|Europe from the European Space Agency's Envisat satellite |
A View from 2020: The Eurozone
Break-Up of 2013; Viewed from 2020, events over the past three years and events
over the coming years may still be debated. Charles Goodhart, emeritus
consultant of Morgan Stanley, the US investment bank, looks back in his old age
at the difficult events of 2009-13
(born 1936) is emeritus professor of banking and finance at the London School of Economics
and one of the original members of the Bank of England's Monetary Policy
Committee (MPC). He is undoubtedly well aware of the limitations of looking too
far ahead in economics. Even in recent months, the mainly Anglo-Saxon-based
doomsayers who were in full voice in May and June about the survival of the EMU
(European Monetary Union) have abandoned their soap boxes as Germany, the
powerhouse of the common currency area, is leading the still fragile recovery
and the euro has rebounded versus the US dollar. It is of course much too early
to declare victory.
The development of the
European Union is one of history's remarkable achievements.
powers of our time," the German chancellor Otto von Bismarck
told a Russian diplomat in 1879, "are like travellers unknown to each other, whom
chance has brought together in a carriage. They watch each other and when one of
them puts his hand into his pocket, his neighbour gets ready his own revolver,
in order to be able to fire the first shot."
On June 02, 2008, the European
Central Bank celebrated its 10th anniversary and President Jean-Claude Trichet
said: "This historic vision has always been
closely associated with the search for prosperity and the preservation of peace.
Voltaire's remark: “En effet l’histoire n’est que le tableau des crimes et des
malheurs” - - “Indeed, history is nothing more than a tableau of crimes and
misfortunes” - - from the perspective of the mid-twentieth century could not
have been more apt. It is no surprise that it was at
that point in time that Europeans decided to accelerate the march towards
Bismarck is reputed to have
said that legislating is like sausage making; it is better not to see them being made. So it is in the EU,
where there are 27 countries with disparate interests.
Within the EU, the
Eurozone is an experiment where members have
independence in the area of fiscal policy while monetary policy is run by the
European Central Bank. We know that the Stability and Growth Pact was far from
adequate in enforcing discipline on misgoverned members. However,
the euro has been a success
(check the record from 1999) despite
the problems and it has not ignited a civil war! Harvard
University economist, Martin Feldstein, said in 1997: "The
American experience with the secession of the South may contain some lessons
about the danger of a treaty or constitution that has no exits."
In 1973, when
Ireland joined the then European Economic Community, its export/GDP
(gross domestic product) ratio was 21.4%.
By 1993, it was 51.1%;
in 1999 - the year of the euro's launch - - and it was above 90%in 2009.
Jacob Funk Kirkegaard, a
Danish economist at the Peterson Institute for International Economics in
Washington DC, said last June that there
had been little love by financial markets for European leaders. But one had to
wonder about the level of disdain reflected in surveys of City of London
economists and global investors showing agreement about the likelihood of a
breakup of the Eurozone. He asked how can a majority of 25 City of London
economists conclude that “a euro breakup of
greater or lesser proportions will occur during the next Parliamentary term“
- - within five years, in other words - - a view supported by 40% of global
investors polled by Bloomberg?
economic and political facts, it would seem, he observed.
Kirkegaard argued that
politically unthinkable that Germany would undermine 60 years of pro-European
policies by leaving the Eurozone and thereby destroying the entire European
Union, which has anchored its identity and powered its postwar authority.
2013, a more economically secure German population is very unlikely to opt for
economically perilous options.
article, June 2010; The Euro: Despite the markets and prophets of doom, the common currency is safer
Leaving the euro: Lessons from Argentina
Ireland and leaving the Euro: 10 questions for pub-stool economists
Prof. Charles Goodhart writes that looking back with the
benefit of hindsight, the European collapse of 2013 appears from the vantage
point of 2020 to have had a certain grim inevitability. Yet at the time, and in
the years leading up to this debacle, it was far from clear what the future
would hold, and many protagonists, especially in the policymaking arena,
continued to contend that all would turn out alright, especially if their own
policy proposals were followed.
|Prof. Charles Goodhart |
Although much was made at the time of the failure
of Greece to get its public finances under control, even before 2008, many of
the countries with construction booms, e.g., Ireland and Spain, had been running
public sector surpluses. It was not so obvious in 2007/8 that these countries
would be in any future difficulty. Yet such booms, and imbalances, cannot go on
forever. It should have been clear that, once the housing/finance boom (as
marked in the UK as anywhere else) was punctured, it would not be easy for the
countries involved to grow their output and exports sufficiently to pay off
their external/internal debts without distress.
The Build-Up to Collapse
Cause of the Break-Up: Two Chief Policy
Goodhart says the collapse was mainly caused by
two key failures among European leaders. The first was the assumption that the
unbalanced pattern of intra-European growth that had persisted from 1999 until
2008 could, and would, last indefinitely. The second was that these leaders
could not agree on an over-arching vision for the longer-term future of the
1. Assuming debt-fuelled growth could
Imbalances that were a natural result of the
construction of the Eurozone were allowed to persist far too long.
- Low interest rates =
construction boom: The entry of the southern
European and peripheral countries, such as Ireland, into the Eurozone (and
the prospective entry of Eastern European economies) had led to a housing
and construction boom in those countries as nominal interest rates fell
sharply; at the same time interest rates converged to a euro area ‘norm' in
the build up to the euro's launch.
- Accelerated by bank lending:
Accelerating the boom, housing and construction sectors were
enthusiastically financed by banks (and their shadows) both within and
outside their own country.
- Result = Private indebtedness
and a loss of competitiveness... The result
in these countries was a massive increase in private sector indebtedness,
largely matched by increasing capital inflows (from banks in Germany,
France, etc.), and by the same token a large current account deficit. The
construction boom of 1999-2007 in the peripheral European countries had been
partly responsible for unit labour costs rising faster there than in
Germany; indeed, this was part of the adjustment process in response to the
- ...leading to almost insoluble
problems when the boom turned to bust... By
the time the boom broke in 2007/8, several Eurozone economies had seen major
losses in competitiveness over that boom. If a recovery in competitiveness
was to be the chosen route to salvation, then this required wage/price
declines (relative to Germany), i.e., internal devaluation, of eye-popping
intensity. Some succeeded (Latvia - not a Eurozone member, but pegged to
the euro); some made a good attempt (Ireland); but in others it was beyond
the capacity of the body politic. The shift of national indebtedness from
the private to the public sectors in 2008-10 deferred, but did not resolve,
- ...and a weakened banking
system: As economies had become over-indebted
during the preceding boom, their banks were in particular difficulties.
These banks held claims on local property, now fallen in value, and with
liabilities (e.g., via the interbank market) to banks elsewhere in Europe.
2. The lack of a unified vision
The second main policy failure was that the
European political leaders could not agree on an over-arching vision for the
longer-term future of the Eurozone, for the ultimate end-game.
One set of leaders continued to hanker for a more
centralised, federal Europe with a shift of fiscal competences to a central
budget, and enhanced political unification. A second set of leaders felt that
the Eurozone, and to a lesser extent also the single market, should comprise a
narrower grouping of nation states with similar economies, and between whom
labour and capital could flow very freely.
Group 1: Stick together at all
costs: For this group, even the weakest member
of the Eurozone (Greece) had to be propped up, kept intact. Restructuring their
debt, even if done in an orderly way, if that was feasible, would be a disaster
and unthinkable. Entry into the euro system should be a one-way street with no
exit. But in return for continuing (fiscal) support, all the member nation
states should increasingly lose their independence to set their own fiscal
policies, becoming more like US states in this respect. Given the difficulties
that the periphery would have in regaining growth and competitiveness, that
vision of the European end-game implied (fiscal) transfers from the stronger
members of the Eurozone of an unlimited and potentially unbounded (both in time
and amount) extent.
Group 2: No ‘transfer union':
Goodhart says many countries, notably Germany and the Netherlands inside the
Eurozone, and the UK outside, were not prepared to sign up for such a ‘transfer
union'. They had a different vision of the longer-term development of the
Eurozone. Their end-game was that the Eurozone should be a narrower grouping of
nation states with similar economies, and between whom labour and capital could
flow very freely, more akin to the optimal currency area of theory, rather than
the more inclusive Eurozone of 1999-2012. In their view, fiscal transfers were
a wasted subsidy to bad behaviour and replete with ‘moral hazard'. If other
countries could not match up to the German example, they should be encouraged to
restructure, not prevented. As countries' economic conditions changed, they
should have (and utilise) the option of leaving, and possibly then subsequently
rejoining, the Eurozone. The Eurozone should be a voluntary union of similarly
minded and similar-economic nation states, not a mélange of differing economies
herded together within a nascent federal United States of Europe.
|Green: EU countries using the euro: Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain
Mauve: EU countries not using the euro
The Consequences of Policy Failure...
The main consequences of these policy failures
was 1) an almost inevitable over-focus on austerity measures post-recession. 2)
An open debate about the European ‘end-game' that caused the markets to become,
and remain, unsettled.
1) Policymakers focused excessively
on austerity: Given lost competitiveness and
over-indebtedness, a major focus of economic policy should have been on the
questions of how to enable these countries to meet their debts through enhanced
competitiveness and growth. Instead, the focus was almost entirely on
additional public sector austerity. This focus was largely forced upon the
politicians by the developing Greek crisis of 2009-10, whereby a vicious spiral
ensued. Market doubts about the ability of the Greek government to meet its
debt commitments led to higher risk premia, which led to further doubts about
solvency. And such worries about Greece soon led to contagious overspills into
the risk premia of other over-indebted Eurozone countries.
2) Open political disagreement and
so unsettled markets: Once the European crisis
began to unfold, in 2010, the incompatibility of these differing visions began
to cause difficulties. At each stage in the crisis, the federalists would
insist that some way of helping Greece, or Spain, or Portugal must be found, and
that such help would soon be on its way. But in each case, such help meant
putting cash on the table, and in almost every instance those opposed to a
‘transfer union' would then express doubts about whether they could/would/should
put up the money. The backing and filling, the internal debate about the
European end-game among the political elite was a major factor causing markets
to become, and to remain, unsettled.
When the crisis did reach a local climax in
spring 2010, there were hopes that the combined IMF/EU support for Greece, and
the wider and bigger European Stabilisation Fund, could assuage market fears.
But both of these were perceived as temporary financing measures, not a means of
resolving or removing the underlying problem of over-indebtedness in these
countries. Moreover, there were valid concerns that such temporary measures
would not give sufficient time for readjustment in the peripheral countries, and
would not be extended should there still seem to be a continuing need for that.
Response to the Crisis: Shooting the
Prof. Goodhart says there were several measures
employed to counter the crisis. One of the most important was the weight
political leaders put on attempting to limit the capacity of the markets to
destabilize the Eurozone.
The Lehman collapse in September 2008 punctured
the European housing/construction boom. A combination of automatic fiscal
stabilisers and Keynesian stimuli led to sharply increasing fiscal deficits and
rising debt ratios. Whereas in October 2008 most fiscal authorities could
credibly support their own banking systems, by mid-2010 in many countries the
fiscal system and the banks were struggling. The worse the fiscal position, the
more threatened was the solvency of the banking system, and vice versa.
But there was also an element of self-fulfilling
amplification via market pressures. Such pressures raised risk premia and
interest rates and hence made sustainability harder to maintain. Many political
leaders convinced themselves, though few others, that the crisis was largely the
result of market over-reaction, and of failure by the credit ratings agencies to
give due weight to the determination and to the reforms of the European
The need was, therefore, felt to be to limit the
capacity of markets to destabilise the Eurozone.
Step 1: CDS restrictions
The first step was taken in May 2010, when
Germany took measures to prevent the use of ‘naked' CDS (credit default swaps)
in its own country, though there was no apparent evidence that the CDS market
had had any significant effect on European sovereign bond markets, or their risk
premia. Although the EC encouraged the adoption of similar measures elsewhere
in the EU throughout the summer of 2010, bond markets did not recover, except
temporarily in July to October, and risk premia remained elevated.
Step 2: The formation of the ERA
Credit ratings agencies (CRAs) followed the
market down, and a slow but steady drumbeat of ratings downgrades for the
Eurozone peripherals continued throughout 2010. But each such downgrade
triggered off some further sales. European politicians believed that the CRAs
were being willfully blind to their major reforms and restorative measures.
No more private rating agencies:
On January, 2011 the European Commission announced the formation of the European
Ratings Agency (ERA). Henceforth no European body, sovereign or corporate,
could use, display or pay for any rating except that of the ERA. To mark its
independence from politics the ERA was sited in Cologne, not Brussels or
ERA rated most EU sovereigns AAA...
All EU sovereigns with the exception of Greece, Iceland and the UK were then
rated AAA, with a special rating of AAA* for Germany and France.
...upon which market prices failed
to rise... Much to the chagrin of both the EC and
of the ERA, market prices failed to respond significantly to the (changes in
the) ratings applied by the ERA. But this was taken by these same groups as yet
another instance and indication of the inefficiency of such market prices.
Ratings become ‘fundamental' values
and ‘mark-to-fundamental' accounting followed: If
market prices did not reflect fundamentals then what did? The answer, of
course, was the ratings of the ERA. Given a rating of an asset by the ERA,
another committee was established to transform that rating into a ‘fundamental
value', often markedly different from the current market value. Pressure was
then placed, increasingly through 2011 and 2012, on the IASB (International
Accounting Standards Board) to shift from a ‘mark-to-market' accounting
procedure to a ‘mark-to-fundamental' procedure.
Banks incentivized to buy ‘cheap'
government bonds: ‘Mark-to-fundamental'
accounting had the consequence that it provided financial institutions with an
incentive to buy and hold assets, such as Portuguese bonds, where market values
were below ‘fundamental' values. Say such a bond traded at, say, 60, but its
fundamental value was assessed as 100. Its purchase would generate an immediate
profit, and addition to capital, of 40, with a similar disincentive for any
sale. Likewise ‘mark-to-fundamentals' could dissuade purchases of assets whose
market value exceeded its assessed fundamental value.
Attempts to circumvent the market power of the
ERA's ratings and assessed fundamental values by the use of various ‘artificial'
derivatives were vigorously resisted and combated.
Goodhart says the initial stage of the sovereign
debt crisis had built up quickly, once realisation of the parlous state of Greek
public finances interacted with an appreciation of the clash of political vision
on the future of the Eurozone. That clash of political vision, investors
decided, not only could, but probably would, leave Greece on its own and
virtually unable to pay its debts (at least in full and on time).
Naturally the authorities sought to portray the
plight of Greece as peculiar, even unique to Greece. While there was some truth
in that, the deeper reality was that the crisis was one of over-indebtedness,
with the debts distributed variously in the peripheral countries among their
public sectors, banks, non-financial companies and households. The
underlying problem was that the counterpart assets, castles in Spain, office
blocks in Dublin, etc., were not such as quasi-automatically to generate
repayment flows, for example in higher net exports. Indeed, much of the capital
inflow had pushed up property prices, rather than new building, leaving the
borrowers in net negative equity when the tide went out. After the event, this
became obvious, but beforehand hardly anyone, whether borrower, lender,
regulator, politician or economist saw the dangers.
Early Stages of the Break-Up
April 2010: Debt rollover and bank
financing problems: The economist says the
immediate and most pressing problem soon became one of financing the new and
roll-over debt requirements of these peripheral countries. The snowball effect,
whereby increasing risk margins led to higher interest rates, and higher
interest rates made solvency ever more questionable, was taking hold. This
vicious spiral was leading towards a collapse of some peripheral countries' bond
markets, and a fiscal crisis. Moreover, many European banks held large amounts
of such debt, and the bond price declines reinforced concerns about bank
solvency, leading to problems for banks in refinancing themselves in wholesale
May 2010: IMF/EU rescue package:
The first, and immediate, objective was to stop the snowball from gathering
speed. This was done in two steps. First, after - what seemed to the markets
interminable delays, largely - an IMF/EU ‘rescue package' of €110bn was put
together on 2 May 2010 for Greece. Second, in order to counter the overspill
onto other countries, and other markets, a number of steps were taken over the
weekend of May 9. These included the assemblage of a European Stabilisation
Fund, amounting to €440bn, (which could be called upon by countries facing acute
financial difficulties, but which would require severe IMF-style constraints on
their fiscal independence if they did so); and also a, less than full-hearted,
agreement by the ECB to buy some bonds of those countries where the markets had
The impact on markets of such measures was
reduced by the accounts of political tensions at the highest Eurozone levels,
and by the patent unhappiness with these developments in Germany, so risk
margins and bond yields having initially retreated sharply, soon began edging
back up again. But this mattered less now since a financing back-stop was now
in place, if only temporarily. Such financing measures had bought time.
Summer 2010: the calm before the
storm: For a time a lull in the crisis did
ensue. The publication of the stress tests on the largest European banks did
not do as much to restore confidence, as the prior 2009 US precedent had done,
but at least it did not make matters worse, and showed that the prospects for
the bigger banks were controllable. Moreover, 2Q10 proved to be the peak of
the recovery for most developed economies that year, so the arriving data
from July till October for out-turns remained good. The onset of the holiday
season was a welcome relief, and as policymakers departed to the beaches in
July/August 2010, there was some hope that an awkward corner might have been
No Fundamental Solutions in Prospect
No corner was turned in summer 2010, as equity
and bond markets, and forward-looking surveys, indicated. The fall in output
and quite dramatic rise in the debt ratio of the Eurozone peripherals apparent
in the early months of 2011 made the prospect of debt repayment seem
increasingly improbable. Against that background it was hard to see how and why
markets in such debt would ever recover on their own.
Burden of indebtedness had simply
shifted... The financing deals for Greece, and
potentially for the other peripherals, simply shifted the indebtedness from weak
holders to stronger creditors, such as the ECB and potentially the German
taxpayer, without resolving the over-arching question of whether, and how, that
debt might ever get paid back.
...with fading prospects of that
debt being paid back: Prof. Goodhart says if one
is excessively indebted, the first imperative is to stop running further huge
current deficits. So, whether pressured from outside, by markets, or jumping
voluntarily, the watchword for public finance in the developed world in 2010 was
retrenchment. Almost all the peripherals, inside and outside the Eurozone, and
many of the major EU countries took strong measures to cut government
expenditures and raise tax rates, simultaneously. The problem was that both the
household sector, and indeed the banks, felt just as over-indebted and in need
of deleveraging as governments. Companies, or at least large companies, were
relatively flush with cash, but in the generally deflationary conditions of
2008-14, where was the incentive to invest?
The economist says what is so odd, looking back
on the debacle from the comfort of 2020, is why anyone should have thought that
fiscal austerity on its own could have been a solution for the over-indebtedness
of 2009/11. If one tries to read the literature of that time, it appears that
the authorities put a lot of weight then on a, largely illusory, deus ex
machina entitled ‘structural reform'. Whereas the measures actually
proposed under this general heading, such as making it easier for employers to
fire long-term employees, reducing workers' pensions and raising retirement
ages, would have long-term benefits, it is less apparent why they should have
been expected to raise growth in the immediate future.
The exports of peripheral countries
failed to pick up: So where was growth to come
from, which might lessen the debt burden? Prof. Goodhart says the desideratum,
of course, was that it should come from net exports, but net exports over the
world as a whole must sum to zero. The decline in the euro and pound vis a vis
the dollar, yen, yuan and Asian/commodity countries did provide some assistance
to the Northern European states, such as Germany and UK, but even so this was
partly offset by a fall in exports to the peripherals. Moreover, these latter
countries depended quite heavily on tourism, and the political/social
disturbances there, for example the general strikes in Greece and Spain, had the
unfortunate side-effect of stunting the tourist trade during the main holiday
season in 2010.
But net exports grew as domestic
demand shrank: Effectively, the only way to
achieve consistency between surplus/deficits in the peripheral countries, and
also, though to a much lesser extent, for the UK, was for a decline in real
output/expenditures. This reduced the level of private sector savings and
surplus, raised the public sector deficit, and cut imports, thereby raising net
exports. While this squared the circle between surpluses/deficits and
incomes/expenditures, it made the debt overhang even worse. With GDP falling,
tax revenues declining, and debt ratios rising even further, and fast, the
over-indebtedness problem rapidly came to seem insurmountable. Although the
European Ratings Agency maintained its sang-froid and AAA ratings, e.g., for
Ireland, Portugal and Spain, the commercial CRAs did not.
Re-instatement of QE in the UK...
As an offset to the general shift towards fiscal austerity in 2010, apart from
just a vague hope that something (new innovation, ‘structural reform', demand
from China) would turn up, there was one available strategy, which was to use
monetary easing to counteract fiscal deflation. With nominal interest rates
already nearly at zero, that implied a return to greater use of credit and
quantitative easing, thereby also driving down relative exchange rates, and
putting further downwards pressure on real interest rates from higher expected
Prof. Goodhart says says when the first
disappointing estimate of GDP in the UK for 3Q appeared in October 2010, a
heated debate ensued in the MPC there. On the one hand disappointing output
growth, a fall in exports to Southern Europe, rising unemployment, especially as
individuals were shifted from disability benefit to unemployment benefit,
strikes and social disaffection in response to the expenditure cuts, and the
prospect of continuing fiscal austerity, all served to press the argument for a
vigorous re-start to QE. On the other hand, both inflation and inflation
expectations remained above the desired level, with the prospect of the sharp
rise in VAT yet to come; QE had not been a panacea before, and it was unclear
whether QE and potential future inflation would be consistent with the mandate
of achieving the two percent inflation for CPI, which was required of the MPC.
The final decision to reinstate QE, and on a large scale, was finely balanced.
...but not in the Eurozone...
While the decision to go for further monetary easing was difficult in the UK, it
was impossible to take this route in the Eurozone. The country that benefited
most from the decline in the value of the euro was Germany, and the rate of
growth of Germany in 2H10 was better than in any other Eurozone country.
Although credit expansion and the broad monetary aggregates in the Eurozone as a
whole remained sluggish, the Germans, and several of their northern supporters,
such as Austria and the Netherlands, could see no case for monetary expansion in
the Eurozone as a whole, simply in order to benefit the countries in difficulty
in southern Europe.
...or the US:
Similarly, in the US, there was insufficient consensus on the FOMC to enable
further resort to CE or QE. The continued high level of the monetary base and
concerns about future inflationary dangers and about the constitutional
propriety of credit and/or quantitative easing, left the majority in doubt at
the wisdom of pursuing QE further. This was in spite of the fact that the
housing market continued to weaken quite sharply and unemployment remained
And QE's prospects for success had
anyway faded: There was a further problem in
trying to use monetary expansion as a counterweight to fiscal austerity. This
was that the weakness of the banks and the prospective introduction of tougher
regulations, despite the welcome delays announced in July 2010, meant that the
banks had no enthusiasm; indeed, they claimed little capacity, to expand their
balance sheets. Thus QE, and CE, simply generated ever-larger cash balances for
banks at their central banks, an outcome which unduly frightened those who saw
future inflationary dangers from such a build-up of ‘excess' balances at the
central nanks. This argument was eerily reminiscent of the Fed's concern with
similar ‘excess' cash balances in 1937. Thus one major channel for expansion
via monetary easing appeared to be largely blocked off.
The Final Stages of the Crisis
5 August 2011 - German objection to
EFSF extension: Prof. Goodhart says that it was
at this stage, on August 5, 2011, that the final stage of the crisis began. The
trigger was an announcement by a senior official in the German Ministry of
Finance that under no circumstances would Germany agree to any extension of the
European Stabilisation Fund. During the subsequent press conference, the
official said that, if the Southern European countries had failed to achieve a
recovery through their own reforms that would enable them to stand on their own
feet by 2013, then some other means with dealing with their debt would have to
be found. This announcement was taken by all market participants as implying
that some form of debt restructuring for several of these countries would,
almost inevitably, take place in 2013; and, as one would expect, the effect of
that on current bond prices was immediate.
With yields going up, and bond markets in these
countries effectively shutting, several of the affected countries, such as
Portugal and Spain, immediately applied to draw on funding from the European
Stabilisation Fund. This, of course, put further pressure on the need for
support from the German taxpayer, and made the Germans, and their supporters,
even more determined that the ESF should not be continued indefinitely.
Debt restructuring came to seem
inevitable: Such economic and market developments
led virtually everyone, with the exception of a few super-optimists in the EC,
to appreciate that the game was up, and that, at a minimum, some form of
restructuring of the debt burden of such over-indebted countries would be
necessary. Such pessimism was further reinforced by additional gloomy data on
GDP from these countries for 2Q11 arriving in late-summer 2011. But how was
this restructuring to be undertaken and where would the burden fall? In
particular banks throughout the Eurozone held large volumes of such debt, much
of which was being used as collateral against borrowing from the ECB, and some
of which was held directly via bond purchases of the ECB.
February 2012: First debt
restructuring negotiations: The first proposal
was to restructure the outstanding debt of the peripheral countries involved
into zero coupon long-dated nominal bonds with a final bullet repayment. These
bonds' present value in July 2011 would be equal to the nominal outstanding
value of existing debt, i.e., that there would be no reduction in nominal debt,
but that the resulting cash flows would be pushed out into the far future. With
no default, the European Ratings Agency (ERA) would continue to give such debt
an AAA rating, and, under the mark-to-fundamental procedure, earlier described,
banks could continue to hold these at face value on their books. While this
seemed in principle a neat way of handling the problem, the calculated nominal
end value of the debt that would have to be ultimately repaid was so enormous
that the whole exercise was perceived as pure artifice.
2012: Growing discontent across
Europe: Meanwhile, the peripheral nations
themselves were becoming increasingly unhappy at the prospect of interminable
negative growth, decay and austerity. There was a need to break away from this
appalling set of constraints. Fortunately, there was no extremist political
‘ism', as there had been with communism and fascism in the 1930s waiting in the
wings. Nevertheless, the electorates in all these countries were becoming
increasingly unhappy and demanding some way out of the economic waste-land that
appeared to be stretching ahead of them. Where was hope to come from?
January 2013: Madrid ‘Accord':
The Prime Minister of Spain called a ‘secret' meeting of Prime Ministers from
other Mediterranean countries. They discussed what additional possible measures
could be undertaken, while in each case being consistent with continued
membership of the Eurozone. Unfortunately, the media reached the conclusion
that the meeting was being held to consider a joint exit from the euro. While
this was not true in fact, formal denials were not believed, especially since
earlier denials that the meeting was taking place at all were soon shown to be
12 January 2013 retail banking
crisis: Once that (unfounded) rumour hit the
tabloids, a major bank run on the banks in Greece, Portugal and Spain started
almost immediately, with queues of depositors trying to switch their funds into
banks in Germany or France. For a few hours the ECB sought to withstand the
flood of recycling the flow out of the Mediterranean countries back to the banks
there. But this involved taking on ever more risky assets as collateral for
these loans, exposing the ECB itself to increasing risk of loss. At this point
the ECB urgently notified all member governments of the Eurozone that it could
not continue to recycle the flood of transfers without being formally
indemnified against loss by the joint and several guarantee of all member
governments, and that it needed a positive answer before markets reopened the
In such circumstances the potential extent of
commitment that such an indemnification might involve was not quantifiable.
Several governments, despite much soul-searching at overnight meetings,
therefore felt unable to give such a commitment on behalf of their taxpayers.
17 January 2013: Grey Wednesday:
It became clear that the banks in these countries were facing illiquidity and
closure, since the ECB felt unable to help further. The result was then
effectively inevitable, and involved, for these countries,
1. Putting in place exchange controls and
an Argentine-type ‘corralito' on depositors bank withdrawals;
2. Calling a bank holiday, until new
national notes, reverting to drachma, pesetas and escudos, could be printed and
3. Abandoning the euro, and passing a
decree that all foreign debts, whether public or private, were now to be payable
in local currency, in effect a default; and
4. Recapitalising locally head-quartered
financial intermediaries by issuing them with local currency bonds, with a
counterpart equity participation.
The Birth of the Medi
New currencies devalue sharply:
Prof. Goodhart says had the currencies that had exited the euro immediately
suffered a major devaluation, of about 35-40%, and nominal interest rates on
their bonds rose sharply. Although their departure from the euro was, in a
sense, both inadvertent and unwanted, steps were put in motion to expel such
countries from the EU, unless they agreed to honour their debts denominated in
euro, which by then had become effectively impossible for them to do.
Further bank solvency pressure:
The default of these countries, and the collapse in the euro-value of credits
against them, both public and private, such as interbank claims, placed great
pressure on the solvency of those banks, especially in France, Germany and
Ireland, that had lent to the defaulting countries. The immediate response of
governments in the EU (exclusive of the defaulters) was, as it had been in
October 2008 (after the Lehman collapse) both to guarantee, once again, all bank
liabilities and to purchase bank equity in sufficient amount to meet the higher
Basel III core tier 1 requirements. A problem for both Ireland and Italy was
that this pushed up yet further their own debt/GDP ratios which were already
regarded, by markets, as dangerously high.
Another bout of contagion: The euro's foreign exchange market value against the
dollar was subject to much uncertainty and enhanced volatility. On the one
hand, shorn of the weaker Mediterranean brethren and ever closer to a DM
grouping, it could be expected to soar. On the other, both the banks and public
sector finances in the Eurozone had been damaged by the default of the leavers,
and so the Eurozone itself was weakened. Such weakness, however, was not evenly
spread, with Ireland, Italy and then France in that order falling under
suspicion. Credit ratings, other than those of the ERA, for Ireland and Italy
fell further, and their CDS rates rose sharply. These countries were next in
line for contagion.
Different paths for Italy and
Ireland: At that point, the Italians had a
difficult choice to make. They could either withdraw from the (northern) euro,
and put themselves in a position of leading the southern bloc of European
countries, or they could try to hang on, with enforced deflation, as the
‘weakest link' of the euro. Much the same dilemma
faced the Irish; rejoin sterling (an option dismissed on political grounds); go
it alone (dismissed since Eire was too small on its own); join the southern bloc
of countries; or tough out continuing deflation in the remaining Eurozone. It
was a very close call in both cases, but they chose differently. The Italians
decided that they would rather dominate a Mediterranean tier of countries than
be a weakened appendix to a northern Eurozone, while the Irish concluded that
their ability to generate FDI from the USA depended on them staying in the
The establishment of the medi:
Prof. Goodhart says following the Italians' decision, a new Southern European
currency, the medi, was established with an accompanying MCB (Medi Central Bank)
set up in Florence. The medi depreciated further against the US dollar, while
the Euro appreciated. In Germany and France those in work enjoyed sharp
increases in real incomes, even though unemployment rose. Feeling richer they
consumed more. The sharp decline in competitiveness in the euro-area countries
led manufacturers there increasingly to invest abroad, including in the medi
countries, much to the disquiet of their governments.
Imbalances finally start to
correct...at enormous cost: The sharply divergent
path of exchange rates, depreciating for the medi, appreciating for the euro,
was accompanied by an increase in inflation in the medi countries and deflation
in the euro. Real interest rates rose in the Eurozone and fell in the medi
countries; investment ratios and net exports fell in the euro-countries and rose
in the medi countries. Consumption, as already noted, rose in the
euro-countries, while in the medi countries the experience of over-indebtedness,
followed by austerity and crisis, restrained consumption. At least this time
the fall in real interest rates encouraged business investment, not housing and
commercial property, in the southern bloc. Thus the intra-European imbalances
were, finally, being corrected, but at what enormous cost?
Even after the event one has to wonder whether
there could have been a better way of sorting out Europe's internal
Lessons from the Crisis
Prof. Goodhart concludes his scenario from the
2020 vantage point, saying that the origins of this crisis went back a long way
in history, back to the debates in the 1970s and 1980s between the French
‘monetarists' and the German ‘economists'. The French ‘monetarists' believed
that political and economic union could, and should, be driven forwards by
adopting monetary union. Whereas a monetary union without prior political and
fiscal unification would surely cause tensions, these could, it was hoped, be
creatively harnessed to push forward to ever closer union.
In contrast, the German ‘economists' felt that
monetary union should properly come last in the sequential build-up to political
and economic union, the final coronation of a successful process. The German
economists lost the key battle in 1990 when Gemany's Chancellor Kohl agreed to
accept a single European monetary system, but the debacle in Europe in 2012-13
suggests that they have won the longer war.
The crisis was essentially about the broader
politics of Europe and to a lesser extent about the economic details of deficits
and debt ratios.
Goodhart says a major political problem had been
that the European executive, e.g., the President of the European Commission, was
not democratically elected and had no popular mandate. Instead, they were
appointed by national leaders responsible to them (i.e., to the leading national
political figures) rather than to the people of Europe. Imagine how the USA
might have developed if the President was appointed by the leading politicians
in the big States rather than by a Presidential election. Instead, what was
needed, we can see with hindsight, was a new political initiative.