City wire montreux may 2012 on eurozone crisis

www.europe-economics.com

Where does the Eurozone Crisis go from here?

Andrew Lilico

Presentation to CityWire event, Montreux

9 May 2012

http://www.europe-economics.com/page/22/andrew-lilico.htm


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)


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%


Austerity Plans are Large in Scale


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%


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


Austerity Plans are to be Implemented without an External Depreciation


-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)


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%


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)


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[?]


Real Unit Labour Costs

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 201190

100

110

120

130

140

150

GreeceItalyPortugalSpainIrelandFranceBelgiumAustriaGermany


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


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


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


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


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


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:


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


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


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


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%


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%


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


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


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


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


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)


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


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


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?

City wire montreux may 2012 on eurozone crisis

Economy & Finance

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