Tuesday, August 9, 2011


Otra vez un Agosto "sangriento".

Lo que está en juego debería estar muy claro y, sin embargo, asistimos una y otra vez a la repetición de la misma confusión, impotencia y falta de decisión.

Demasiado poco y demasiado tarde.

Algunas referencias a una situación que no puede ser peor ni más peligrosa:



The Eurozone crisis is accelerating dangerously and could tip the world into a new recession that cannot be fought. Interest rates are already zero and governments cannot borrow much anymore. The spectre of the 1930s, including competitive devaluations and Eurozone break up, is getting dangerously relevant. This column argues that the only way forward is for the ECB to guarantee the entire stock of Eurozone debt and for Eurozone members to adopt effective, national fiscal institutions.

In this crisis, Eurozone leaders’ motto seems to be “too little too late”.

They got it badly wrong the first weekend in May 2010. Having announced that they had saved Greece, financial markets said “not good enough”. The next weekend they came up with a more substantial plan, but even this proved to be too little too late.

After months of living in denial, Eurozone leaders finally recognised that Greece was not going to be able to restart borrowing on its own. They came up with another plan. On 21 July 2011, they got it badly wrong again. Financial markets are again saying “not good enough”.

Cluelessness, powerlessness, or weakness?

In contrast to the extreme clarity of the market’s message, the raft of declarations from policymakers around the world suggests:

  • They still do not to understand how dangerous the situation is; or
  • They do not understand what they need to do, or
  • They are unwilling to do what they know must be done.

This is why reassuring words backfire. Markets suspect that nice words are all that policymakers are in a position to offer. This prevarication by Eurozone leaders needs to change rapidly if a disaster is to be avoided.

A clear misunderstanding of the situation

For a year and a half, policymakers have thrown good money after bad in carefully measured doses. Whether it was due to political expediency (gambling for redemption) or due to wishful thinking (the economic recovery will fix everything), policymakers have misdiagnosed the problem.

Unfortunately, we are not a situation where a “bridging loan” can help highly indebted nations get through a rough spot. Feeding markets a few dollops of euros is like treating a broken leg with ice; it may help for a while but it fails to address the core problem.

In short, we are not in a liquidity crisis; we are in a confidence crisis.

The danger ahead

History tells us that a loss of confidence can trigger a cyclone of doubt and falling bond prices. Once triggered, such cyclones can and have washed away even the mightiest. The mechanics of such cyclones are well understood.

When investors assign a positive probability to sovereign default, nations must pay a risk premium to continue borrowing and rolling-over their debt. The higher interest payments raise the debt-service burden. The cyclone gains strength as this tends to undermine solvency which in turn stokes doubts and raises the risk premium.

Fiscal austerity is needed to avoid such cyclones, but attempts to redress solvency via fiscal austerity in the midst of a crisis may make things worse. Cutting spending and raising taxes can trigger or deepen a recession that lowers tax receipts and raises welfare spending – again undermining the debt’s sustainability. When markets see this, they ask for a higher risk premium and the cyclone gains strength.

Eurozone investors’ fears are amplified by the poisonous combination of banks that are both in fragile state overall and heavily invested in Eurozone bonds. As we saw in Ireland and Iceland, governments who have to bail out their banks can find themselves drawn into a self-fulfilling confidence crisis.

The size of the problem

The real danger lies in the fact that financial market equilibria concern stocks, not flows. We are not talking about the fraction of the debt that is due in the next months – as we would be if this were a liquidity crisis. The cyclone logic gets applied to the entire stock of national debt. This involves truly astronomical sums. When we add up the public debts of Greece, Ireland, Portugal, Spain and Italy, we reach something like €3,350 billion; that is 35% of the Eurozone GDP; 130% of German GDP.

The contagion has spread, and will continue spreading until a real solution is in place.

  • Italy and Spain probably passed the point of no return.
  • Belgium and France could be next.

The Italian case has shown that a mundane political accident – a public disagreement between the Prime Minister and the Finance Minister – can start the cyclone turning. Further rating downgrades of Eurozone nations – an event that cannot be ruled out given the US’s downgrade – could be the next trigger. A recession in the US and/or Europe could be another.

Solutions that won’t work

Plainly, we are facing a very dangerous situation. Eurozone leaders must quickly wake up and realise the severity of the threat they face. Their 21 July plan – which involved the EFSF fixing the problem defined as Greece while Italy and Spain are now the issue – is dead on arrival. There is no way the EFSF can deal with the amounts involved. If it tries we will have a German debt crisis.

This is a continuation of the central mistake made by policymakers – the belief that it is enough to buy a little bit of debts now and then to quiet financial markets until things get better.

What must be done to halt the confidence crisis?

The authorities must jump ahead of the curve and put in place an arrangement that effectively stops the rot. Instead of reacting, policymakers must start acting. There is only one way to stop the cyclone of doubt and falling bond prices. We must put a floor on public debt valuation. The stock of sovereign debt must be divided into two piles – bonds to guarantee, and bonds to default upon. This is how one jumps ahead of the curve.

The only institution in the world that can put up such amounts of money is the ECB. This is why central banks are lender in last resort. In fact, the ECB does not have to spend this money.

Guaranteeing public debts does not have to be expensive. As suggested to me by David Lucca from the New York Fed, the model should be bank deposit guarantees.

  • In 2008, most countries guaranteed 100% of bank deposits to stem incipient bank runs and guess what? There was no bank run and not one cent had to be spent.
  • In the case at hand, it is likely that the markets would challenge the ECB, so some money will be spent, but most likely very little.

In fact, the best solution is for the ECB to simply guarantee the rollover at face value of maturing sovereign debts. This should immediately stop the sovereign debt crisis.

By contrast, using the EFSF would be expensive. The EFSF would have to raise money – i.e. raise public debts – to buy public debts.

What to do about Eurozone public finances?

An ECB guarantee would handle the debt crisis, but would not address the ongoing problem of government deficits. Here is where the IMF comes in. The financing of ongoing deficits is the job of the IMF. In setting up its conditions, the IMF should resist its ancient gut reaction of imposing immediate austerity. Greece & Co. need to grow first and stabilize their debts next, in that order.

Here it is worth noting a striking change of roles. Markets are supposed to be short-termists while governments take pride in taking the longer view. In this crisis, we have seen governments offering solutions that aim at immediate results. Market participants, on the other hand, seem to be waiting for credible commitments to restore public finance health sometime in the future.

Markets understand that Greece or Italy cannot cut their deficits in the midst of a recession. All they want is to be reassured that politicians are ready to give up the deficit game and eventually reduce debts, even if that takes decades.

On this score there may be a glimmer of hope. Portugal, Ireland and Italy are now actively preparing institutional changes in the spirit of the Swiss and German debt brakes or the Swedish Fiscal Council. (The French President has put forward his own modest – probably insufficient – constitutional amendment, but divided politics in the run to elections next year stand in the way.) The EU Commission has also made a similar proposal, unfortunately buried with the fateful Euro-plus project of strengthening the Stability and Growth Pact.

Effective institutions and an ECB guarantee will do it

Shouldering this burden is not something the ECB will do lightly. But it should consider the alternative. If the ECB is not willing to do this job, it will have to spend huge sums to buy back public debts.

Because of the stock nature of financial markets, the ECB’s call for the EFSF to take the lead is wholly inadequate. When the EFSF runs out of resources, the ECB will have to stand ready to buy potentially all of the distressed sovereign debts – a list that is bound to expand if this course of action is maintained.

The ECB will have to buy back the debt at distressed prices to avoid raising their market values and therefore the cost of the rescue. In short, as lender of last resort, the EBC will have to organize debt defaults. This will lead to bank failures and more public money to be spent, again by the ECB. Here the ECB might ask their Swiss and Swedish colleagues how to bail banks out and make a profit on it.

There are no doubt other solutions but all are bound to involve the ECB. The key is that markets will not be quieted down until comprehensive measures are taken. The “kick the can down the road” strategy has been politically expedient, but its cost has been enormous.


It was wrong to bailout Greece in May 2010 (Wyplosz 2011). But now is not the time for regret. It is not the time to try to correct past mistakes. We will eventually have to draw the lessons from the crisis – and governments should ask impartial experts to do that – but now we have no choice. We must follow to its bitter end the logic adopted in May 2010.

In the end, finding a good solution is technically easy, but politically difficult.

Europeans have watched the US’s conflict over the debt ceiling with awe and scorn, but their behaviour over the last year and half has been much worse.

  • The French want to pour money on the problem;
  • The Germans want to punish fiscal misbehaviour; and
  • The ECB does not want to bear risk.

All of that is bringing the world to a new recession, which we will not be able to combat because interest rates are at the zero lower bound and governments cannot borrow much anymore.

The spectre of the 1930s, including competitive devaluations as the euro breaks up, is getting dangerously relevant.

Charles Wyplosz © voxEU.org


Wyplosz Charles (2010). “And now? A dark scenario”, VoxEU.org, 3 May.


So can we avoid another severe recession? It might simply be mission impossible. The best bet is for those countries that have not lost market access – the US, UK, Japan, and Germany – to introduce new short-term fiscal stimulus while committing to medium-term fiscal austerity. The US downgrade will hasten demands for fiscal reduction, but America in particular should commit to look for significant cuts in the medium term, not an immediate fiscal drag that will worsen growth and deficits.

Most western central banks should also introduce further QE, even though its effect will be limited. The European Central Bank should not just stop rate hiking: it should cut rates to zero and make big purchases of government bonds to prevent Italy or Spain losing market access – the outcome of which would be a truly major crisis, requiring doubling (or tripling) of bail-out resources, or debt workouts and a eurozone break-up.

Finally, since this is a crisis of solvency as well as liquidity, orderly debt restructuring must begin. This means across the board reduction on the mortgage debt for the roughly half of America’s households that are underwater, and bail-ins for creditors of banks in distress. Greek-style coercive maturity extensions, at risk free rates, must also come for Portugal and Ireland, with Italy and Spain to follow if they lose market access. Another recession may not be preventable. But policy can stop a second depression. That is reason enough for swift and targeted action.

The writer is chairman of Roubini Global Economics, professor at the Stern School, NYU and co-author of Crisis Economics

Copyright The Financial Times Limited 2011


Heleen Mees.Copyright.VoxEU.org


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