By Peter Boone and Simon Johnson
In the aftermath of the Irish bailout, the German proposal for a future sovereign and/or senior bank debt restructuring mechanism within the eurozone makes complete political sense to the electorate in stronger European countries. They do not want to write “blank checks” to weaker countries and to out-of-control financial institutions going forward; creditors to countries that run into trouble will face likely losses.
While the details of this “burden sharing” approach remain to be hammered out (after Sunday’s announcements), there is no way for German or other politicians to backtrack on the broad strategic principles. But once this arrangement is in place, say in 2013 or thereabouts, all eurozone countries will (a) be able to sustain less debt than has recently been regarded as the norm, and (b) become vulnerable to the kinds of speculative attacks in debt markets that we have seen in recent weeks – to reduce funding rollover dangers, they will all need to lengthen the maturity of their outstanding debt.
The end point is clear. Last week the markets began to work backwards to today’s debt profiles; major disruptions still lie ahead.
Ultimately, there will be a eurozone will greater shared fiscal authority, a common cross-border resolution authority for failed banks, and likely greater economic integration. But there are four scenarios regarding who ends up in that eurozone – and how we get there.
First, as officials hope, the IMF bailouts for Greece and Ireland may work – by stopping the panic and reassuring the investors that there will be enough growth to make even those debt burdens sustainable. This seems most unlikely, particularly given what we have seen of the IMF package for Ireland so far.
In this scenario, everyone can continue to stay inside the eurozone. The debt profiles of Greece and Ireland would remain vulnerable, as would slow growth in Portugal and whatever Spanish banks are hiding in their so-called “stress tests.” Germany agrees to foot an open ended bill because its leadership becomes scared of the consequences. The ECB buys a lot of bonds, one way or another.
Second, there is the current market consensus that a package of IMF-European Union support for Portugal and perhaps Spain would truly stabilize the situation. This consensus is fragile – and perhaps more wishful thinking than anything else – but likely to motivate official efforts in the week ahead. But this is what we call the Maginot Line Illusion, i.e., an idea that ignores the potential for trouble to jump to other potentially weaker eurozone countries, such as Italy, France or Belgium.
In this scenario, Greece probably leaves the eurozone and restructures its debt. The Germans say “Greece should never have been admitted; this was the original and only mistake.” Ireland stays in the eurozone but many of its citizens emigrate. There could be significant grants from Germany and even from outside the eurozone, depending on how much fear spreads around the globe.
Third, there is the thoughtful view of Willem Buiter – currently chief economist at Citigroup and still a brilliant critic of the global financial system. In a presentation circulating last week (not publicly available), he predicts “three or more sovereign defaults in the next five years.” His logic is impeccable – once it is easier to restructure debts, the temptation is to do exactly that; the market knows this and so brings everything forward in time.
Fourth, we have the unthinkable – nicely articulated by the Financial Times’ Lex column on Friday. Divide the eurozone into “relatively prudent” and “relatively imprudent”, in terms of fiscal policy. Adjust that for the forward-looking ability to run a primary surplus (i.e., can a country run a budget surplus on a pre-interest basis, needed to pay down the government debt if under pressure.) Adjust this further for off-balance sheet losses incurred by a country’s banks in the “extreme stress” scenario that begins with the default on senior Irish debt guaranteed by the sovereign – another “Lehman moment”.
Now the eurozone (more likely, some kind of Neue Deutsche Mark, NDM) becomes Germany, the Netherlands, Austria, Finland, and a few smaller countries. Italy is out – even though northern Italy should remain, two currency zones within one country probably does not make sense (sorry Catalonia).
In this scenario, France is the interesting case. Does France leaving the eurozone break the Franco-German alliance that has underpinned European integration since its inception?
Even this extreme scenario is not so bad for political stability and economic recovery. The weaker peripheral countries will be damaged for a generation, but European integration is about more than attempting to share a currency between countries with divergent fiscal policies and no convergence in productivity.
The NDM area will do well; in fact, growth there is already strong – they will probably want to raise interest rates soon. The rump eurozone will flounder but the positive effects of exchange rate depreciation will be rediscovered, at least for those without too much debt.