A re-cap of Vox columns on the Eurozone crisis

Richard Baldwin

As early as 2008, Vox columnists provided research-based warnings that the global crisis could lead to a Eurozone crisis. This column provides a recap of the contributions on this site where leading economists used economic logic and a firm grasp of the facts to think ahead about Europe. The main outline of today’s crisis was plain months ago; EU leaders’ dilatory response made things worse.

As the Eurozone crisis unfolded, economists writing for VoxEU applied basic economic principles and a firm grasp of the facts in thinking ahead about the problems facing Europe. It was possible to foresee many of the problems that have tripped up Eurozone policymakers in the past weeks. This column collects the most prominent, most insightful contributions. Reading them through as a collection makes it clear that European leaders collectively failed to heed blatant warning signs. They fell on the wrong side of the old truism so aptly characterised by Gros and Mayer (2010b) that “a liquidity problem postponed is a problem solved, but a solvency problem postponed is a problem made intractable.”

Early warnings

In 2008, Carmen Reinhart finished an incredibly timely study with Ken Rogoff on 800 years of financial crises. One of the strongest stylised facts was that severe banking crises were often followed by sovereign debt crises. The logic was simple. The boom that inflated the crisis bubble made government finances look unnaturally good and helped convince the government that nationalising bad private debt was a good idea. This boosts the government’s debt to GDP ratio – often by double digit figures just as the crisis-induced recession ravages the government’s budget; taxes plummet and social spending soars. This combination often shifts a government from a dodgy debt ratio to fire-alarm territory in a year or two with the episode ending, not infrequently, with a partial government debt default.

Carmen posted three warnings on Vox:

How right she was.1

Barry Eichengreen added specificity to this in January 2009 with his insightful column “Was the euro a mistake?”, noting: “What started as the Subprime Crisis in 2007 and morphed in the Global Credit Crisis in 2008 has become the Euro Crisis in 2009. Sober people are now contemplating whether a Eurozone member such as Greece might default on its debt.” The alternative to default was “fiscal retrenchment, wage reductions, and assistance from the EU and the IMF for the cash-strapped government.”

He predicted – again dead on – that “this alternative will be excruciatingly painful. No one will like it except possibly the IMF, which will relish the opportunity of reasserting its role as lender to developed countries. There will be demonstrations against the fiscal cuts and wage reductions. Politicians will lose support and governments will fall. The EU will resist providing financial assistance for its more troublesome members. But, ultimately, everyone will swallow hard and proceed, much as the US Congress, having played rejectionist once, swallowed hard and passed the $700 billion bank bailout bill when disaster loomed.” He closed by predicting: “In the end, the EU will overcome its bailout aversion.” That was over a year before last weekend’s decision.

Charles Wyplosz and Paul De Grauwe also gave early warnings, both in December 2009. These pointed out the importance of distinguishing between Greece’s debt problem and its competitiveness problem.

Eurozone break up and other misunderstandings

Much of the discussion on the Greek crisis was economically uninformed – with many commentators mentioning the possibility of Greece abandoning the euro. Barry Eichengreen, as far back as 17 Nov 2007, reasoned that this was just not possible in a column entitled “Eurozone breakup would trigger the mother of all financial crises”. The point was applied specifically to Greece by two columns that appeared in February 2010 (Baldwin and Wyplosz 2010, and Cavallo and Cottani 2010).

The fiscal crisis in several European countries has led many commentators to suggest novel solutions, including a holiday from the euro. Augusto de la Torre, Eduardo Levy-Yeyati, and Sergio Schmukler put it well in their 6 March 2010 column: “The fiscal crisis in several European countries has led many commentators to suggest novel solutions, including a holiday from the euro. This column examines the much-cited example of Argentina and argues that such ideas look better on paper than in practice. What these countries need is a ‘good old bailout’ – conditional on ‘getting the house in order’.” Many other myths were cleared up by Charles Wyplosz in his column “The Eurozone debt crisis: Facts and myths”.

Thinking ahead on the outlines of the solution

As 2010 progressed and it became clear that some sort of rescue would be necessary, Vox columnists used straightforward economic reasoning and wisdom gathered from past crises to discuss the outlines of what the package should look like. Eurozone national leaders initially rejected IMF involvement, but to Vox columnists this was folly. As Charles Wyplosz wrote in February 2010: “if Greece, and other countries, needs support to refinance their public debts, they can and should call the IMF. In contrast to EU countries that have no instrument to impose debt discipline (the Stability Pact has failed over and again and is completely discredited by now), the IMF operates an effective conditionality machinery.” Juergen Matthes (2010) elaborated the logical force behind the point.

Looking at the silver lining, Michael Burda (2010) argued: “the painful fiscal adjustments could turn out to be a good thing for Europe’s political integration, but the region has to take the next step and set up a European Monetary Fund.”

A proposed solution was laid out by Daniel Gros and Thomas Mayer (2010a) that involved a European Monetary Fund, which would be capable of organising an orderly default as a measure of last resort. They discussed how its funding could be structured in a way to minimise moral hazard. Mathias Hoffman (2010) offered a more market-oriented version of the European Monetary Fund.

In April, Giancarlo Corsetti and Harold James (2010) drew on historical lessons to outline what the Eurozone leaders had to do. They argued that the recipe for tackling such crises successfully is simple. “A solution requires a credible demonstration of political will. Deferring a crisis in the end leads to greater costs and more extensive damage. At the moment, such a demonstration that there is a real meaning to the concept of Europe would involve the acceptance that in some closely defined circumstances, some greater degree of fiscal and financial centralisation is required.”

This was followed by astute analysis by Cinzia Alcidi and Daniel Gros concerning the essential differences among the troubled Eurozone members. In “Is Greece different? Adjustment difficulties in southern Europe”, they argued that the causes of these overvalued currencies and twin deficits were different in the “PIGS” (Portugal, Ireland, Greece and Spain). For Greece and Portugal the problem is insolvency; for Ireland and Spain, illiquidity.

As May 2010 arrived, the pace of contributions quickened. It was clear that something had to be done and that EU politicians were trying to postpone the inevitable. Jacques Melitz (2010), however, proposed a more radical solution. He asserted that blame for the Greek-linked difficulty lay largely at the feet of the ECB and Eurozone government officials who declared that Greek default was a big problem for the euro. He argued that a change of doctrine was necessary: nothing as manageable as a Greek government default should be allowed to upset Eurozone. He noted that in June 2009, the state of California came close to default when it paid its employees in vouchers. While the move did affect bond spreads, nothing occurred in the dollar-zone that even remotely resembled the turmoil in Europe caused by Greece even though the Californian economy is four times larger relative to the US than the Greek one is relative to the Eurozone.

Dark clouds and dark thoughts

EU leaders finally took action during the first weekend of May 2010. As it turned out it was too little – we are still hoping it wasn’t too late as well. As the debt-crisis storm clouds gathered in the second week of May 2010, Charles Wyplosz and Barry Eichengreen each warned that things could spin out of control if EU, or at least Eurozone, leaders failed to act much more decisively.

The first sentence in Wyplosz’s column “And now? A dark scenario” is: “The plan will not work.” But even more striking than his prediction was his analysis: “The drop in public spending … will provoke a profound recession that will deepen the deficit. This, along with the social and political impact of the crisis, will undoubtedly prevent the Greek government from delivering on its commitments. … The EU governments, facing another loss of face (after letting the IMF into the den), may be tempted by forbearance. If they do, they will eventually to put in more money. If they don’t, the Greek government will default, precisely what the whole plan aims at avoiding.”

And he goes on: “The next headache should be contagion. There was no fundamental reason for markets to run on the Greek debt. But we know that self-fulfilling crises may happen, and that they may be contagious. Even if it seems unfair, other countries stand to face the same situation. Already we see markets fretting about Portugal and Spain.”

In closing, he points out that the situation could have been avoided, if EU leaders had faced up to the facts earlier. “It would have been very easy to let Greece go straight to the IMF months ago and reschedule its debt with IMF’s assistance. This would have been a partial default, and the haircut could have been quite small. Most banks that are exposed to the Greek debt should have been able to withstand such losses. With a grace period of, say, three years, Greece would have had the breathing space that the latest plan tries so hard to organise, but much simpler and much, much less dangerous.”

Greece’s situation had some novel elements, but sovereign default is old hat. Eduardo Borensztein and Ugo Panizza (2010) contributed a research-based perspective, drawing on their work with a large database of default episodes. They note: “recent experience suggests that the economic costs of default may not be as high as it is commonly thought … however, in all defaults studied … recovery was helped by exchange-rate depreciation. Since this does not seem to be an option for countries that belong to the Eurozone, Greece may pay a steep cost if it were to default.”

Barry Eichengreen (2010) provided another penetrating insight on 7 May 2010 – just before the Eurozone Finance Ministers agreed to set up the European Stabilisation Fund. “European leaders and the IMF have badly bungled their efforts to stabilise Europe’s financial markets. They have one last chance, but success will require a radical change in mindset.” He ended with a stark call to action: “It’s not a pretty picture. The IMF botched its rescue. The ECB hesitates to erect the necessary ring-fence around Greece. Portuguese and Spanish policymakers underestimate the gravity of their position. German leaders are in denial. But although it may be too late for Greece, it is still not too late for Europe. That said, a solution will require everyone to wake up.”

Giancarlo Corsetti (2010) also pointed out that although using the euro seemed to shield economies with structural problems from the “original sin” – the obligation to borrow in foreign currency while the ability to pay is in domestic currency – in fact the sin is still there. Reforms that boost the nation’s competitiveness or the government’s fiscal positions reduce short-term government revenue directly or via a recession. He concludes that solving the problem will require coordinated Eurozone intervention to correct internal imbalances.

Is the European Stabilisation Fund enough?

The Eurozone did eventually wake up, realising that what they’d done over the first weekend of May was too little; over the second weekend they put together what looked like a massive package and markets liked it. Stocks rallied, bond yields fell, and the euro briefly strengthened. The details of the second package, however, emerged only slowly.

Three Vox columns posted just after the outlines of the EU’s second became clear all assert that even the second package was lacking essential elements. Daniel Gros and Thomas Mayer (2010b) argue that while the European Stabilisation Mechanism was a good start, more needed to be done. They propose that all EU bank supervisors should conduct stress tests to gauge their banks’ exposure to risky sovereign debt; those who fail should be re-capitalised or closed to ring-fence the problem. The “Mechanism” should also be transformed into an institution that manages the Eurozone’s rescue contributions, supervises conditionality, and sets up mechanisms for orderly debt rescheduling should austerity programmes fail.

Charles Wyplosz (2010c) worried that this was a hollow rescue noting that while markets liked the plan, a closer look showed that the money is announced but not available. When markets realise this, he claimed, they may do to Portugal and Spain what they did to Greece. Worse still, crucial principles have been sacrificed for the sake of unconvincing announcements. He closed darkly in predicting: “The debt crisis is unlikely to go away and the monetary union will have to be reconstructed to re-establish the principle of collective fiscal discipline.”

Mike Burda and Stefan Gerlach (2010) also argued that more was needed. If the euro is to survive the current decade, they reasoned, Greece cannot happen again. To prevent this, the EU needs to set up an independent institution to vet fiscal plans of Eurozone governments and apply a sliding scale of sanctions. Like Wyplosz, they weren’t sure to call the Eurzone’s second rescue attempt a success: “Future monetary historians will judge whether it was a brilliant move by Eurozone governments which put an end to speculation or the first step down a slippery path to ruin.”

References

Baldwin, Richard and Charles Wyplosz (2010), “How to destroy the Eurozone: Feldstein’s euro-holiday idea”, VoxEU.org, 22 February.

Burda, Michael (2010), “Greece: It’s not all tragedy”, VoxEU.org, 13 March.

Burda, Michael and Stefan Gerlach (2010), “Greek lessons”, VoxEU.org, 11 May.

Cavallo, Domingo and Joaquín Cottani (2010), “For Greece, a “fiscal devaluation” is a better solution than a “temporary holiday” from the Eurozone”, VoxEU.org, 22 February.

Cinzia, Alcidi and Daniel Gros (2010), “Is Greece different? Adjustment difficulties in southern Europe”, VoxEU.org, 22 April.

Corsetti, Giancarlo (2010), “The ‘original sin’ in the Eurozone”, VoxEU.org, 9 May.

Corsetti, Giancarlo and Harold James (2010), “A stitch in time saves twenty-seven”, VoxEU.org, 12 April.

de la Torre, Augusto, Eduardo Levy-Yeyati, and Sergio Schmukler (2010), “Varieties of internal devaluation: Peripheral Europe in the Argentine mirror”, VoxEU.org, 6 March.

De Grauwe, Paul (2009) “Greece: The start of a systemic crisis of the Eurozone?”, VoxEU.org, 15 December.

Eichengreen, Barry (2007), “Eurozone breakup would trigger the mother of all financial crises”, VoxEU.org, 17 November.

Eichengreen, Barry (2009), “Was the euro a mistake?”, VoxEU.org, 20 January.

Eichengreen, Barry (2010), “It is not too late for Europe”, VoxEU.org, 7 May.

Grazia Attinasi, Maria, Cristina Checherita, and Christiane Nickel (2010), “What explains the surge in euro-area sovereign spreads during the financial crisis of 2007-09?”, VoxEU.org, 11 January.

Gros, Daniel and Thomas Mayer (2010a), “How to deal with sovereign default in Europe: Towards a Euro(pean) Monetary Fund”, VoxEU.org, 15 March.

Gros, Daniel and Thomas Mayer (2010b), “Financial Stability beyond Greece: Making the most out of the European Stabilisation Mechanism”, VoxEU.org, 11 May.

Hoffman, Mathias (2010), “How Europe should harness market forces to deal with sovereign credit risk”, VoxEU.org, 20 March.

Melitz, Jacques (2010), “Eurozone: Time for reform? A proposal”, VoxEU.org, 2 May.

Matthes, Juergen (2010), “Why the IMF should be involved in solving imminent fiscal debt crises in Eurozone countries”, VoxEU.org, 27 February.

Reinhart, Carmen (2008), “Eight hundred years of financial folly”, VoxEU.org, 5 May.

Reinhart, Carmen (2009), “The economic and fiscal consequences of financial crises”, VoxEU.org, 26 January.

Reinhart, Carmen (2010), “From financial crash to debt crisis”, Vox Talks with Romesh Vaitilingam, VoxEU.org, 9 April.

Reinhart, Carmen and Kenneth Rogoff (2008). “This Time its Different: A Panoramic View of Eight Centuries of Financial Crises” NBER Working Paper 13882, March 2008.

Wyplosz, Charles (2009), “Greece: The party is over”, VoxEU.org, 14 December.

Wyplosz, Charles (2010a), “The Eurozone debt crisis: Facts and myths”, VoxEU.org, 9 February.

Wyplosz, Charles (2010b), “And now? A dark scenario”, VoxEU.org, 3 May.

Wyplosz, Charles (2010c), “European Stabilisation Mechanism: Promises, realities and principles”, VoxEU.org, 12 May.

Econometric analysis in a column by Attinasi et al. (2010) showed that Eurzone bond spreads reacted to just the factors to which Reinhart had pointed.