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- The problem: #Eurozone countries have run up very large public sector deficits and very large external imbalances
- Evidence shows an intensification of the European financial crisis on several fronts
- Lachman: Three ways in which the Euro in its present form could unravel.
1. Recently there have been a number of disturbing economic and political developments in Europe that heighten the risk that the Eurozone will experience a spate of sovereign debt defaults within the next six months. Defaults in the European periphery would almost certainly cause a major European banking crisis that would likely sow the seeds for an unraveling of the Euro in its present form. They would also have meaningfully adverse implications for both the US and the global economies.
2. Among the more concerning recent European economic and political developments are the following:
a. Greece’s IMF-EU financial support program has veered badly off track. This has prompted the IMF-EU to temporarily suspend talks with Greece on a program review. Greece’s economy is now contracting at a significantly faster pace than was envisaged in its IMF program, which is giving rise to ever increasing signs of Greek austerity fatigue. At the same time, Greece’s tax revenue collections and privatization receipts are also falling well short of the IMF’s targets.
b. The Eurozone debt crisis has now spread from Greece, Ireland and Portugal to Spain and Italy. In addition, French banks are now also experiencing difficulty in funding themselves in the wholesale market. The markets are aptly describing Spain and Italy as too big to fail yet too big to bail.
c. The clearest of signs of "bailout fatigue" are now to be found in Europe’s core countries. In Germany, Chancellor Angela Merkel is experiencing real political resistance to the idea of any enlargement of the European Financial Stability Fund or to the issuance of Eurobonds. A similar electoral pushback to bailouts is being experienced in Finland, the Netherlands, and Austria.
d. Economic growth has slowed abruptly in core Europe. This raises the real prospect of a double dip recession in France and Germany, which diminishes the prospect that the peripheral countries can export their way out of trouble.
3. Conceptually there are three ways in which the Euro in its present form could unravel.
a. Countries in the European periphery could experience an increased degree of "austerity fatigue". This could undermine their willingness to stay the course of IMF-EU imposed fiscal austerity and structural reform;
b. A marked pick up in capital outflows and runs on domestic bank deposits could make it extremely difficult for countries in the Eurozone periphery to remain within the Euro;
c. "Bailout fatigue" could intensify in the core European countries. This could undermine attempts by the IMF and EU to financially prop up the periphery.
Sadly, there appears to be evidence that pressure is intensifying on all three of these fronts.
"Most importantly, an intensification of the Eurozone debt crisis would adversely impact the US."
4. At the heart of the Eurozone debt crisis is the fact that a number of Eurozone countries have run up very large public sector deficits and very large external imbalances. These domestic and external imbalances are unusually difficult to correct within the straightjacket of Euro membership that precludes exchange rate devaluation to promote exports.
5. IMF imposed austerity has already caused sharp GDP contractions in Greece, Ireland, and Portugal. Yet the IMF programs for these three countries envisage continued budget austerity and wage and price deflation over the next three years. This is almost certain to deepen the recessions in these three countries and to increase their public debt to GDP ratios to levels that are clearly unsustainable.
6. The Euro-zone debt crisis can only really be understood if it is seen as a crisis affecting the European banking system in an important way:
i. The total sovereign debt of Greece, Ireland, and Portugal is US$1 trillion. In addition Spain’s sovereign debt is US$1 trillion. If all of this debt is written down by 30 cents on the dollar, that would represent a huge hit to the European banking-system. A Greek sovereign default would be the largest sovereign debt default on record.
ii. The IMF estimates that were the countries in the periphery to default on their debts, European banks could suffer a capital shortfall of around EUR 200 billion. Such a shock would almost certainly precipitate a Lehman-style European banking crisis.
iii. The core countries will fight strongly to keep countries from defaulting since they do not want to have a domestic banking crisis. However, it is not clear that they will have the political will to come up with sufficient money, on terms that might be acceptable to Europe’s peripheral countries, in order to prevent a European banking crisis.
7. The European banking system is already showing early signs of the same sort of strains that were experienced in the US financial system in 2008-2009.The French, Italian, and Spanish banks are all having trouble funding themselves in the wholesale market, while the European banks are growing ever more distrustful of lending to one another.
8. The main instrument being used to bailout the periphery is the European Financial Stability Fund, which was set up in May 2010 to prop up the Eurozone’s peripheral countries. While this Fund might have been sufficient to cover the public sector borrowing needs of Greece, Ireland, and Portugal, it is clearly insufficient to cover the public borrowing needs of Italy and Spain.
9. In principle, the Eurozone could be kept intact by countries in Europe’s core acquiescing to the idea of a Eurobond issue that would be severally and jointly guaranteed by all 17 members. However, the idea of Eurobond is being strongly opposed by the German, Finish, Dutch, and Austrian electorates which see the Eurobond as an unwelcome step in the direction of converting the European Monetary Union from a currency union into a transfer union. This makes it highly unlikely that the Eurobond issue will get off the ground.
10. The United States economy would be adversely impacted by a series of European debt defaults and a consequent European banking crisis. It would be impacted through a variety of channels at the very time that the US economy already looks like it is flirting with a double dip recession:
a.A renewed recession in Europe would reduce export possibilities for the US to an important economic bloc;
b. A European banking crisis would likely weaken the Euro. This would put US firms at a competitive disadvantage both in Europe and in third markets;
c. Most importantly, an intensification of the Eurozone debt crisis would adversely impact the US through the financial market channel and through the probable increase in global risk aversion. In that respect, it bears recalling that the US financial system’s exposure to the European banking system is considerable as indicated by the following factors;
i. According to the Fitch rating agency, as of June 2011, US money market funds had loans outstanding to European banks in excess of US$1 trillion;
ii. According to the Bank for International Settlements, US banks have claims on banks in Germany and France of around US$1.2 trillion;
iii. US banks have written derivative CDS contracts on European sovereigns of more than US$400 billion.