1. 2011 is likely to be an even more challenging year for the Eurozone than was 2010. This is bound to cause renewed stress in the European banking system and to intensify doubts about the longer-run survival of the Euro in its present form.
2. The seriousness of any intensification of the Eurozone debt crisis for the global economic recovery should not be underestimated for the following reasons:
• There is every prospect that Greece and Ireland will default on their sovereign debts within the next twelve to eighteen months. Were such defaults indeed to occur, they would be the largest sovereign debt defaults in history.
• Ongoing difficulties in Greece and Ireland are almost certain to result in an escalation of contagion to Portugal and Spain since both of these countries have extraordinarily large external financing needs in 2011. It is only a matter of time before these countries will need to be bailed out.
• Debt restructuring in Europe's periphery would constitute a major blow to the European banking system since the major part of the periphery's US$2 trillion in sovereign debt is held by the West European banking system
• A banking crisis in Europe, coupled with a renewed European economic downturn, will have serious implications for the global economic recovery since it would almost certainly result in an increase in global risk aversion.
Massive Economic Imbalances
3. The underlying cause of the Eurozone's present economic crisis is the extraordinarily large budget deficits and external imbalances that were allowed to develop in the European periphery over the past decade. Whereas the Stability and Growth Pact had envisaged budget deficits no larger than 3 percent of GDP, by 2009 Greece's budget deficit had exceeded 15 percent of GDP while those in Ireland and Spain exceeded 11 percent of GDP. Budget deficits of this order of magnitude have placed these countries' public finances on a clearly unsustainable path.
4. Compounding the periphery's economic problems has been the emergence of very large external imbalances and of large losses in international competitiveness. By 2009, Greece and Portugal had external current account deficits of over 10 percent of GDP. At the same time, the gross external debt of Portugal and Spain was of the order of 230 percent of GDP and 140 percent of GDP, respectively.
5. The essence of the Eurozone's present economic predicament is that, stuck within the Eurozone, the peripheral countries cannot resort to currency devaluation to restore international competitiveness. Nor can they devalue their currency to boost exports as a cushion to offset the highly negative impact on their economies from the major fiscal retrenchment that they need. Attempting to correct their large domestic and external imbalances without resort to debt restructuring or currency devaluation is a sure recipe for the deepest of domestic economic recessions.
6. Countries in Europe's periphery have solvency rather than liquidity problems in the sense that they cannot reduce their imbalances without precipitating very deep recessions. This notion is best illustrated by Greece's present economic situation. The May 2010 US$140 billion IMF-EU three-year support program for Greece envisages that Greece aim to reduce its budget deficit from over 15 percent of GDP in 2009 to 3 percent of GDP by 2013. It also envisages that Greece aim to restore international competitiveness through domestic price and wage deflation. If the experience of Latvia and Ireland, two countries that have been engaged in savage budget retrenchment within a fixed exchange rate system, is any guide, Greece could very well see its nominal GDP contracting by 15 to 20 percent over the next three years.
Desmond Lachman Resident Fellow AEI