidity and money wage exibility than

the Keynesian conguration, makes these theCottarelli et. al. examples of limited relevanceto Greece. Sustained high real growth in Greecewould, as we argued earlier, require an economic

have taken place in May 2010, as a preconditionfor Greek access to EU and IMF funds. Instead, arestructuring, if and when it occurs, will be againstthe IMF/EU agreement and would impose capitallosses on Greeces Eurozone creditors, becausethe loans from the Greek facility (and from theEFSF) are pari passu with the outstanding Greekdebt (the IMF claims preferred creditor status).

In a recent IMF study (Cottarelli et. al. 2010) it isargued that sovereign default in todays advancedeconomies is unnecessary, undesirable andunlikely. Certainly for the most highly indebtedEurozone sovereigns (such as Greece, Italy and

even Ireland (if we add to the conventionalgross general government debt the exposure ofthe sovereign to toxic bank assets through theNAMA (the state-owned bad bank), through thecost of recapitalising the banks and through itsguarantee of most of the remaining bank debt),the undesirability of a sovereign default is notobvious. Any breach of contract damages therule of law, but there are circumstances wheredefault may be the lesser evil.

The results of both private (debtor) andsocial cost-benet analyses of sovereign default

depend on what the alternatives are, i.e. onwhich taxes will be raised and which spendingprogrammes will be cut. Sovereign defaultredistributes resources from the creditors

Why was a restructuring not already part ofthe original IMF/EU agreement for Greece?

The answer is that a Greek sovereign defaultwould not be costless to the rest of the

Eurozone

Table 2 Claims of European banks on Greece, $ billion, March 2010

Q4 2009 Q1 2010

Total $billion% of European Banks

TotalTotal $ billion

% of European BanksTotal

European Banks 193.1 182.6

France 78.8 40.8 71.1 39.0

Switzerland 3.7 1.9 4.2 2.3Germany 45.0 23.3 44.2 24.2

UK 15.4 8.0 11.8 6.4

Netherlands 12.2 6.3 11.3 6.2

Portugal 9.8 5.1 11.7 6.4

Ireland 8.6 4.5 8.0 4.4

Italy 6.9 3.6 6.8 3.7

Belgium 3.8 2.0 3.7 2.0

Austria 4.8 2.5 5.2 2.8

Spain 1.2 0.6 1.2 0.6

Sweden 0.7 0.4 1.0 0.5

Turkey 0.3 0.2 0.5 0.3

Note: European banks refer to domestically-owned banks of European countries that report claims on an ultimate risk basis (i.e.Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland,Turkey and the UK).

Source: BIS (2010) http://www.bis.org/statistics/consstats.htm , Table 9D, and Citi Investment Research and Analysis
http://www.bis.org/statistics/consstats.htmhttp://www.bis.org/statistics/consstats.htm



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over a wide range of private sector portfolios (ortaken under the wings of the state, through theGreek facility or through the ECBs purchasesof Greek sovereign debt, by transferring it tostate-owned or state-controlled banks like KfWor CDC, or directly to a government-ownedbad bank or to the Treasury balance sheet), thesystemic damage that could be caused by a Greeksovereign default would diminish. The threat:we dont have to bail Greece out, we can livewith the nancial consequences of a sovereigndefault in Greece, should become more credibleas time passes.

The most immediate threat to the Greeksovereign is, in our view, likely to come throughits banking system. Greece has no independentnational central bank which can, in the nalanalysis, be compelled by the government toact the way the government wants it to act. TheGreek commercial banks now obtain most of their

short-term funding from the ECB/Eurosystem,using mainly Greek sovereign debt as collateral.When the value of the Greek sovereign debtdeclines in the secondary market, the mark-to-market value of the collateral offered by theGreek banks to the ECB/Eurosystem declines andtriggers margin calls (demands for additionalcollateral to make up for the reduced value ofthe existing collateral). Their funding needsare likely to be exacerbated by a withdrawal ofdeposits that could become a run both fromdeposits over the limit of the deposit insurance

scheme and from deposits below that limit, ifthe solvency of the national deposit insurancescheme is in doubt.

Similarly, while the EFSF is technically onlysupposed to be a sovereign liquidity facility andbanks cannot directly access it, much of theconcerns about scal sustainability of Eurozonecountries that led to its creation are driven bycontingent liabilities that the sovereigns wouldtake on if some of their nancial institutions fail.

The sovereign debt problems encountered bymost advanced industrial countries are thus thelogical nal chapter of a classic pass the baby

(aka hot potato) game of excessive sectoraldebt or leverage. First, excessively-indebtedhouseholds passed part of their debt back to theircreditors the banks. Then the banks, excessivelyleveraged and at risk of default, passed part oftheir debt to the sovereign. Finally, the nowoverly-indebted sovereign is passing the debtback to the households, through higher taxes,lower public spending, the risk of default, or thethreat of monetisation and ination.

Should Greece leave the Eurozone?

Is a scally-challenged country likely to want toleave the Eurozone? The brief answer is no quitethe contrary. A scally weak country is better offin the Eurozone than outside it.

and political transformation that appearshighly unlikely under current circumstances.The blanket statement that sovereign defaultin todays advanced economies is unnecessary,undesirable and unlikely would appear to bebased on bad economics and simplistic politicaleconomy.

The role o the banking sector

Why was a restructuring not already part ofthe original IMF/EU agreement for Greece? Theanswer is that a Greek sovereign default wouldnot be costless to the rest of the Eurozone. Thereason is that most of the exposure to the Greeksovereign and to other Greek borrowers (e.g.the Greek banks) is with the banks from otherEurozone member states (see below). The choicefaced by the French and German authorities inparticular is to either bailout Greece or to bailout

their own banks. Politically, neither nancialrescue action would be popular. Which onewould be cheaper nancially?

European banks, especially Eurozone banks,are seriously exposed to Greek risk, as is clearfrom Table 2, which reproduces some of theBank for International Settlements data on theconsolidated foreign claims of reporting banks

ultimate risk basis. For the 24 reporting countries,the total exposure of their banks to Greece atthe end of September 2009 was $298.3 billion.European banks accounted for almost all of this,$272.4 billion.

We believe it is plausible that a bailout ofGreece with tough conditionality would becheaper for the Eurozone member states than abailout of their own banks, should Greece defaultunilaterally. The reason is that a tough bailoutwould discourage recidivism by Greece as well asemulation of its scal irresponsibility by otherwould-be applicants for nancial support (e.g.

Spain, Portugal, Italy, Ireland etc). However, asoft bailout of Greece would be more expensivethan a bailout of the domestic banks of the otherEurozone members, because it would lead toopen-ended and uncapped future demands fornancial support from all and sundry.

The threat of letting Greece fail and insteadbailing out the banks of France, Germany andother Eurozone countries whose banks areexposed to the Greek sovereign and to Greekprivate sector risk may in the spring of 2010have had rather limited credibility because of the

extreme concentration of this exposure in theEurozone banks. As the exposure to the Greeksovereign, and to Greece generally, is moved offthe balance sheets of the Eurozone banks duringthe next three years and dispersed more thinly

A scally weak country is better off in theEurozone than outside it.



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Leaving the Eurozone means leaving theEU. There is no such thing as a formerEurozone member that continues as anEU member. A current member wishingto leave the Eurozone but continue as anEU member would have to leave both theEurozone and the EU and then re-apply forEU membership. Under the Lisbon Treaty,there now is a procedure for leaving the EU(see Athanassiou (2009)).

A country cannot be expelled from theEurozone, or from the EU (see Athanassiou(2009)).

The only real threat of the Eurozone breaking upcomes from the possibility that one or more of thescally strongest and more competitive members(Germany) could decide to leave the Eurozone(and the EU), because of a fear of becoming thebailer-out of rst resort for all would-be scally-insolvent Eurozone member states. The changingof the generations in Germany from Kohl toSchrder and then to Merkel has weakenedthe traditional umbilical link of Germany, and

especially Germanys political class, to the EUand the Eurozone, but not (yet) to the point thatone can reasonably envisage Germany leavingthe Eurozone and the EU. Given half a decadeof funding and subsidising other countries withunsustainable scal positions and no capacity orwillingness to correct these, that could change.

Prospects or Eurozone: Institutional reorm tosurvive and prosper

The EFSF constitutes an important step towardsthe creation of a minimal scal Europe

necessary for the survival and prosperity ofthe Eurozone for both political and economicreasons.

To the nations sharing a common currencyin a formally symmetric monetary union(rather than by unilateral adoption of anothernations currency), national sovereign defaultbecomes an issue of common concern, beyondwhat would be called for by purely individuallyrational national concerns about contagion andother spillovers. However, recognising nationalsovereign default as a common concern does

not mean that national sovereign risk is fullypooled in a monetary union. The debt of thesovereign of an individual member state canstill be restructured, be subject to a haircut or bedefaulted on unilaterally. Subsidies from solvent

The only argument for leaving the Eurozone isthat the introduction of a new national currency(New Drachma, say) would lead to an immediatesharp nominal and real depreciation of thenew currency and a gain in competitiveness,which would be most welcome. It also wouldnot last. The key rigidities in small openeconomies like Greece are real rigidities, notpersistent Keynesian nominal rigidities, whichare necessary for a depreciation or devaluationof the nominal exchange rate to have a materialand durable impact on real competitiveness.Unless the balance of economic and politicalpower is changed fundamentally, a depreciationof the nominal exchange rate would soon leadto adjustments of domestic costs and pricesthat would restore the old uncompetitive realequilibrium.

All other arguments either favour staying in fora scally weak country or are neutral.

As regards the existing stock of sovereigndebt, in or out makes no difference. Re-denominating the old euro-denominateddebt in New Drachma would be an actof default. A country might as well stayin the Eurozone and default on the euro-denominated debt.

As regards new government borrowing,issuing New Drachma-denominateddebt would be more costly (because anexchange risk premium would be added

to the sovereign risk premium) than newborrowing using euro-denominated debt aspart of the Eurozone.

There would be massive balance sheetdisruption for banks, other nancialinstitutions and other corporates withlarge balance sheets, as the existing stockof assets and liabilities would remain eurodenominated but there would no longerbe a euro lender of last resort. It may bepossible for contract and securities enteredinto or issued under Greek law alone, to

be redenominated in New Drachma by theGreek parliament passing the necessarylegislation. While such actions wouldnot make the Greek sovereign a likelytarget for lawsuits in foreign courts, theywould constitute acts of default that couldtrigger credit default swaps. In addition,cross-border contracts and securitiesissued in other jurisdictions could notbe redenominated that way without thismaking the Greek sovereign vulnerable toforeign lawsuits.

There would be no scal-nancial supportfrom other Eurozone member states shoulda country leave the Eurozone.

Re-denominating the old euro-denominateddebt in New Drachma would be an actof default. A country might as well stayin the Eurozone and default on the euro-

denominated debt.



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Stabilisation Mechanism would require that itbe able, once it has been fully pre-funded (as itought to be), to nance all Eurozone sovereignsfor 2 years. That means at least 2 trillion offunds available for transfer. This enhanced EFSFshould be pre-funded. Without pre-funding, if alarge member state (Spain or Italy) were to end upusing the facility, the likelihood of the remainingmembers being able to fund the EFSF throughtriple-A debt issuance would be low. Speedy pre-funding could only occur if the EFSF were toborrow the funds from the ECB/Eurosystem inthe rst instance, with the loans from or debt tothe ECB/Eurosystem repaid over a period of years perhaps as much as a decade.

Third, the conditionality attached to theloans has to be tough and credible, and mustbe enforced rigorously. Any nation requestinguse of the facility has to be willing to accept thefull array of scal-nancial and structural reform

conditionality.Fourth, the loan facilities must be supplemented

with a Sovereign Debt Restructuring Mechanismto achieve an orderly restructuring of the debtof sovereigns for whom default is unavoidable.This mechanism could be invoked ex-ante,that is, there could be an upfront sovereigndebt restructuring involving both maturitylengthening and haircuts for the creditors,should the European Commission, the ECB andthe IMF determine that there either is a sovereigninsolvency problem or that the odds on a

successful program are much better following arestructuring of the public debt.

The Sovereign Debt Restructuring Mechanismshould also be invoked ex-post, in the case ofwilful non-compliance with the conditionality

by a borrowing country. This is because theultimate sanctions against nations wilfullyfailing to comply with the conditionality are therefusal to extend new loans and the calling ofoutstanding loans, as well as the loss of eligibilityfor the non-compliant nations sovereign debtas collateral with the Eurosystem. This would inall likelihood push the non-compliant borrowerinto default. This default should be handled inan orderly manner through the Sovereign DebtRestructuring Mechanism.

Other possible sanctions for non-compliance

with conditionality include the forfeit ofStructural and Cohesion Funds, the suspensionof voting rights in the Eurogroup (the nanceministers of the Eurozone) and in Econ, andsuspension of voting rights in ECB Governing

sovereigns to sovereigns of doubtful scal probityare not necessarily called for.

Unilateral sovereign default by one or moreEurozone member state government would froma technical economic and nancial perspective beconsistent with the survival of the Eurozone. Thedefaulting sovereign would have no economicincentive to leave, and the countries that wouldotherwise have been called upon to providenancial support to prevent the sovereign defaultwill also be happy to stay in, even if they wouldhave been inclined to leave should the nancialsupport for the scally weak member statehave turned into an open-ended and uncappedstream of subsidies. It is, however, likely thatpolitical support for continued membership inthe Eurozone (and the EU) would decline bothamong the political elites of the defaultingcountry and among its citizens.

From an economic perspective too, it is clearthat a minimal scal Europe is necessary to makeup for the loss of independent monetary policy asa sovereign default prevention mechanism. Theloss of macroeconomic stabilisation potentialassociated with giving up independent nationalmonetary policy (including the alleged ability

of nations to use national monetary policy tomanage the real effective exchange rate in adesirable manner) is, in our view, at best a minorissue. It may in fact well turn out to represent a netgain rather than a loss. This is because, in a worldwith a high degree of nancial capital mobilityand a oating exchange rate, the exchange rateis more likely to be a source of extraneous noise,excess volatility and persistent misalignmentof real exchange rates than an effective bufferagainst internal or external shocks. But giving upany scope for the discretionary use of both theanticipated and the unanticipated ination taxes

to reduce the real value of domestic-currency-denominated monetary and non-monetarypublic debt should be compensated for by someform of mutual scal or liquidity insurance.

In addition to the creation of the EFSF, somefurther actions are required to create an effectiveminimal scal Europe.

First, the EFSF should be made permanent. Therisk of one or more Eurozone nations strayingfrom the path of scal probity will always bewith us. So should the institutions and policyinstruments to deal with that contingency.

Second, the size of the EFSF should be increased.For it to be an effective deterrent, it has to satisfyColin Powells dictum that if you go in at all,you go in with overwhelming force. We believethat a big bazooka version of the European

...it is clear that a minimal scal Europeis necessary to make up for the loss of

independent monetary policy as a sovereigndefault prevention mechanism.

...a collective, simultaneous scal crisisaffecting all ve peripheral Eurozone

countries could stretch the political fabricof cross-border scal-nancial solidarity to

breaking point



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current member states) is both farther into thefuture (say 5 to 10 years) and very small, becausewe dont consider a soft bailout to be a likelyoutcome of the current bailout game.

Although we believe that the too big to saveproblem has been overstated as regards Spain andeven Italy, a collective, simultaneous scal crisisaffecting all ve peripheral Eurozone countriescould stretch the political fabric of cross-borderscal-nancial solidarity to breaking point. Thenancial and economic resources to preventa default are clearly there the average scalposition of the Eurozone is signicantly strongerthan that of the US and the UK, and we considerneither the US nor the UK to be likely candidatesfor sovereign default. The politics of cross-bordermutual scal insurance and support are, however,complex and may not fall in place at the pacerequired by an unfolding nancial crisis.

Reerences

Ahrend, R., Catte, P. and Price, R. (2006),Interactions between monetary and scalpolicy: how monetary conditions affect scalconsolidation, OECD Economics DepartmentWorking Paper 521.

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Alesina, Alberto and Silvia Ardagna (2002), Tales

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Ardagna, S. (2004), Fiscal stabilisations: when dothey work and why?European Economic Review,Vol. 48, No 5, pp.10471074

Asonuma, Tamon (2009), Sovereign default andrenegotiation: recovery rates, interest spreadsand credit history, Boston University workingpaper, April 12,

Athanassiou, Phoebus (2009), Withdrawal andExpulsion from the EU and EUROZONE,European Central Bank Legal Working PaperSeries 10, December 2009.

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Council. Loss of voting rights would requireTreaty amendments.

Fifth, a well-functioning monetary unionrequires a fund to recapitalise systemicallyimportant cross-border nancial institutions,either to permit them to continue operatingor to allow them to be wound up or liquidatedwithout unnecessary social costs. Lets call thisthe Financial Institution Recapitalisation Fund.Its funding (which could be created using theEnhanced Cooperation procedures in the LisbonTreaty) could come from the national Treasuriesof the Eurozone or the EU, from the systemicallyimportant nancial institutions that wouldbenet from it, or from some combination ofthese two sources. The EFSF and the FinancialInstitution Recapitalisation Fund could beseparate institutions or they could be merged.

Finally, note that the minimal scal Europedoes not require independent tax and borrowing

powers for a supranational European FiscalAuthority.

Conclusion

The current scal problems faced by Greeceand other Eurozone countries are of a severityunprecedented in peace time. The resolutionof this situation will most likely involve acombination of scal pain and debt restructuring,with the latter all but inevitable in the case ofGreece.

Nevertheless, the Eurozone and the EU couldcome out of this crisis stronger than it went in. Arst step has already been taken with the creationof the EFSF. Further steps to create a viable minimalscal Europe are needed, including a burden-sharing arrangement for the recapitalisation ororderly liquidation of systemically importantcross-border nancial institutions, an increase inthe size and duration (to eternity) of the EFSF,credible conditionality attached to the loans itdisburses, and the creation of an Sovereign DebtRestructuring Mechanism for Eurozone stategovernments.

Any rational would-be sovereign defaulterwould stay in the Eurozone. The near-termrisks to the Eurozone, though very small, comefrom possible outbursts of irrationality andmisunderstandings of each others intentions bythe protagonists in the sovereign debt debate.A clear example would be the removal of theGreek Prime and nance ministers (Papandreouand Papaconstantinou) from their positions andtheir replacement by isolationists, populists orconspiracy theorists. The new leadership could,in a t of collective blindness, decide to leave the

Eurozone and the EU. We consider this highlyunlikely, but not impossible. The risk of Germanyand other scally strong countries deciding toleave the Eurozone and the EU (and to recreate itunder a different name without the scally weak
http://www.bankofengland.co.uk/publications/speeches/2009/speech409.pdfhttps://editorialexpress.com/cgi-bin/conference/download.cgi?db_name=NASM2009&paper_id=288https://editorialexpress.com/cgi-bin/conference/download.cgi?db_name=NASM2009&paper_id=288https://editorialexpress.com/cgi-bin/conference/download.cgi?db_name=NASM2009&paper_id=288https://editorialexpress.com/cgi-bin/conference/download.cgi?db_name=NASM2009&paper_id=288https://editorialexpress.com/cgi-bin/conference/download.cgi?db_name=NASM2009&paper_id=288https://editorialexpress.com/cgi-bin/conference/download.cgi?db_name=NASM2009&paper_id=288http://www.bankofengland.co.uk/publications/speeches/2009/speech409.pdf



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CEPR

POLICYINSIGHTNo.51

The Centre for Economic Policy Research, founded in 1983, is a network of over 700 researchersbased mainly in universities throughout Europe, who collaborate through the Centre in researchand its dissemination. The Centres goal is to promote research excellence and policy relevance inEuropean economics. CEPR Research Fellows and Afliates are based in over 237 different institutions

in 28 countries. Because it draws on such a large network of researchers, CEPR is able to produce awide range of research which not only addresses key policy issues, but also reects a broad spectrumof individual viewpoints and perspectives. CEPR has made key contributions to a wide range ofEuropean and global policy issues for over two decades. CEPR research may include views on policy,but the Executive Committee of the Centre does not give prior review to its publications, and theCentre takes no institutional policy positions. The opinions expressed in this paper are those of theauthor and not necessarily those of the Centre for Economic Policy Research.

Willem Buiter is Chief Economist of Citigroup. Prior to his appointment at Citigroup, he was professorof European Political Economy at the European Institute of the London School of Economics andPolitical Science. He was a member of the Monetary Policy Committee of the Bank of England (1997-2000) and Chief Economist and Special Adviser to the President at the European Bank for Reconstructionand Development (EBRD) (2000-2005). He has held academic appointments at Princeton University,the University of Bristol, Yale University and the University of Cambridge and has been a consultantand advisor to the International Monetary Fund, The World Bank, The Inter-American DevelopmentBank, the EBRD, the European Communities and a number of national governments and governmentagencies. Since 2005, he is an Advisor to Goldman Sachs International. He has published widely onsubjects such as open economy macroeconomics, monetary and exchange rate theory, scal policy,social security, economic development and transition economies. He obtained his PhD in Economicsfrom Yale in 1975. He is a CEPR Research Fellow.

Ebrahim Rahbari is an Economist in the Global Economics Team at Citigroup. He holds a PhD inEconomics from London Business School and a BA (Hons) in Economics and Management fromOxford University. His research focuses on the interaction between macroeconomic drivers andnancial market developments and the resulting policy implications, in particular in an international

context.

Policy Insight 51

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