Subject: Eurozone:Time for Damage Limitation - (Uncomfortable Truth)
From: "Michael Andrews" <[email-masked]>
To: "Hunter Biden" <[email-masked]>, "Eric Schwerin" <[email-masked]>, "Curtis Hastings" <[email-masked]>, "Devon Archer" <[email-masked]>
Date: Thu, 9 Dec 2010 14:02:52 -0500

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Eurozone: Time for damage limitation

by Simon Tilford, 9 December 2010

Time is running out to prevent the eurozone crisis from imperilling  
Europe's banking system and with it the integrity of the currency  
union. It is beholden on policy-makers to minimise the economic (and  
hence political costs) to the EU. Three things need to happen: the  
debts of Greece, Ireland and Portugal need to be restructured as soon  
as possible; the European Commission and the European Central Bank  
(ECB) need to do everything to make sure that the adjustments facing  
the other struggling euro economies are realistic; and there needs to  
be policy co-ordination between the member-states aimed at ensuring  
balanced economic growth across the currency union. This requires  
leadership and an honest and better informed debate about the causes  
of the crisis. Both are in short supply.

The adjustments facing Greece, Ireland or Portugal were always a tall  
order. Now that borrowing costs have ballooned, those adjustments are  
impossible. Under no plausible economic growth forecasts will these  
economies be able to pay back their debts. However, eurozone policy- 
makers continue to treat the crisis as one of liquidity rather than  
solvency, providing indebted member-states with loans (at punitive  
interest rates) but doing nothing to improve their chances of being  
able to service them. This is the worst of all possible worlds.  
Investors have taken fright and pushed up the borrowing costs of  
countries whose debts might otherwise have proved manageable. Far from  
limiting creditor losses, they risk spiralling out of control. Piling  
up more debt when solvency (not liquidity) is the issue is self- 
defeating.

The bail-out of Ireland simply increases that country's already  
unsustainable levels of debt, while insulating investors. The ECB and  
the Commission opposed restructuring the debts of the Irish banking  
sector. Instead, they have argued for ever more implausible degrees of  
fiscal austerity in return for extending costly loans. Unsurprisingly,  
the Irish government's borrowing costs remain prohibitively high. A  
bail-out of Portugal will be similarly ineffective. It will benefit  
lucky investors, but do nothing to improve Portugal's prospects. The  
loss of confidence in the eurozone and resulting surge in borrowing  
costs threatens to draw Spain into the insolvent camp, ultimately  
requiring a Spanish debt restructuring. This would be catastrophic for  
Europe's banks and would impose huge fiscal costs.

Of course, restructuring the debts of Greece, Ireland and Portugal  
will be costly for creditors. But if debt positions are unsustainable  
the problem needs to be addressed sooner rather than later. Banks  
based in eurozone members such as France and Germany, as well as in  
non-eurozone countries such as the UK and US, would suffer big losses  
on their investments in the defaulting countries. The ECB would also  
book losses. This would be messy and governments would have to bite  
the bullet and recapitalise their banks. But it would ultimately prove  
less damaging to economies such as Ireland, Greece and Portugal, and  
the currency union as a whole, than persisting on a course that  
promises an even bigger restructuring (and bigger losses) down the line.

The second part of the strategy would be to ensure that the adjustment  
process facing Spain and other hard-hit economies is a manageable one.  
The ECB could help by launching an aggressive programme of government  
bond purchases. Monies from the European Financial Stability Fund  
(EFSF) could also be used to tide the countries over until they regain  
access to the financial markets on affordable terms. But these  
countries' fiscal programmes will also have to be consistent with a  
return to decent economic growth. Crucially, cuts in spending on  
education and infrastructure must be kept to a minimum, as these would  
further reduce growth potential. Reforms of pension and healthcare  
systems would go a long way to address investors' concerns about the  
long-term sustainability of countries' fiscal positions.

The third part of the strategy – rebalancing economic growth in the  
eurozone – will be the hardest to execute, but is essential if future  
crises are to be avoided. Governments need to support the Commission's  
drive to foster closer economic integration and to co-ordinate their  
policies to ensure that they are compatible with balanced economic  
growth across the eurozone. Huge current account balances are not  
consistent with a stable currency union, because one way or another  
they require massive (and hence politically and economically  
destabilising) transfers between the participating economies. However,  
even if trade imbalances are reduced, there will have to be greater  
fiscal supra-nationalism. This could take the form of a common E-bond,  
some minimal fiscal union, or ideally a combination of the two.  
Without some element of fiscal supra-nationalism, the adjustment costs  
facing countries that cede trade competitiveness within the eurozone  
will simply be too high.

However unpalatable these measures are to eurozone governments, the  
European Commission and the ECB, they can all be done if governments  
can summon the political will. Governments have to explain to their  
voters why debt relief for Greece, Ireland and Portugal and the  
resulting injection of public funds into banks is necessary in order  
to head off far greater costs down the line. They have to summon the  
political courage to make the case for greater economic integration. A  
fiscal union can also be fashioned in such a way that limits moral  
hazard. But all of this requires leadership, not least from Germany.  
The fact that the alternative – a series of ever larger and  
ineffective bail-outs, culminating in far bigger defaults and a  
systemic banking sector crash – is much worse, ought to focus minds.  
After all, under that scenario the political glue holding the union  
together could dissolve altogether.

Simon Tilford is chief economist at the Centre for European Reform.