The eurozone had no mechanisms for cross-border financing of borrowers who had lost access to funds. In theory, adjustment should have occurred via the classical mechanisms: a spiral of sovereign defaults, banking collapses, slumps, unemployment, falling wages, fiscal retrenchment and all round misery. Nobody forewarned the public that such brutality lay in wait. Politicians did not understand this either. When the time came, they all flinched.
So what has to be done? The answer comes in two pairs: the first is “stocks and flows”; the second is “financing and adjustment”. Stocks refers to cleaning up the legacy of the past. Flows refer to the need to return to sustainable economic growth. Financing and adjustment refer to the how and the when of efforts to clean up stocks and restore sustainability to flows.
Several eurozone members have emerged from the crisis with huge overhangs of private and sovereign debt. If these stocks cannot be rolled over, a mixture of financing and restructuring remains. Either the official sector provides finance or it ensures a restructuring of debt in terms of face value, maturity or interest rates. In the case of Greece, the decision has been made to finance the debt overhang, via the official sector, indefinitely. No voluntary private financing exists. The private sector debt restructuring now being organised offers next to no relief to Greece, but substantial relief to erstwhile private lenders. In the case of Greece certainly (and Portugal and Ireland possibly), substantial reduction in the burden of debt service are essential.
This stock problem runs through banking, too, where the overhang of bad loans impairs both solvency and liquidity. Again, the solution is financing – injections of capital and support from the central bank – and restructuring – write-downs of assets and some liabilities. So long as the overhangs of bad debt remain, private finance will not return.
Dealing with the stocks is relatively simple. A far bigger challenge is to achieve sustainable flows of income and expenditure, at high levels of economic activity. That means far more than the fiscal austerity with which Europeans are obsessed. To paraphrase the Roman historian Tacitus, “they make a depression and call it stability.” If activity is to be restored, the structural external deficits must fall to levels readily financed through private markets.
What makes adjustment still more difficult is that it involves two sides. If external deficits are to fall, so must surpluses elsewhere. That has obvious implications for Germany and other core countries. But the latter do not recognise the need to adjust. They believe one hand can clap. The two-handed nature of adjustment may not matter so much for small debtor countries. It matters far more for bigger ones.
If the needed adjustment proves impossible within the straightjacket of the eurozone, two alternatives exist: exit or permanent financing via a fiscal union, so putting failing economies on life support. Doing the latter may be possible for one or two small economies. But it would be impossible, economically or politically, for larger ones. This is why today’s high spreads on Italian and Spanish debt are so dangerous for the future of the eurozone.
The bare minimum the eurozone needs to cope with its crisis is an effective mechanism for writing down the debts of evidently insolvent private and sovereign borrowers, such as Greece; funds large enough to manage the illiquid bond markets of potentially solvent governments; and ways to make the financial system credibly solvent immediately.
Yet, alas, the eurozone requires more still: it needs a credible path of adjustment, at whose end we see weaker economies restored to health. If such a path is not found, the eurozone, as it is now, will fracture. The question is not if, but when. The challenge is simply as big as that.
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