Europe’s Debt Troubles

U of T Magazine editor Scott Anderson spoke recently with economics professor Margarida Duarte about the risk of a new financial crisis, originating in Europe.

How did some countries – Greece, Portugal and Ireland, primarily – get into such a bad situation with government debt?
When the euro was created 10 years ago, the member countries of the eurozone chose to relinquish independent monetary policy in exchange for the benefits of further economic integration. However they remained fiscally independent. In Canada and the U.S., when a negative shock hits a province or state, it receives fiscal transfers that are paid for by the provinces or states that did not experience the shock. This does not happen among members of the eurozone.

As well, the members of the eurozone are diverse countries. Germany has a history of fiscal discipline and a monetary policy consistent with low inflation. Other countries, such as Greece and Portugal, have histories of much more expansive fiscal and monetary policies and higher average levels of inflation. In order to accommodate these diverse countries within the umbrella of a common monetary policy, countries joining the euro were required to meet “convergence criteria” meant to ensure that every country pursued policies that were consistent with fiscal discipline and low inflation.

Clearly this was not the case. Many eurozone countries failed to meet the convergence criteria. The financial crisis of 2008 then exacerbated many countries’ fiscal problems. So what we have now is a very serious debt problem. The markets are signaling that Greece and Portugal will not be able to repay the debt they have. The European Union (EU) has been treating the situation as more of a liquidity crisis in that the countries will eventually be able to repay – they are not bankrupt. What they need is to be provided liquidity – bailout loans. There’s a discrepancy right now between what the markets are saying and the actions of the EU, the European Central Bank and the International Monetary Fund.

Past experience would suggest that the markets are usually right. What do you think is needed to turn things around?
The EU and the IMF have extended loans to Greece on several conditions: that it raise taxes; reduce government spending; and adopt structural reforms. These conditions are expected to enable Greece to eliminate its deficit (not including interest payments) in two years. But even then, its accumulated debt will be about 150 per cent of GDP. The government’s interest bill will be about eight per cent of GDP. In other words, Greece’s most rational course of action is to default.

So why hasn’t Greece defaulted yet? One reason is that a large part of Greek debt is being held by German and French banks. Under the regulatory financial framework of the EU, government debt of all eurozone countries is considered to be risk-free. This means that banks that lend to a eurozone government do not need to adjust their capital requirements. In the event that they are lending to governments that actually have a high risk of default, this means that their capital requirements will be too low. It’s suspected that the European banking system is severely undercapitalized at this point.

So a Greek default could lead to the implosion of one or more banks in Europe?
Yes, that is the fear. Looking at it simplistically, France and Germany are in the position of having to either bail out the Greek government or bail out their own countries’ banks.

What do you think the correct course of action is?
This is a difficult question. It’s uncertain what’s going to happen next. Until now, the eurozone’s regulatory framework did not recognize that some member countries are more likely to default on their debt than others. I think there’s a course of action that allows for institutional reform – the creation of loan facilities that allow for fiscal insurance within the eurozone. Some steps have already been taken in this direction. Last year, the EU created a financial stabilization facility that has been used to bail out Greece, Portugal and Ireland. But I think the only way a net transfer of resources from the fiscally responsible countries to the fiscally less responsible countries will be accepted politically is if there is a loss of fiscal independence and a credible commitment by all governments — and in particular the less disciplined ones – to follow strict fiscal policies.

What’s also worrisome, especially in the event of a Greek default, is the fact that there is not one institution at the EU level or the eurozone level that is responsible for recapitalizing banks in a banking crisis.

Like the Fed in the U.S.?
Right, the Fed can print money and lend it to banks. The ECB can print money, but can’t lend to banks. The national institutions in the EU that can lend to banks cannot print money. In the event of a Greek default, which would affect the entire European financial system, countries could agree to act together. But it would not be an act of one institution.

It seems like they need to act quickly, which doesn’t always happen when you have several countries involved.
I think they need to act very quickly. Institutional reform would make the eurozone stronger than it currently is.

How high a risk do you think there is of Greece being forced out of the euro or of the euro to disappear?
Greece has a very high level of debt that it may not be able to repay. It can’t pursue independent monetary policy, and it has not made any structural reforms since entering the EU. It is very uncompetitive with respect to the other EU members; it imports more than it exports, so it has a balance of payments problem as well. To exit the euro would provide a very short-term solution to all these problems. Exiting the euro and re-denominating the debt to a new currency amounts to a default. In order to solve that part of the problem, they might as well just default and stick with the euro.

Fifteen years ago, Greece decided that adopting the low inflation policies the ECB was going to impose on all of its member countries would be of a greater benefit than the ability to pursue independent monetary policy. It’s not clear to me that this has changed. Being in the euro commits them to medium- and long-term policies that are consistent with fiscal discipline and low inflation – and that is good.

In the medium term, I think the more critical question is whether the fiscally disciplined countries such as Germany want to be in a currency union with less fiscally disciplined countries.

Is there a historical precedent for a currency union working without a political union?
I don’t think so. The creation of the euro was a unique monetary event.

Is there anything else the Greek government can do? There’s already a lot of political opposition to the current reforms.
It’s a very difficult situation. The cost of defaulting is exclusion from the capital markets – international and also potentially domestic. But the market’s memory is short. If they default and adopt the structural reforms and eliminate their primary deficit, they would be in a much better situation. I think they are very close to being in a situation where a default is the rational decision, from a unilateral point of view.

With the lack of an institutional mechanism within the EU to recapitalize banks, could this trigger another global banking crisis?
Yes, it could. The U.S. performed “stress tests” on banks and used the results to change the banks’ capital requirements, if necessary. Stress tests have been done in Europe as well, but individual countries are conducting the tests. So everyone has the incentive to say, “Our banks are fine,” and the tests are not seen as very credible. The general perception is that the European banking system is very fragile and cannot absorb the losses that would be associated with a disorderly Greek default.

What are the implications for North America?
I think we could see a second wave of financial crisis causing shortages in liquidity and another economic downturn.

Do you think any North American banks are at risk?
I don’t know the answer to that. In the first wave of the financial crisis, Canada was affected but the Canadian financial system was revealed to be very strong. I think a second wave would be less severe for Canada than the first. However, financial systems are so interconnected that it is unclear how this crisis will play out and which banks are exposed to which risks. Financial products these days are so complex that it’s very had to track.

Do you think we could experience a significant downturn?
In the event of a financial crisis in Europe, we can expect a global economic downturn. How severe it will be depends on linkages that are difficult to speculate on.

Some people have mentioned Spain and Italy as potential risks. Do you see danger there?
I think there’s a very big danger of the crisis spreading. Spain was hit hard by the financial crisis: unemployment is very high, tax revenues are plummeting and the fiscal position of the Spanish government is deteriorating rapidly. The financial markets could target Spain. As the risk premium on Spanish government debt increases, it becomes more and more expensive for the Spanish government to finance itself. It really looks like that in order to solve these problems in way that preserves the eurozone, institutional reform is needed. There needs to be fiscal insurance among member countries, and this is only politically viable by limiting each country’s fiscal independence.

A shorter version of this Q&A appeared in the print edition of U of T Magazine’s Autumn 2011 issue.