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Will the crisis in Europe spread?

May 13, 2010 10:37 IST

The euro 750-bn package shows the will to protect the EU, but yoking structurally surplus nations to deficit ones makes the euro's survival risky - more capital flows to the US and emerging markets will hurt them.

Arvind Subramanian
Senior Fellow, Peterson Institute for International Economics

Huge debt write-offs will still be required, a single-currency Europe cannot survive. Greater flows to the US and emerging markets as a result of the crisis will hit these countries

The European Union has surprised most with an unprecedented euro 750 billion emergency plan to prevent the Greek crisis from spreading to other parts of Europe.

Given the size of the earlier bailout package, this shows a level of political will we have not seen so far. If the Greek crisis had spread to Portugal, the problem would have become more serious since once bond yields rose there, Spanish banks would have been in trouble.

So it is not surprising that markets have reacted the way they have to the package which will help firewall Spain and Portugal. But I would still predict that the euro zone, as we know it, will probably not survive.

First, give credit to the EU for getting ahead of the curve and stanching the very serious prospect of contagion. For now, by deploying the Powell doctrine - throwing as much fiscal ammunition as possible in the form of money and especially guarantees of wobbly government IOUs - the crisis has been averted.

Unfortunately, the flip side of this intervention is the massive moral hazard created both by bailing out holders of government paper and now by letting the pressure off countries like Greece, Spain and Portugal to undertake massive adjustment.

The good case scenario is that financial markets stabilise, growth returns and the problem countries can grow out of trouble. In the case of Greece, that looks very unlikely because its fiscal predicament requires not just adjustment and financing but devaluation and debt restructuring. Substantial debt write-offs will remain necessary.

But in the medium run, two serious doubts remain about the euro zone. The recent package runs against everything Germany and German economic orthodoxy stands for. It will soon realise that it can no longer acquiesce in the situation of being the country that bails out profligate southern partners.

The second and perhaps more important, the European crisis has shown us that the attempt to integrate the periphery into the core has failed comprehensively. How it is possible to have structurally surplus countries such as Germany yoked to structurally deficit countries?

So, there has to be a de facto, if not de jure, separation between the periphery and core countries. Germany is not likely to say it will generate more demand in order to avoid surpluses so that the periphery can be kept happy. In the long run, it is probably more sustainable to have deficit countries with their own currencies with perhaps the others converging around one with Germany as the anchor.

For now, the crisis might be contained, but the risk remains that uncertainty in Europe will spill over to the rest of the world in the sense there will be a flight to the dollar and to emerging markets. The strengthening of the dollar will slow US' growth a bit, but it's not going to be like Lehman since consumer spending is back; and Germany is growing again.

I don't know if this is double dip since I think the US recovery will go on, with the recent turmoil not strong enough to derail US recovery. But the process is not going to be smooth, and we'll see lots of ups and downs. When the smoke clears, we'll find that there's a lot more debt that needs to be restructured in countries like Greece and Portugal, and there will be a need for two sets of currencies in Europe. Things will go up and down for another 6-12 months before they finally settle.

Uncertainty in Europe  also means a problem for emerging markets since, apart from the US, they will also see large currency inflows and an appreciation in currencies. At this point, countries will be faced with the classic trilemma, so I think they'll have to start thinking of a Tobin tax.

To the extent the dollar appreciates a bit, and China keeps to the peg, this will allow it to appreciate a bit automatically. RBI will have to think carefully about what it wants to do - does it want the rupee to go to 40 against the dollar?

Capital coming to emerging markets will hurt exports growth, but it won't dampen overall growth since investment levels will pick up as a result, and so will consumption. But the big danger here is of the asset bubbles that it will create, and the distortionary impact that has, including possible policy action by the central bank to correct that. Ways have to be looked at to dampen inflows.

Arvind Subramanian is also senior fellow, Centre for Global Development and senior research professor, Johns Hopkins University

Jahangir Aziz
India Chief Economist, JP Morgan Chase

This is not the time to hit the panic button. A political commitment to the EU and financial stability measures by ECB are likely to help Europe overcome the crisis

Things look bad for Europe and will get worse before improving. But the problems in southern Europe are unlikely to implode into another October 2008-style crisis. Unlike the October crisis, which only a handful of analysts had foreseen, southern Europe's oncoming, inextricable mess was seen by many.

The world is replete with examples of large and persistent fiscal deficits, fixed exchange rate, and falling productivity ending in tears. Southern Europe was no different. Yet the party went on for quite a while as the market kept funding the deficit-laden countries, hoping that the strength of the core (Germany and France) of the EU would delay the day of reckoning.

But scarred by the October crisis, markets today are quite touchy about excessive leverage, be it in companies, banks, or governments. And so, the day of reckoning is here.

Things have also been muddied by the overlay of the economics and politics of being in the EU. Typically, countries extricate themselves from a sovereign debt crisis through a combination of fiscal tightening, monetising and restructuring the of the debt, and devaluing of the currency.

But, remaining within the euro zone precludes devaluation; direct monetisation is ruled out by the Lisbon treaty; and debt restructuring is likely to be a no-go area for now. So the entire burden of adjustment has fallen on fiscal policy, which is daunting, given the massive size of the deficit and debt of these countries.

So despite the ¤110 billion rescue package for Greece aimed at taking it out from the funding market until 2013, the contagion spread to Ireland and Portugal, with Spain and Italy being threatened to be the next in line. The combined funding needs of these countries are so large (euro 200 billion in next three months) that a rescue package seems inconceivable.

While moral suasion on European banks and co-opting them in the Greek rescue package may reduce the risk of their cutting exposure to southern European assets, these banks have increasingly tapped the US markets for funding. US money funds can quickly become wary of the asset quality of the European banks, engulfing the whole of the EU in a crisis.

The consequent economic slowdown in Europe and the further weakening of the euro would adversely affect both the US and the emerging economies. And those who prophesied a double dip in global growth would be proven right, although for entirely different reasons.

But while the economics of the EU may have hamstrung the crisis management, the politics of the EU is the key to resolving and containing this crisis. As long as the political commitment to the EU is intact, economic solutions will be stitched together.

And there are solutions, thanks to our vast experiences of dealing with past debt crises. Measures such as debt buy-back by the European Central Bank in the secondary market directly or through a created entity; extension of the ECB repo window to two-three years; EU-provided debt guarantees; and reinstated foreign exchange swap lines with the US Fed will be needed along with fiscal consolidation and structural reforms, to allay fears of financial markets.

But, in the absence of a central fiscal authority, the euro zone is finding hard to coordinate actions. And this means that ECB has to step in. This won't be easy. ECB will need to credibly explain that it is taking these extraordinary steps to preserve financial stability just as the Bank of England had to argue why monetising the deficit was needed to meet its inflation target not too long ago.

Unlike the October crisis, when the nature and the extent of the problem and that of the solutions were largely unknown causing financial markets to freeze, this time around the problem and the solutions are both known. Financial markets will remain in turmoil, but the crisis will not blow up as long as the market believes there is political commitment to the EU.

We have seen monetary and fiscal authorities globally take extraordinary actions in the last two years. Sunday's $1 trillion EU/IMF stabilisation fund is one such action. Perhaps as subsequent market reaction suggests more steps may be needed and likely delivered.

The good news is that the EU is getting there. The bad news is the trillion dollars and probably some more will be added to the already massive global liquidity. But I guess in these extraordinary times we will worry about that a bit later.

Views expressed are personal

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