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4 options to address the eurozone's stock and flow imbalances the rising risk of a disorderly break-up - november 1 2011 (1)


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  • 1. ECONOMIC  RESEARCH   1  November  1,  2011   Four  Options  to  Address  the   Stock  and   Page  |  1   Flow  Imbalances:  The  Rising  Risk  of  a  Disorderly   Break-­‐Up   By  Nouriel  Roubini   The  latest  eurozone  (EZ)  rescue  package  starts  to  deal  with  some  but  not  all  of  the  stock  imbalances   (large  and  potentially  unsustainable  debt  levels  in  the  public  and  private  sectors)  between  the  core   and   periphery   of   the   bloc,   but   does   not   address   the   serious   flow   imbalances   (lack   of   growth   and   competitiveness  and  large  current  account  and  fiscal  deficits  in  the  periphery)  and,  as  such,  will  not   .   The   package   fails   to   recognize   that   the   restoration   of   growth   and   competitiveness   are   the   key   to   success   as   they   make   stocks   of   liabilities   more   sustainable   and   reduce   flow   imbalances   (such   as   current   account   and   fiscal   deficits);   in   fact,   the   proposals   heighten   the   risk   of   a   deeper   and   longer   recession.   Thus,   financial   engineering   alone   is   bound   to   fail,   as   markets   started   to   recognize   soon   after  the  new  plan  was  announced.   Stock   and   flow   problems   can   be   addressed   with   a   variety   of   policy   tools.   Stock   imbalances   can   be   addressed   via   growth,   higher   savings,   inflation/depreciation   or   debt   reduction/conversion   into   equity.   Flow   imbalances   require   policies   that   lead   to   the   reduction   of   fiscal   and   current   account   deficits   and   the   restoration   of   competitiveness   and   growth.   The   reduction   of   large   current   account   deficits  requires  both  expenditure  reduction  (relative  to  income)  and  expenditure  switching  via  real   depreciation.  Such  real  depreciation  can  be  achieved  via:  Nominal  depreciation  of  the  euro;  structural   policies   that   increase   productivity   growth   above   wage   growth   and   thus   reduce   unit   labor   costs;   deflation  via  a  reduction  of  nominal  wages  and  prices;  or  exit  from  the  monetary  union  and   a  return   to  national  currencies.  The  restoration  of  growth  is  conditional  on  the  restoration  of  competitiveness   and   other   macro   policies   (monetary   easing;   a   weaker   currency;   and   fiscal   easing   in   the   core)   to   restore   growth   in   the   short   run   as   fiscal   austerity   and   reforms   have   a   negative   short-­‐run   effect   on   output.   We  identify  four  possible  sets  of  policy  options  for  the  EZ  to  address  its  stock  and  flow  problems:     o 1)   Growth   and   competiveness   are   restored   (through   aggressive   monetary   easing,   a   much   weaker   euro   and   fiscal   easing   in   the   core,   while   the   periphery   undergoes   painful   fiscal   austerity  and  structural  reforms)  and  the  monetary  union  survives  for  most  members,  with   debt  reductions  being  the  exception  rather  than  the  rule;     o 2)   A   deflationary/depressionary   adjustment   in   tandem   with   painful   structural   reforms   that   becomes,  for  some  member  states,  socially  unsustainable  as  growth  is  depressed  for  many   years  and  growth  and  competitiveness  are  restored  too  late;     o 3)   The   core   permanently   subsidizes   the   periphery via   both   debt   reduction   and   unilateral   transfers  that  take  the  form  of  a  transfer  union  to  avoid  break-­‐up  if  the  periphery  is  stuck  in   an  outcome  of  permanent  stagnation  and  loss  of  competitiveness;    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 2. ECONOMIC  RESEARCH   2   o 4)  The  EZ  sees  widespread  debt  restructurings/reductions  to  reduce  unsustainable  stocks  of   debt  and  eventually  breaks  up  to  restore  competitiveness  and  flow  balances  via  a  return  to   Page  |  2   national  currencies.   These  four  policy  options    recent  three  main  scenarios  for  the  EZ:     o Scenario   1   (everything   goes   according   to   plan,   so   Italy   and   Spain   grow   again   and   are   once   more   able   to   borrow   at   affordable   spreads   without   official   support;   to   which   we   assign   a   40%  probability)  is,  in  our  view,  likely  to  succeed  only  if  Option  1  (macro  policy  reflation  of   the   EZ)   is   implemented   soon;   but   Germany,   the   EZ   core   and   the   ECB   want   to   achieve   Scenario  1  by  implementing  Option  2  (deflation,  austerity  and  reforms),  which  will  only  lead   to  entrenched  recession  for  many  years  and  a  backlash  against  this  draconian  adjustment.   o Scenario   2   (kick   the   can,   but   hit   a   wall   in   12   months   as   Spain,   Italy   and   other   fragile   affordable   sovereign   spreads;   50%   probability)   is   reached   if   the   recessionary   and   deflationary  Option  2  is  pursued;  however,  pursuit  of  Option  2  could  also  lead  to  Scenario  3.   o Scenario   3   (kick   the   can   and  it   explodes   as   Greece   collapses   in   a   disorderly   fashion   before   Italy  and  Spain  are  given  the  time  to  resolve  their  illiquidity,  solvency  and  growth  problems;   10%   probability)   is   analogous   to   Option   4   (widespread   debt   restructurings/reductions   and   break-­‐up  of  the  EZ).     Option  4  (debt  reductions  and  EZ  break-­‐up)  is  also  the  outcome  of  this  policy  if  the  pursuit  of  Option   2   (favored   by   Germany,   the   core   and   the   ECB)   fails   and   Option   1   (macro   reflation)   is   then   not   attempted,  while  Option  3  (permanent  subsidy  by  the  core  of  a  depressed  uncompetitive  periphery)   turns  out  to  be  politically  unfeasible.  Then,  debt  reductions  and  exit  from  the  EZ  across  the  periphery   become  the  most  likely  outcome,  i.e.  a  break-­‐up  of  the  EZ.   So,  in  terms  of  this  non-­‐linear  set  of  scenarios,  the  periphery  will  push  for  Options  1  or  3  as  a  way  to   avoid  Option  4;  but  if  Germany/the  core/the  ECB  stick  with  Option  2,  Scenarios  2  or  3  rather  than  1   will   materialize  and  the  EZ  will  eventually  end  up  with  Option  4,   i.e.  debt   reductions,  exit   from  the   monetary  union  and  the  break-­‐up  of  the  monetary  union.  We  are  of  the  view  that,  unless  Option  2  is   abandoned  and  Option  1  is  soon  adopted,  a  vicious  and  ever-­‐deepening  recession  will  envelope  both   the  periphery  and  the  core  of  the  EZ  and  a  disorderly  break-­‐up  will  gradually  occur  as  first  private  and   public  debts  are  coercively  reduced  and  next  a  growing  number  of  EZ  countries  exit  the  union.   Among   the   six   EZ   countries   in   trouble   so   far   (Greece,   Portugal,   Ireland,   Cyprus,   Spain   and   Italy),   a   subset   of   them   will   experience   restructurings   and   reductions   of   their   public   and   private   debts   as   a   way   to   resolve   their   stock   imbalances.   And   a   different   subset   of   these   six   countries   may   also   eventually  decide  to  exit  the  EZ  to  resolve  their  flow  imbalances.  If  enough  of  them  coercively  reduce   their  debts  and  exit  the  monetary  union,  the  EZ  will  effectively  break-­‐up  over  time,  in  a  slow  motion   train  wreck.    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 3. ECONOMIC  RESEARCH   3   The   announcement   of   the   most   recent   EZ   rescue   package   (acceptance   of   a   bigger   haircut   for   Greek   private   creditors,   the   recapitalization   of   EZ   banks   and   the   use   of   guarantees   and   financial   leverage   in   the   hope   of   Page  |  3   preventing   Italy   and   Spain   losing   market   access)   led   to   markets   rallying   for   a   day   as   the   tail   risk   of   a   disorderly   situation  in  the  EZ,  temporarily,  diminished.  By  the  next  day,  Italian  yields  and  spreads  were  still  close  to  their  high,   serving   as   a   reminder as   we   argued   in   The   Last   Shot   on   Goal:   Will   Eurozone   Leaders   Succeed   in   Ending   the   Crisis?,  co-­‐authored  with  Megan  Greene that  the   fundamental  problems  will  not  be  resolved  by  this  trio  of   policy  actions.     To   put   the   latest   package   in   context,   we   need   to   first   assess   the   fundamental   problems   facing   the   EZ   and   the   potential  scenarios  for  the  monetary  union.     EZ  Flow  Problems   The   EZ   suffers   from   both   stock   and   flow   problems,   which   are   related   to   each   other.   The   flow   problems   were   and/or  are:     Large   fiscal   and   current   account   deficits   in   most   members   of   the   EZ   periphery   (Greece,   Ireland,   Portugal,  Cyprus,  Spain  and  Italy);     Economic   weakness,   manifesting   itself   in   renewed   near   recession   or   outright   recession   and   weak   actual  and  potential  growth;     The   long-­‐term   loss   of   competitiveness,   driven   by   three   factors:   Loss   of   export   market   share   to   emerging   markets   (EMs)   in   traditional   labor-­‐intensive   low-­‐valued-­‐added   sectors;   real   appreciation,  driven  by  wages  growing  more  than  productivity  since  the  inception  of  the  EZ;  and  the   relative  strength  of  the  value  of  the  euro  in  the  past  decade.     EZ  Stock  Problems     The  stock  problems  are  the  large  and  possibly  unsustainable  stock  of  liabilities  of:  The  government  (in  most  of  the   periphery  with  the  exception  of  Spain);  the  private  non-­‐financial  sector  (mostly  in  Spain,  Ireland  and  Portugal);  the   banking   and   financial   system   (in   most   of   the   periphery);   and   the   country   (external   debt),   especially   in   Greece,   Spain,  Portugal,  Cyprus  and  Ireland.     Stock   vulnerabilities   are   the   result   of   flow   imbalances:   A   big   fiscal   deficit   results   in   a   growing   and   large   stock   of   public   debt   (Greece,   Italy,   Ireland,   Cyprus,   Portugal)   and   in   a   large   stock   of   foreign   debt   when   private   sector   savings-­‐investment   imbalances   are   also   large;   a   wide   current   account   deficit whether   driven   by   private   sector   imbalances   (like   in   Spain   and   Ireland)   or   public   sector   ones   (Greece,   Cyprus,   Portugal) leads   to   a   build-­‐up   of   foreign  debt.  In  some  cases,  the  excesses  started  in  the  private  sector  (housing  boom  and  then  bust  in  Ireland  and   Spain);  so,  initially  it  was  a  buildup  of  private  debts  and  of  foreign  debts  driven  by  large  current  account  deficits.  In   other  cases,  the  excesses  started  in  the  public  sector  (Greece,  Italy,  Portugal,  Cyprus),  leading  to  a  large  stock  of   public   debt   and   of   foreign   debt via   current   account   deficits in   the   subset   of   countries   with   fragile   savings-­‐ investment  imbalances  in  their  private  sectors  (Greece,  Portugal,  Cyprus).     Until   recently,   Italy   had   a   public   debt   problem   but   not   current   account   and   foreign   debt   problems   as   the   high   savings  of  the  household  sector  prevented  the  fiscal  deficit  from  turning  into  a  current  account  deficit.  But  now,   the   sharp   fall   in   private   savings   has   led   to   the   emergence   of   a   current   account   deficit   even   there.   In   Spain   and   Ireland,  the  flow  and  stock  imbalances  started  in  the  private  sector  leading  to  large  current  account  deficits  and   foreign   debts,   but   once   the   Spanish   and   Irish   housing   sectors   went   bust   and   resulted   in   sharp   fiscal   deficits in    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 4. ECONOMIC  RESEARCH   4   part,   due   to   the   socialization   of   private   losses the   ensuing   rise   in   public   debt   created   a   sovereign   debt   sustainability  problem.     Page  |  4   Recent  Policy  Actions  Start  to  Deal  With  Some  Stock  Vulnerabilities   The  recent  EZ  package  starts  to  deal  with  some but  by  no  means  all of  the  stock  imbalances  in  the  EZ  periphery.   First,  public  debt in  some  (Greece)  but  not  all  of  the  countries  where  it  is  unsustainable  (Portugal,  Ireland,  Cyprus,   Italy) will  be  reduced  (50%  haircut  on  private  creditors,  though  the  July  plan  will  have  to  be  completely  scrapped,   and  the  new  details  are  lacking  at  this  point).  Second,  the  excessive  amount  of  debt  relative  to  the  equity/capital  of   EZ   banks  will  be  partly  addressed to  prevent   insolvency by  recapitalizing  EZ   banks   (both  in  the  periphery  and   the   core).   These   banks   suffer   from   low   capital   ratios   and   potential   erosion   of   their   capital   through   losses,   given   exposures  to  sovereigns,  busted  real  estate  and  rising   non-­‐performing  loans  as  a  result  of  the  growing  recession.   But   the   capital   needs   of   EZ   banks,   given   these   tail-­‐risk   losses,   are   much   larger   than   the   100   billion   of   recapitalization  needs  that  the  EZ  has  identified.  Third,  illiquidity of  banks  and  sovereigns risks  turning  illiquidity   into   insolvency   as   self-­‐fulfilling   bad   equilibria   of   runs   on   short-­‐term   liabilities   of   banks   and   governments   are   possible.   Thus,   the   full   allotment   policy   would   prevent   such   a   run   on   bank   liabilities   in   principle   only   for   banks  that  are  illiquid  but  solvent,  but  in  practice  even  possibly  for  insolvent  banks.     For   sovereigns   that   have   lost   market   credibility and   whose   spreads   could   blow   to   an   unsustainable   level .  Bail-­‐ big  bazooka   of  the  fin  is  necessary  to  provide  time  and  financing   for   the   flow   adjustment fiscal   and   structural to   restore   market   confidence   and   reduce   spreads   to   sustainable   levels.  In  each  case,  assumptions  need  to  be  made  about  whether  a  country  is  a)  illiquid  but  solvent  given  financing   to  prevent  loss  of  market  access,  time  and  enough  adjustment/austerity  (possibly  Italy  and  Spain);  b)  illiquid  and   insolvent   (Greece,   clearly);   or   c)   illiquid   and   near   insolvent   and   already   needing   conditional   financing   given   that   market  access  has  already  been  lost  (Portugal,  Ireland  and  Cyprus).     But  even  if  Italy  and  Spain  were  illiquid  and  solvent  given  time,  financing  and  adjustment,  the  big  bazooka  that  the   EZ  needs  to  backstop  banks  and  sovereigns  in  the  periphery  is  at  least   2  trillion  and  possibly   3  trillion  rather  than   the  fuzzy   1  trillion  that  the  EZ  vaguely  committed  to  at  the  recent  summit.  So,  on  all  three  counts,  the  recent  EZ   plan  falls  short  of  addressing  the  stock  problems  of  highly  indebted  sovereigns,  the  capital  needs  of  EZ  banks  and   the  liquidity  needs  of  EZ  banks  and  sovereigns;  it  also  does  little  or  nothing  to  restore  competitiveness  and  growth   in  the  short  run.     Critical  Role  of  Flow  Factors  in  Resolving  Stock  Sustainability  Issues   To   make   stocks   sustainable,   it   is   crucially   important   to   address   flow   imbalances,   for   several   reasons.   First   of   all,   without   economic   growth,   you   have   a   dual   problem:   a)   The   socio-­‐political   backlash   against   fiscal   austerity   and   reforms  becomes  overwhelming  as  no  society  can  accept  year  after  year  of  economic  contraction  to  deal  with  its   imbalances;  b)   more  importantly,  to  attain  sustainability,  flow  deficits  (fiscal  and  current   account)  and  excessive   debt  stocks  (private  and  public,  domestic  and  foreign)  need  to  be  stabilized  and  reduced,  but  if  output  keeps  on   falling,  such  deficit  and  debt  ratios  keep  on  rising  to  unsustainable  levels.     Second,  restoring  growth  is  also  important  because,  without  growth,  absolute  fiscal  deficits  become  larger  rather   than   smaller   (given   automatic   stabilizers).   Third,   restoring   external   competitiveness   is   key   as   that   loss   of   competitiveness  led in  the  first   place to  current   account   deficits  and   the   accumulation  of  foreign   debt   and  to    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 5. ECONOMIC  RESEARCH   5   lower  economic  growth  as  the  trade  balance  detracts  from  GDP  growth  when  it  is  in  a  large  and  growing  deficit.  So,   unless   growth   and   external   competitiveness   are   restored,   flow   imbalances   (fiscal   and   current   account   deficits)   Page  |  5   persist   and   stabilizing   domestic   and   external   deficits   becomes   mission   impossible.   Finally,   note   that,   unless   growth   and   competitiveness   are   restored,   even   dealing   with   stock   problems   via   debt   reduction   will   not   work  as   flow  deficits  (fiscal  and  current  account)  will  continue  and,  eventually,  even  reduced  debt  ratios  will  rise  again  if   the  denominator  of  the  debt  ratio  (debt  to  GDP),  i.e.  GDP,  keeps  on  falling.  Growth  also  matters  as  credit  risk measured   by   real   interest   rates   on   public,   private   and   external   debt,   which   measures   the   default   risk will   be   higher  the  lower  the  economic  growth  rate.  So,  for  any  given  debt  level,  a  lower  GDP  growth  rate  that  leads  to  a   higher  credit  spread  makes  those  debt  dynamics  more  unsustainable  (as  sustainability  depends  on  the  differential   between  real  interest  rates  and  growth  rates  times  the  initial  debt  ratio).   The  Current  Account  Flow  Deficit  Problem  in  the  EZ  Periphery   While  the  issue  of  fiscal  deficits  and  public  debt  has  been  overemphasized  in  the  recent  policy  debate  about   the   problems   of   the   EZ,   one   should   not   underestimate   the   role   of   external current   account imbalances.   These   periphery  has  suffered  implies  that  such  deficits  are  now  not  financeable  in  the  absence  of  official  finance.  These   deficits   are   the   result   of   savings-­‐investment   imbalances   in   both   the   private   (Spain,   Ireland,   Portugal)   and   public   sectors   (Greece,   Portugal,   Cyprus,   Italy);   they   are   also   the   result   of   the   real   appreciation   of   these   countries   following  a  decade  of  declining  export  market  share,  the  growth  of  wages  in  excess  of  productivity  growth  and  the   strength  of  the  euro.  Some  of  these  deficits  are  now  cyclically  lower  given  that  the  collapse  of  output/demand  has   led  to  a  fall  in  imports.  But,  on  a  structural  basis,  unless  the  real  appreciation  is  reversed,  the  restoration  of  growth   to  its  potential  level  would  result  in  the  resumption  of  large and  now  not  financeable external  deficits.     So,  the  modest  reduction  in  current  account  deficits  in  the  periphery  that  has  been  seen  since  2009  is  deceptive:  It   for   the   most   part reflect   an   improvement   in   competitiveness;   it   is   only   the   result   of   a   severe   and   persistent   recession.   Real   depreciation   is   required   to   restore   such   competiveness   while   ensuring   sustained   economic   growth.   An   inability   to   restore   competitiveness   and   thus   growth   would   eventually   undermine   the   monetary   union   as   private   creditors   are   now after   a   sudden   stop unwilling   to   finance   such   deficits.   So,   eliminating  the  external  current  account  deficit  is  as  critical  to  restoring  debt  sustainability  as  reducing  flow  fiscal   deficits.   And   fiscal   deficits   are   not   the   only   explanation   of   the   external   deficits   as   real   appreciation   and   loss   of   competitiveness   are   as   important,   if   not   more   important,   than   fiscal   imbalances,   in   explaining   such   external   imbalances.   The  Recent  EZ  Package  Does  Little  or  Nothing  to  Restore,  in  the  Short  Term,  Growth  and  Competitiveness,  Which   Are  the  Key  to  Sustainability   The  latest  economic  data such  as  the  EZ  PMIs strongly  suggest  that  the  EZ not  just  the  periphery,  but  also  the   core are  falling  back  into  a  recession.  This  is   very  clear  in  the  periphery  where  some  countries  never  got  out  of   their  first   2008  recession,  while  the  others  are  plunging   back  into  recession  after  a   very  moderate   recovery.  But   even  in  the  core  of  the  EZ,  the  latest  data  suggest  that  a  recession  is  looming.   The   recent   EZ   package   (a   bigger   Greek   haircut,   bank   recaps   and   a   levered   European   Financial   Stability   Facility   (EFSF),   together   with   more   fiscal   austerity   and   a   push   toward   structural   reforms)   does   nothing   to   restore   competitiveness   and   growth   in   the   short   run.   In   fact,   it   actually   exacerbates   the   risk   of   a   deeper   and   longer   recession.  Fiscal  austerity  is  necessary  to  prevent  a  fiscal  train  wreck,  but,  in  the  short  run  (as  recent  IMF  studies    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 6. ECONOMIC  RESEARCH   6   suggest),   raising   taxes,   reducing   transfer   payments   and   cutting   government   spending   (even   inefficient/unproductive  expenditure)  has  a  negative  effect  on  economic  growth,  as  it  reduces  aggregate  demand   Page  |  6   and   disposable   income.   Moreover,   even   structural   reforms   that   will   eventually   boost   growth   via   higher   productivity  growth  have  a  short-­‐run  negative  effect:  You  need  to  fire  unproductive  public  employees;  you  need  to   fire  workers  in  weak  firms  and  sectors;  you  need  to  shut  down  unprofitable  firms  in  declining  sectors;  you  need  to   move   labor   and   capital   from   declining   sectors   to   new   sectors   in   which   the   country   may   have   a   comparative   advantage.   This   all   takes   time   and,   in   the   absence   of   a   rapid   real   depreciation,   what   are   the   sectors   in   which   a   periphery   country   has   a   new   comparative   advantage?   Even   necessary   structural   reforms like   fiscal   austerity reduce  output  and  GDP  in  the  short  run  before  they  have  beneficial  medium-­‐term  effects  on  growth.     To   restore   growth   and   competitiveness:   The   ECB   would   have   to   rapidly   reverse   its   policy   hikes,   sharply   reduce   policy  rates  toward  zero  and  do  more  quantitative  and  credit  easing;  the  value  of  the  euro  would  have  to  sharply   fall  toward  parity  with  the  U.S.  dollar;  and  the  core  of  the  EZ  would  have  to  implement  significant  fiscal  stimulus  if   the   periphery   is   forced   into   necessary   but   contractionary   fiscal   austerity   (which   will   have   a   short-­‐term   drag   on   growth).   Options  for  Dealing  with  Stock  and  Flow  Problems   Stock   imbalances large   and   potentially   unsustainable   liabilities can   be   addressed   in   multiple   ways:   a)   high   economic  growth  can  heal  most  wounds,  especially  debt  wounds  given  that  fast  growth  in  the  denominator  of  the   debt   ratio   (i.e.   GDP)   can   lead   over   time   to   a   lowering   of   debt   ratios;   b)   low   spending   and   higher   savings   in   the   private   and   public   sectors   can   lead   to   lower   fiscal   deficits   and   lower   current   account   deficits   (lower   flow   imbalances)  that,  over  time,  reduce  the  stocks  of  public  and  external  debt  relative  to  GDP;  c)  inflation  and/or  forms   of  financial  repression  can  reduce  the  real  value  of  debts;  the  same  can  occur  with  unexpected  depreciation  of  the   currency  if  the  liabilities  are  in  a  domestic  currency;  d)  debts  can  be  reduced  via  debt  restructurings  and  reductions,   including  the  conversion  of  debt  into  equity.  The  last  option  is  key:  If  growth  remains  anemic  in  the  EZ;  if  savings   lead  to  the  paradox  of  thrift  (a  more  severe  short-­‐term  recession)  and  if  monetization,  inflation  or  devaluations  are   not   pursued  by  the  ECB,  the  only  way  to  deal   with  excessive  private  and  public  debts  becomes   some  orderly  or   disorderly  reduction  of  such  debts  and/or  their  conversion  into  equity.   Flow  imbalances  are  more  difficult  to  resolve  as  they  imply   a  reduction  of  fiscal  and  current  account  deficits  that   are   consistent   with   sustainable   growth   and   with   the   restoration   of   competitiveness,   which   requires   real   depreciation.  To  reduce  external  current  account  deficits the  key  to  restoring  competitiveness  and  growth you   need   both   decreases   in   expenditure   (private   and   public)   and   expenditure-­‐switching   through   a   real   depreciation.   Such   real   depreciation   can   occur   in   four   ways:   a)   a   nominal   depreciation   of   the   euro   large   enough   to   lead   to   a   sharp  real  depreciation  in  the  periphery;  b)  structural  reforms  that  increase  productivity  growth  while  keeping  a  lid   on   wage   growth   below   productivity   growth   and   thus   reduce   unit   labor   costs   over   time;   c)   real   depreciation   via   deflation a  cumulative  persistent  fall  in  prices  and  wages  that  achieves  a  sharp  real  depreciation;  and  d)  exit  from   the  monetary  union  and  return  to  a  national  currency  that  leads  to  a  nominal  and  real  depreciation.  The  key  issue   here  is as  we  will  discuss  in  detail  below that  achieving  the  real  depreciation  via  route  a)  is  unlikely,  as  there  are   many  reasons  why  the  euro  will  not  weaken  enough;  getting  it  via  b)  may  take  way  too  long a  decade  or  more when  the  sudden  stop  requires  a  rapid  turnaround  of  the  external  deficit;  achieving  it  via  c)  may  also  take  too  long   and  would  be  associated  with  a  persistent  recession,  while  leading  to  massive  balance-­‐sheet   effects;  thus  the  d)   option exit  from  EZ becomes  the  only  available  one  if  the  other  three  are  not  feasible/desirable.    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 7. ECONOMIC  RESEARCH   7   Additionally,  if  growth  and  competitiveness  are  restored  in  short  order,  this  is  the  best  way on  top  of  decreased   expenditure  via  fiscal  austerity to  reduce  both  the  fiscal  and  current  account  imbalances  as  well  as  the  relative   Page  |  7   ones  (i.e.  as  a  share  of  GDP).  In  other  terms,  fiscal  austerity  and  structural  reforms  eventually  restore  growth  and   productivity,  but  they  are,  in  the  short  run,  recessionary.  Thus,  other  macro  policies  are  needed  to  restore  growth,   which   is   critical   to   make   the   adjustment   politically   and   financially   feasible.   Therefore,   macro   policies   consistent   with  a  rapid  return  to  economic  growth  are  the  key  to  resolving  flow  problems.   Four  Options  to  Address  the  Stock  and  Flow  Problems  of  the  EZ   Given   the   above   analysis   of   the   structural   and   fundamental   problems   faced   by   the   EZ,   there   are   four   possible   options  to  deal  with  the   stock  and  flow  problems;  each  option  implies  a  different   future  for  the  monetary   union.  Each  reduces  unsustainable  debts  and  restores  growth  and  competitiveness  and  reduces  flow  imbalances   via  a  different  combination  of  the  policies  discussed  above   1. Growth   and   Competiveness   Are   Restored.   In   this   first   option,   policies   are   undertaken   to   rapidly   restore   growth   and   competitiveness   (monetary   easing,   a   weaker   euro,   core   fiscal   easing   and   the   reduction  of  unsustainable  public  and  private  debts  in  clear  insolvency  cases),  to  reduce  flow  deficits   and   to   restore   private,   public   and   external   debt   sustainability,   all   while   the   periphery   undertakes   continued  painful  austerity  and  structural  reforms.  In  this  scenario,  the  EZ  survives  in  the  sense  that   most  members maybe  with  the  exceptions  of  Greece  and  possibly  Portugal remain  in  the  EZ  and   most   members again,   with   the   exceptions   of   Greece   and   possibly   Portugal avoid   a   coercive   restructuring  of  their  public  and  private  debts.  This  solution  requires  a  nominal  and  real  depreciation   of  the  euro  and,  for  a  period  of  time,  higher  (lower)  inflation  in  the  core  (periphery)  of  the  EZ  than  the   current  ECB  target  to  restore,  via  real  depreciation,  the  competitiveness  of  the  periphery  and  rapidly   eliminate  its  unsustainable  current  account  deficit.     2. The   Deflationary/Depressionary   Route   to   the   Restoration   of   Competitiveness.   Growth   and   competitiveness  are  not  restored  in  the  short  run  as  the  core/Germany  imposes  an  adjustment  based   on   deflationary   and   depressionary   draconian   fiscal   austerity   and   structural   reforms   that,   in   the   absence  of  appropriate  expansionary  macro  policies,  makes  the  recession  of  the  periphery  severe  and   persistent   and   does   This   depression/deflationary   path   becomes   politically   and   socially   unsustainable   for   most but   possibly   not   all of   the   EZ   periphery   as   it   implies   five-­‐ten   years   of   ever-­‐falling   output   to   restore   competitiveness   via   deflation   and   eventual   structural   reforms.   And   with   output   falling   in   the   short   run  and  a  fall  in  prices/wages,  stock  problems  worsen  for  a  while  (as  both  nominal  and  real  GDP  are   falling)  until  the  restoration  of  growth  eventually  takes  care  of  the  stock  imbalances.  Since,  for  most   EZ  members,  Option  2  becomes  politically  and  socially  unfeasible,  in  the  absence  of  a  path  that  leads   to  Option  1,  Option  2  evolves  into  Options  3  or  4.   3. The   Core   Permanently   Subsidizes   the   Periphery.   If   Option   1   does   not   materialize   while   Option   2   becomes  politically-­‐socially  unsustainable,  the  only  other  way  to  avoid  Option  4  (EZ  break-­‐up)  is  not   just  via  a  reduction  of  the  unsustainable  stocks  of  liabilities  in  the  periphery  (a  capital  levy  on  the  core   of   creditors),   but   also   via   a   permanent   subsidization   of   the   uncompetitive   periphery   by   the   core.   Since  the  lack  of  a  restoration  of  growth/competiveness  implies  a  permanent  external  deficit  (trade   deficit)  in  the  periphery  with  a  trade  surplus  in  the  core  that  implies  an  unsustainable  current  account   deficit  in  the  periphery,  the  only  way  in  which  the  core  can  prevent  the  periphery  from  exiting  the  EZ    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 8. ECONOMIC  RESEARCH   8    flow  deficit  problem)  is  to  make   a   unilateral   permanent   yearly   transfer   payment   (of   the   order   of   several   percentage   points   of   core   Page  |  8   GDP,  possibly  as  high  as  5%  of  GDP)  to  the  periphery  to  prevent  the  trade  deficit  from  turning  into  an   unsustainable   current   account   deficit   that   in   turn   leads   to   the   accumulation   of   even   more   unsustainable   external   debt.   Such   a   unilateral   transfer   sustains   the   GNP   of   the   periphery   while   its   GDP   remains   permanently   depressed   as   competitiveness   is   not   restored.   So,   stock   problems   are   addressed   via   repeated   restructurings,   extensions   and   haircuts   of   privately   held   debt   (bonds)   and   bilateral/multilateral  loans  as  well  as   via   recapitalizations   of  banks  that  include   some  conversion  of   debt   into   equity.   Meanwhile,   flow   problems   are   addressed   via   a   permanent   yearly   subsidy   to   the   periphery  from  the  core.     4. The  EZ  Experiences  Widespread  Debt  Restructurings.  Members  of  the  periphery  react  to  the  Option   2  (depression/deflation)  that  is  currently  imposed  on  them  by  Germany  and  the  ECB  by,  first,  losing   market   access   (or   not   regaining   it)   and   are   thus   forced,   once   official   finance   runs   out   (because   of   political  and/or  financial  constraints  in  the  core),  to  coercively  restructure  their  public  and  also  their   private   debts   (say,   of   banks  and   financial   institutions).   Even   such   a   debt   reduction   is   insufficient   to   restore  growth  and  competitiveness  as  it  partially  deals  with  stock  problems,  but  does  not  deal  with   flow  problems.  If,  then,  the  flow  problem  is  not  resolved  via  a  permanent  subsidization  of  the  income   of   the   periphery   by   the   core   (Option   3),   then   the   only   other   way   to   restore   growth   and   competitiveness  is  via  exit  from  the  monetary  union  and  a  return  to  the  national  currency.  The  EZ  can   survive  the  exit  of  its  smaller  members  (Greece,  Portugal,  Cyprus),  but  if  debt  restructurings  and  the   exit  of  Italy  and/or  Spain  become  necessary/inevitable,  the  EZ  effectively  breaks  up,  with  only  a  small   core Germany   and   a   few   core   members remaining   in   a   smaller   and   much   damaged   monetary   union.   An  Assessment  of  the  Likelihood  of  the  Four  Options   Option  1:  Most  Desirable  But  Quite  Unlikely  as  Contrary  to  the  Goals  and  Constraints  of  Germany/the  ECB   Which  one  of  these  four  options  is  most  likely?  Option  1  appears  the  most  desirable  as  it  leads  to  the  survival  and   success   of   the   EZ.   However,   it   is   not   necessarily   the   most   likely   option   as   it   would   imply   radical,   rapid   and   presumably  unacceptable  changes  in   macro-­‐policy.     First,   the   ECB   would   have   to   reverse   its   policy   tightening   and   aggressively   cut   rates;   even   that   would   not   be   sufficient   as   aggressive   quantitative   easing   (QE)   would   be   necessary   to   restore   growth   and   provide   unlimited   lending  of  last  resort  (LOLR)  to  sovereigns such  as  Spain  and  Italy that  are  possibly  illiquid  but  solvent  if  given   enough  time  and  liquidity  to  resolve  their  problems.  Even  traditional  QE  would  not  be  sufficient  as  unconventional   credit  easing  may  be  necessary  to  restore  credit  growth  to  smaller  firms  and  households  subject  to  a  credit  crunch.   This  is  obviously  not  acceptable  to  the  ECB  and  Germany  as  it  would  require   a  radical  change  (maybe  via  a  treaty   change)  to  the   formal  mandate  (the  bank  is  currently  supposed  to  only  pursue  the  goal  of  price  stability).  The   ECB and  eventually  Germany  as  a  recap  of  the  ECB  would  fall  to  Germany/core would  also  take  a  significant  risk   in  becoming  (for  a  while)  the  LOLR  for  Italy  and  Spain,  which  may  turn  out even  with  massive  liquidity to  be  not   just  illiquid  but  also  insolvent  (there  are  many  future  paths  via  which  the  latter  could  happen).     Second,  the  value  of  the  euro  would  have  to  fall  sharply  compared  with  current  levels,  possibly  toward  parity  with   the  U.S.  dollar  to  reverse  the  loss  of  competitiveness  of  the  periphery.  This  would  imply  that  inflation  would  rise  in   the  core starting  in  Germany for  a  number  of  years  above  2%  to  allow  the  real  depreciation  of  the  periphery  to    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 9. ECONOMIC  RESEARCH   9   occur.   being  politically  acceptable  to  Germany  and  the  ECB.  Also,  with  Germany  being  uber-­‐ competitive  and  with  a  large  external  surplus,  while  the  U.S.  dollar  needs  to  a  weaken  given  the  large  U.S.  current   Page  |  9   account   deficit,   it   is   not   obvious   that   the   euro   would   fall   as   sharply   as   the   periphery   needs,   unless   the   ECB   aggressively   pursues   QE   and   credit   easing   and   jawbones   the   euro   down   with   verbal   and   actual   intervention:   All   very   unlikely   outcomes   given   the   current   mandate   and   the   German/ECB   goal   of   restoring   the   periphery     Third,  the  core  would  have  to  accept  and  implement  a  fiscal  stimulus  to  compensate  for  the  recessionary  effects  of   the  fiscal  austerity  of  the  periphery.  But  Germany  and  the  core  are  vehemently  against  back-­‐loaded  fiscal  austerity   let  alone  fiscal  easing  of  the  type  that  even  the  IMF  is  now  suggesting  to  them.  Germany/the  core  is  of  the  view   that   the   problems   of   the   periphery   were   self-­‐inflicted   even   when   private   imbalances   (like   in   Spain   and   Ireland)   rather  than  public  ones  were  at  the  core  of  financial  difficulties.  So,  austerity  and  reform  are  viewed  by  the  core  as   a  must  for  both  the  periphery  and  also  for  the  core.     Option  2:  Socially-­‐Politically  Unacceptable  as  Implies  a  Persistent  Recession-­‐Depression  in  Most  of  the  Periphery   Option  2  is  the  type  of  adjustment  that  the  ECB  and  Germany  would  like  to  impose  on  the  periphery,  but  it  would   be   socially   and   politically   unacceptable   for   most.   It   is   thus   not   a   stable   equilibrium   but   rather   an   unstable   disequilibrium   that   would   eventually   lead   to   Options   3   or   4.   Since   fiscal   deficits   are   excessive,   they   need   to   be   rapidly  reduced  via  front-­‐loaded  austerity  to  make  public  debts  sustainable.  Current  account  deficits  will  be  partly   reduced  via  the  reduction  of  public  dis-­‐savings.  The  rest  of  the  external  imbalance  will  be  corrected  via  deflation   (internal  devaluation)  and  via  accelerated  structural  reforms  that  increase  productivity  growth,  while  keeping  a  lid   on   wage   growth   below   such   higher   productivity   growth   will   progressively   reduce   unit   labor   costs   and   restore   external  competitiveness.     The   problems   with   the   German/ECB   solution   to   the   growth/competitiveness   issue   are   multiple.   First,   fiscal   austerity   is   necessary,   but   if   implemented   by   the   entire   EZ   it   makes   the   periphery   recession   worse,   deeper   and   longer  and  thus  undermines  the  restoration  of  growth  that  is  necessary  to  make  the  debts  sustainable.  Also,  such   recession   damages   attempts   to   reduce   fiscal   deficits;   and   it   improves   external   balances   only   temporarily   via   a   compression  of  imports,  not  via  a  true  restoration  of  competitiveness;  structural  external  deficits  mostly  remain.     Second,  reducing  unit  labor  costs  via  accelerated  reforms  that  increase  productivity  growth while  keeping  a  lid  on   wage  growth  below  such  rising  productivity  growth is  easier  said  than  done.  It  took  10  to  15  years  for  Germany   to  achieve  its  reduction  of  unit  labor  costs  via  that  route.  And  since  German  unit  labor  costs   have  fallen  by  20%   since  the  inception  of  the  EZ,  while  they  have  risen  by  30%  in  the  EZ  periphery,  the  unit  labor  cost  gap  between   Germany  and  periphery  is  now  about  50%.  So,  if  the  EZ  periphery  were  to  accelerate  reforms  that  actually  depress   output   in  the  short   run,  the  benefits  will   start   to  show  up  after  five  years  or  so;  and  no  country  can  accept   five   years   of   recession   or   depression   before   it   returns   to   growth.   Also,   a   reduction   in   unit   labor   costs   via   a   rise   in   productivity   growth   above   positive   wage   growth as   in   Germany   in   the   past   15   years is   politically   more   feasible as  it  is  associated  with  growth  rather  than  recession than  a  recessionary  adjustment  where  wages  need   to   fall   in   nominal   terms   as   productivity   growth   remains   stagnant   while   output   stagnates   for   a   number   of   years.   Given  the  nominal  downward  rigidity  of  wages  and  prices,  outright  deflation  is  extremely  hard  to  achieve  in  the   absence  of  a  severe  and  persistent  depression.     Third,   deflation/internal   devaluation   is   not   politically-­‐socially   feasible   if   it   leads as   is   likely to   persistent   recession.  Deflation a  5%  fall  in  prices  and  wages  for  five  years  leading  to  a  cumulative  compound  reduction  of    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 10. ECONOMIC  RESEARCH   10   prices   and   wages   of   30%   that   undoes   the   loss   of   competitiveness   of   the   periphery would   be   most   likely   associated  with  a  continued  recession  for  five  more  years,  likely  turning  into  a  depression.     Page  |  10   The  international  experience  of   to  a  real  depreciation  and,  after  three  years  of  an  ever-­‐deepening  recession/depression,  it  defaulted  and  exited  its   currency   board   peg.   The   case   of   EZ   periphery:   Output  fell  by  20%  and  unemployment  surged  to  20%;  the  public  debt  was unlike  in  the  EZ  periphery negligible   as  a  percentage  of  GDP  and  thus  a  small  amount  of  official  finance a  few  billion  euros was  enough  to  backstop   the   country   without   the   massive   balance-­‐sheet   effects   of   deflation;   and   the   willingness   of   the   policy   makers   to   sweat  blood  and  tears  to  avoid  falling  into   ,  for  a  while,  unlimited  (as  opposed   to   the   EZ   periphery   unwillingness   to   give   up   altogether   its   fiscal   independence   to   Germany);   and   even   after   devaluation  and  default  was  avoided,  the  current  backlash  against  such  draconian  adjustment  is  now  very  serious   and   risks   undermining   such   efforts   (while,   equivalently,   the   social   and   political   backlash   against   recessionary   austerity  is  coming  to  a  boil  in  the  EZ  periphery).     The   other   cases   of   successful   reductions   of   large   external   and   fiscal   deficits   and   debts   in   the  European   member   states  in  the  1990s Belgium,  Sweden,  Finland,  Denmark,  etc. are  just   example  as  they   occurred   against   a   background   of   growth   (not   the   current   EZ   recession),   falling   interest   rates   as   expectations   of   EMU  led  to  convergence  trades  (not  the  current  blowing  up  of  sovereign  spreads  and  loss  of  market  access)  and,  in   some  cases,  via  nominal  and  real  depreciations  within  the  flexible  terms  of  the   European  Monetary  System  (not   the  rigid  constraints  of  a  monetary  union  where  there  is  no  national  currency  and  the   value  of  the  euro  remains   excessively  strong).     Some  EZ  periphery  members notably  Ireland are  undergoing  a  degree  of  internal  devaluation,  but  it  is  too  slow   and  small  to  rapidly  restore  competitiveness:  A  fall  in  public  wages  may,  in  due  course,  push  down  private  wages  in   traded  sectors  and  eventually  reduce  unit  labor  costs.     Finally,   the   deflation  route  to  real  depreciation even  if  it  were  politically   feasible makes  the  private  and  debt   unsustainability  problem   more  severe:   After  prices  and  wages  have   fallen  30%  after  a   painful  deflation,  the  real   value   of   private   and   public   debts   would   be   30%   higher,   making   the   case   for   a   sharp   reduction   in   unsustainable   debts  even  more  compelling.     Some   EZ   countries notably   Ireland may   have   a   better   chance   of   restoring   their   competitiveness   via   internal   devaluation   than   others Portugal,   Greece,   Cyprus.   Ireland   has   a   large   and   productive   manufacturing   base as   two-­‐thirds   of   its   manufacturing   industry   is   owned   by   multinational   firms many   in   tech   or   high-­‐value-­‐added   sectors that  made  a  lot  of  FDI  in  Ireland  in  the  past  two  decades  to  create  an  industrial  base in  a  low  corporate   tax   economy for   their   European   and   international   production   activities.   So,   Ireland,   with   some   difficulty,   could   regain  its  competitiveness  in  due  time  if  the  fiscal  adjustment  more  rapidly  leads  to  a  change  in  the  relative  prices   of  traded  to  nontraded  goods.     But,  in  the  case  of  Greece,  Portugal  and  Spain,  the  problems  of  competitiveness  are  much  more  chronic  and   un-­‐ resolvable   without   a   nominal   currency   depreciation:   They   have   permanently   lost   export   market   shares   in   labor   intensive  and  low-­‐value-­‐added  sectors textile,  apparel,  leather  products,  light  labor  intensive  manufacturing to   EMs   -­‐value-­‐added   tech  industries  of  Ireland,  for  example.  Also,  in  these  periphery  countries   (unlike   in  Ireland),  productivity  growth    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 11. ECONOMIC  RESEARCH   11   was  mediocre  even  in  the  years  of  positive  economic  growth  and  restoring  comparative  advantage  without  a  sharp   and  rapid  real  depreciation  looks  less  likely  to  be  achievable.     Page  |  11   Spain  and  Italy  are  in  between  Ireland  on  one  side  and  Greece/Portugal/Cyprus:  They  experienced  as  much  of  an   increase  in  unit  labor  costs  as  the  rest  of  the  periphery  (especially  Spain)  and  they  have  permanently  lost  export   market   share   in   traditionally   labor-­‐intensive   sectors.   Italy   has   implemented   more   structural   corporate   restructuring   than   Spain which   restored   some   competitiveness   in   higher-­‐value-­‐added   sectors because   Spain,   growing  rapidly  during  its  unsustainable  real  estate  bubble,  had  little  incentive  to  improve  the  competitiveness  of   its   traded   sector.   Also,   until   recently,   Italy   did   not   have   the   unsustainable   current   account   deficit   of   Spain   as   its   private   saving   compensated   for   the   dis-­‐savings   of   the   public   sectors.   Spain,   instead,   faces   a   massive   stock   of   private   sector   foreign   liabilities held   by   households,   corporate   firms,   banks   and   financial   firms that   are   not   easily  re-­‐financeable  as  an  external  sudden  stop  has  now   occurred.  But,  in  the   past  year,   deficit   has   now   significantly   increased,   despite   depressed   economic   activity:   A   worrisome   signal   of   a   loss   of   competitiveness.     Option  3:  Not  Acceptable  to  the  EZ  Core  as  it  Implies  Permanent  Subsidies  to  a  Large  Part  of  the  Periphery,  I.e.  a   Transfer  Union  Rather  Than  a  Fiscal  Union   Option   1   implies   a   policy   adjustment   that   is   biased   against   Germany/the   core/the   ECB   as   it   implies   that   these   agents/countries  take  on   significant  credit  risk  and  accept   higher  inflation  to  adjust  inter-­‐EZ  real  exchange  rates;   thus,   it   is   unacceptable   to   them.   Option   2   implies   that   all   the   burden   of   adjustment   is   born   by   the   periphery   in   terms  of  many  years  of  fiscal  belt-­‐tightening  and,  worse,  a  deflationary  recession  that  could  turn  into  a  depression.   Thus,   it   eventually   becomes   unacceptable   to   the   EZ   periphery.   Then,   the   periphery   would   be   tempted   to   unilaterally  reduce  its  debt  burdens  via  coercive  debt  restructuring  first  and  via  exit  from  the  EZ  next,  as  exit,  on   top  of  debt  reduction,  becomes  necessary  to  restore  competitiveness  and  growth.     Then,  if  the  EZ  would  want  to  prevent  a  disorderly  break-­‐up  of  the  EZ,  it  would  not  only  have  to  accept  a  reduction   of  the   unsustainable  debts  that  imposes  a  capital  levy  on  the  core  creditors  (something  that  becomes   unavoidable  to  resolve  the  stock  problems),  but,  more  importantly,  it   would  also  have  to  permanently  subsidize   the   chronic  trade  deficits  to  prevent  such  deficits  from  causing  unsustainable  current  account  deficits   that  are  no  longer  financeable.  Thus,  a  unilateral  permanent  fiscal  transfer  by  the  core  to  the  periphery  would  be   necessary  to  boost  the  periphery  GNP  given  its  depressed  GDP  and  maintain  a  current  account  balance  in  both   the  core  and  periphery,  despite  the  persistent  trade  imbalances  between  the  two  regions.  If  Germany/the  EZ  core   were  to  run  a  permanent  trade  surplus  of  say  4-­‐5%  of  GDP  relative  to  that  of  the  EZ  periphery,  then  a  permanent   yearly  transfer  of  up  to  4-­‐5%  of  GDP  from  the   core  to  periphery  would  be  necessary  to   bribe  the  periphery  to   stay  in  the  EZ  rather  than  exit  the  monetary  union.     Such  unilateral  transfers  from  rich  to  poor  regions  are  not  very  common,   the  context  of  nation  states  where  there  is  a  political  union.  In  Italy,  the  north  has  transferred  income  to  the  south   Similarly,  West  Germany  has  paid  for  unification  with  East   Germany  with  massive  transfer  payments  and  government  spending  on  reconstruction  that  have  lasted  for  over  20   years   now   and   that   are   not   over   yet   (like   the   still-­‐existing   income   tax   surtaxes   to   pay   for   massive   reunification   costs).   In   Australia,   the   fiscal   system   permanently   transfers   income   to   Tasmania,   which   is   the   Australian   equivalent in   terms   of   poverty/low   incomes of   the   Italian   Mezzogiorno   or   East   Germany.   But   even   in   the   context  of  unified  nation  states  with  a  common  national  identity,  such  permanent  transfers  become  politically  and   socially   unacceptable   as   the   rich   regions   resent   such   transfers   and   eventually   revolt   against   them:   In   Italy,   for    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 12. ECONOMIC  RESEARCH   12   example,   political   movements   representing   the   rich   north   (notably,   the   Lega   Nord)   have   become   influential   and   are  now  imposing  a  form  of  fiscal  federalism  that  will,  over  time,  significantly  reduce  transfers  from  the  north  to   Page  |  12   the  south.  And  concerns  are  now  being  expressed  that  such  fiscal  reform  will  lead  to  a  sharp  political  backlash  in   the  south;  even,  in  the  extreme,  threats  of  secession  or  national  breakdown.  So,  permanent  unilateral  transfers  of   income   from   rich   to   poor   regions   become   politically   problematic   even   in   a   unified   political   union   with   a   homogenous  national  identity.     This   suggests   that   the   idea   that   Germany   or   the   core   of   the   EZ   would   accept   a   permanent several   percentage   points  of  its  GDP transfer  of  its  income  to  the  periphery  as  a  condition  for  the  periphery  not  exiting  the  EZ  runs   against  political  trends  and  is  extremely  unlikely  to  occur.  The  EU  has  a  system  of  structural  payments  from  rich  to   poor  states  (southern  and  new   eastern  European  members),  but  these  transfers  are  relatively  modest  (less  than   0.5%  of  the   GDP).  Ramping  them  up  by  a  factor  of  10  to  bribe  the  periphery  into  staying  in  the  EZ  would  be   totally   unacceptable politically   and   otherwise to   Germany   and   the   rest   of   the   core.   Also,   it   would   not   make   economic  sense:  Until  now,  the  excess  of  income  (spending)  over  spending  (income)  in  the  core  (periphery)  that   has  taken  the  form  of  a  current  account  surplus  (deficit)  in  the  core  (periphery)  has  been  financed  with  debt  that,   in  principle,  is  an  asset  of  the  core  and  should  be  paid  back  with  interest  by  the  periphery  over  time.     Now,  instead,  the  core  would  have  first  to  accept  a  capital  levy  on  its  accumulated  assets  over  the  periphery  (its   foreign   assets   accumulated   through   decades   of   current   account   surpluses)   to   allow   the   reductions   of   the   unsustainable  foreign  private  and  public  debts.  The  EZ  core  is  now  grudgingly  accepting  some  of  this   capital   levy   (losses   on   EZ   creditors   coming   from   the   debt   reduction   in   Greece),   but   similar   capital   levies   are   unavoidable  for  the  debts  of  Portugal,  Ireland  and  Cyprus,  and  may  become  unavoidable  even  for  Italy  and  Spain.     But  even  this  much  larger  capital  levy  would  not  be  enough  as  the  persistent  chronic  trade  deficit  of  the  periphery   would  next  have  to  be  financed  not  via  debt-­‐creating  flows,  but  rather  unilateral  transfers  within  a  currency  union.   Providing  a  system  of  vendor  financing  from  the  core  to  periphery  may  have  made  sense  for  the  core  for  a  while  to   sustain  its  export  and  GDP  growth  even  if  it  eventually  leads  to  a  capital  levy  when  the  debtor  is  unable  to  pay.  But   a   system   of   unilateral   transfers   from   the   core   to   periphery   where   the   excess   of   spending   over   income   of   the   periphery  is  financed  by  permanent  grants not  loans core:  It  is  a  permanent  reduction  of  income  and  welfare  and  consumption  for  no  sensible  reason  apart  from  the   vague  goal  of  keeping  the  EZ  together.   The  discussion  above  suggests  that  the  usual  recent  argument i.e.  that  the  EZ  needs  to  become  a  fiscal  union  to   survive   its   crisis is   partially   wrong   and   confusing.   There   is   a   substantial   and   critical   difference   between   a   fiscal   union  and  a  transfer  union.  In  a  fiscal  union,  there  is  true  risk-­‐sharing  and  no  permanent  transfer  of  income  from   one  state/region  to  another.  Where  revenues  and  spending  are  partially  shared  at  the  federal  level,  there  is  risk-­‐ sharing:  When  an  idiosyncratic  shock  occurs  in  one  region  (such  as  a  recession  in  one  state  of  the  union,  but  not  in   other  states),  risk-­‐sharing  implies  that  revenues  and  transfers/spending  are  adjusted  to  reduce  the  effect  of  that   temporary  state-­‐specific  shock  to  the  output  (GDP)  of  that  state  on  its  income  (GNP).  If  such  state-­‐specific  shocks   are   random sometimes   hitting   one   region/state,   sometimes   hitting   another   region/state   of   the   union the   worse-­‐off  region  subject  to  the  negative  output  shock  gets  partially  and  temporarily  subsidized  by  the  region/state   that   is   temporarily   better   off.   And   over   time like   in   any   actuarially   fair   insurance   scheme mutual   insurance   smoothes  shocks  to  income  that  are  driven  by  shocks  to  output.  No  region/state  permanently  subsidizes  another   one.  This  is  a  fiscal  union  where  risk  is  pooled  and  shared.    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 13. ECONOMIC  RESEARCH   13   A   transfer   union   is   a   very   different   animal:   it   is   not   a   fiscal   union   aimed   at   sharing,   insuring   and   smoothing   temporary  regional  output  shocks.  It  is  instead  a  mechanism  that  uses  fiscal  resources taxes,  transfer  payments   Page  |  13   and  public  spending to  permanently  transfer  income  from  richer  region/states  to  poorer  regions/states.  Transfer   unions  are  politically  problematic  even  in  unified  nations  that  are  political  unions  and  are  nationally  homogenous.   They  are  much  more  problematic  when  a  political  union  does  not  exist  and  where  the  arguments  for  a  permanent   transfer  union  are  not  acceptable.  For  a  German  to  accept  a  permanent  transfer  of  her  income  to  the  Greeks  as  a       because   they   breed   moral   hazard.   Even   if   one  could   make   the   argument   that  initial  differences  in  per-­‐capita  income  between  different  regions/states  of  an  economic  union  were  explained   by  exogenous  factors  different  from  endogenous  policy/economic  efforts,  the  existence  of  a  permanent  transfer   union   would   obviously   breed over   time moral   hazard.   The   weak/poor   region   might   not   want   to   make   much   economic/policy/fiscal  effort  to  improve  its  economic/fiscal  conditions  as  it  is  permanently  subsidized  by  the  richer   region.     Moral   hazard   is   thus   the   reason   why   fiscal   unions   come   with   binding   rules   that   limit   the   risk   attached   to   the   transferee  being  fiscally  undisciplined,  to  prevent  a  fiscal  union  becoming  a  transfer  union.  This  is  also  the  reason   why   the   current   efforts   of   Germany/the   core   EZ   to   help   the   periphery   are   subject   to   strict   fiscal   and   structural   conditionality:  Only  if  the  periphery  does  significant  and  painful  fiscal  austerity  and  structural  reforms,  will  the  core   help  the  periphery  to  overcome  its  temporary  fiscal  and  financial  problems.  This  is  also  the  reason  why  any  inter-­‐ EZ   debate   on   future   quasi   or   full   fiscal   union   comes   with   the   express   request   by   Germany/the   core   for   binding   fiscal   rules   (balanced   budgets   over   time,   balanced   budget   amendments,   sanctions   against   deviant   states)   to   prevent  such  a  fiscal  union  from  turning  into  a  transfer  union.   In  conclusion,  Option  3  is  highly  unlikely  and  undesirable  for  the  core  EZ  as  it  would  imply  the  creation  of  a  transfer   union,  rather  than  a  fiscal  union.  But  if  Option  2 deflationary  depression is  unacceptable  to  the  periphery,  only   a   transfer   union   prevents   the   periphery   from   being   tempted   to   avoid   a   persistent   recession,   from   considering   exiting  the  monetary  union  and  restoring  its  growth  and  competitiveness  via  a  return  to  its  national  currency.   Option   4:   Widespread   Debt   Reductions   and   Eventual   EZ   Break-­‐Up Becomes   the   More   Likely   Outcome   as   the   Other  Three  Options  Are  Not  Likely  or  They  Are  Not  Desirable  or  Sustainable   The   core   of   the   EZ   is   unlikely   accept   a   symmetric   adjustment Option   1 that   restores   competitiveness   and   growth  in  the  periphery  via  monetary  and  fiscal  easing  and  a  weaker  euro  that  implies  higher  inflation  for  a  period   of   time   in   the   core,   a   persistent   LOLR   role   for   the   ECB   and   significant   credit   risk   for   the   core   if   some   periphery   members  end  up  being  both  illiquid  and  insolvent.  It  is  instead  pushing  for  Option  2,  recessionary  deflation  in  the   periphery,  which  is  not  politically  acceptable  in  most  of  the  periphery.  Then,  the  only  way  to  keep  the  periphery  in   the  EZ  becomes  both  a  capital  levy  on  the  core  creditors  to  make  the  debts  of  the  periphery  sustainable  and,  on   top   of   that,   unilateral   transfers   in   the   form   of   a   transfer   union   that   permanently   subsidizes   the   depressed   income of  the  EZ  periphery  (caused  by  the  permanent  loss  of  competitiveness  that  remaining  in  the  EZ  implies).     But  such  a  transfer  union  is  not  politically  or  economically  acceptable  to  the   core.  Then,  the  only  other  option  is   first   a   capital   levy   imposed   by   the   periphery   on   the   core in   the   form   of   a   reduction   of   unsustainable   foreign   private  and  public  liabilities to  reduce  such  unsustainable  debt.  But  even  that  debt  reduction  is  not  sufficient  to   restore  competitiveness  and  growth.  And  if  competitiveness  cannot  be  restored  via  Option  1  (a  much  weaker  euro),   or  Option  2  (depressive  deflation  or  too-­‐slow  structural  reform)  or  Option  3  (where  the  incipient  permanent  loss  of    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 14. ECONOMIC  RESEARCH   14   income  via  a  permanent  loss  of  competitiveness  is  permanently  subsidized  by  the  core  via  a  transfer  union),  the   only  other  option  left  is  the  one  of  exiting  the  monetary  union  and  restoring  growth/competitiveness  via  nominal   Page  |  14   and  real  depreciation  resulting  from  ditching  the  euro  and  returning  to  a  national  currency.   Exiting   the   monetary   union   is   not   a   costless   action,   including among   other   problems the   complex   and   costly   process   of   converting   previous   euro   assets   and   liabilities   into   the   new   national   currency   i.e.     Greece  Should  Default  and  Abandon  the  Euro ,  I  discussed   the  pros  and  cons  of  returning  to  a  national  currency  and  how  to  limit  both  the  collateral  damage  of  a  unilateral   exit  and  of  the  contagion  from  such  an  exit  to  the  remaining  EZ  members.     Arguing  that  the  EZ  may  eventually  break  up  usually  leads  to  angry  reactions  among  the  supporters  of  the  EZ  who   argue  that  such  an  option  would  lead   to  disastrous  consequences  for  the  exiting  country,  the  other  EZ  members   and  the  overall  global  economy.   -­‐up  could  be  a  shock   as  severe or  even   more  severe than  the  disorderly  bankruptcy  of  Lehman  Brothers.  But  as  the   Lehman  example  shows,  disorderly   shocks  do  occur  from  time  to  time.  And  the  history  of  financial  crises  suggests  that  very  costly  crises  do  occur  with   a  virulence  and  frequency  that  is  rising.  So,  arguing  that  a  break-­‐up  of  the  EZ  is  impossible  to  fathom  is  not  logical.     Also,  the  oft-­‐heard  argument  that  the  EZ  was  more  a  political  project unifying  Europe  and  permanently  roping  in   Germany   in   a   European   construct than   an   economic   one   and   thus   it   will   survive   regardless   of   its   economic   viability  is  a  logical  non-­‐sequitur.  Political  considerations  may  lead  the  EZ  to  last  longer  or  reduce everything  else   equal the   probability   of   a   break-­‐up.   If   a   monetary   union  becomes  unsustainable  it  will  eventually  break  up,  regardless  of  its  political  benefits.   Which  Outcome  Is  Most  Likely?  Further  Sequential  Debt  Restructurings  and  a  Partial  Break-­‐Up   Also,   we   have   not   argued   that   a   break-­‐up   is   the   only   feasible   outcome.   Option   1   restores   growth   and   competitiveness  via  an  adjustment  that  is  more  symmetric  than  asymmetric both  the  core  and  periphery  need  to   make  some  sacrifices  to  allow  the  survival  of  the  EZ.  And,  eventually,  both  Germany  and  the  ECB  may  accept  such  a   more  symmetric  option  rather  than  let  the  EZ  be  destroyed  if  political  considerations  are  important  in  considering   the  costs  and  benefits  of  alternative  policy  options.  Also,  internal  devaluation  plus  structural  reform  may  work  for   some  EZ  members  such  as  Ireland.  A  formal  transfer  union  is  unlikely,  but  the  core  is  willing  to  accept  some  stock   capital  levy  on  its  claims  on  the  periphery debt  reduction  for  Greece  and  possibly  other  EZ  members and  it  may   accept   some   partial   transfer   payments various   bailouts   that   have   a   subsidy   component   embedded   in   them if   the  periphery  makes  policy  efforts  (both  fiscal  and  structural)  to  fix  some  of  its  problems.  And  arrangements  that   start   as   quasi-­‐fiscal   unions   have   a   tendency over   time to   absorb   components   of   a   partial   transfer   union   (an   incentive-­‐compatible  or  moral-­‐hazard-­‐proof  form  of  a  partial  transfer  union).     Also,  note  that  Option  4  can  be  something  short  of  a  formal  full  break-­‐up  of  the  EZ.  In  some  variants  of  Option  4,   only  some  of  the  weakest  members  of  the  EZ  exit:  Greece,  Portugal  and  Cyprus.  Suppose  that  Italy  and  Spain  were   to  be  successfully  ring-­‐fenced:  i.e.  buying  a  year  of  time  via  the  bazooka  of  the  levered  EFSF  were  to  be  sufficient   for  Italy  and  Spain  to  undertake  credible  fiscal  austerity  and  reforms,  change  their  governments  to  more  credible   ones   and   partially   restore   their   growth   and   competitiveness   so   that   a   year   from   now   they   can   borrow   at   sustainable  spreads  without  any  additional  official  support.  Then,  if  Italy  and  Spain  are  out  of  the  woods  and  a  year   from  now  Greece  and/or  Portugal/Cyprus  require  not  just  debt  reduction,  but  also  exit  from  the  EZ,  a  smaller  EZ   without   Greece  and/or  the  other  two   weak   members   would  be   feasible  and  manageable.  If  two  or  three  of  the   smallest   members   were  to  exit  while  Italy  and  Spain   were   able  to   survive  and  eventually  thrive   within  the  EZ,  a    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 15. ECONOMIC  RESEARCH   15   partial   break-­‐up   of   the   EZ   would   be   feasible   and   possible   without   destroying   the   entire   monetary   union.   But   if   either  Italy  and/or  Spain  were  to  need  a  coercive  restructuring  of  their  public  debt  and,  even  after  that  disruptive   Page  |  15   action,   would   still   need   exit   to   restore   growth/competitiveness,   than   an   effective   break-­‐up   of   the   EZ   would   become  likely.  Even  then,  Germany  and  a  small  group  of  core  countries  might  maintain  a  monetary  union.  But  in   that  outcome,  it  is  not  obvious  that  even  the  fiscally  and  structurally  fragile  and  reform-­‐less  France which  would   lose   its   triple-­‐A   status   and   also   become   the   victim   of   severe   collateral   damage   and   contagion   from   debt   restructurings  and/or  exit  of  Italy/Spain   Political  Benefits  of  the  EZ  May  Not  Trump  Its  Eventual  Economic  Costs   Regarding   the   political   costs   of   a   break-­‐up   of   the   EZ,   it   is   clear   that   Germany   and   France and   other   core   EZ   members would   be   seriously   damaged   by   such   a   break-­‐up   and   would   see   the   major   project   of   economic   and   eventual  political  unification  of  Europe  destroyed.  But  Europe  and  the  EU  would  not  be  destroyed  even  if  the  EZ   were  to  partially  or  fully  break  up.  Some  EU  members  never  joined  or  were  allowed  to  opt  out  of  the  EZ  (Sweden,   Denmark   and  the  UK)  and  some   eastern/central  members  of  the  EU  may  never  qualify  to  join  the  EZ.   So,  an  EU   where  some  countries  are  members  of  the  EZ  and  others  are  not  is  totally  feasible  and  better  and  more  viable  than   an  EZ  that  includes  some  members  that  should  have  never  joined  in  the  first  place.     In  spite  of  the  political  benefits  of  the  EZ  and  the  political  costs  of  a  break-­‐up,  neither  Germany/the  core  nor  the   periphery   would   accept   the   costs   of   a   persistent   EZ   if   its   economic/financial   costs   were   to   hugely   exceed   its   benefits.  It  is  clear  that  Germany  is  ready  to  pull  the  plug  on  Greece and  if  necessary  on  Portugal  and  Cyprus if   Italy  and  Spain  are  successfully  ring-­‐fenced.  Germany/the  core  has  already  accepted  the  principle  and  practice  of   accepting  a  capital  levy  on  its  assets those  of  the  private  German  creditors  of  Greece rather  than  further  fully   socialize  the  cost  of  a   full  and  persistent  bailout  of  an  insolvent   sovereign  such  as  Greece.  It  would  be  willing  to   accept  similar  capital  levies  on  its  claims  of  other  near-­‐insolvent  small  EZ  members  such  as  Portugal  and  Cyprus.   Germany  would  also  accept and  even  manage an  orderly  exit  of  Greece  and  other  smaller  EZ  member  from  the   monetary  union  if/when  Italy  and  Spain  are  successfully  ring-­‐fenced.  So,  a  smaller  EZ  is  still  possible  and  viable.     The  open  issue  is  what  Germany  will  do  a  year  from  now  if,  after  an  attempt  to  provide  catalytic  finance  to  Italy   and  Spain  via  a  levered  EFSF,  either  Italy  and/or  Spain  are  not  able  to  borrow  at  sustainable  rates  without  official   support   if   their   growth   and   competitiveness   and   sovereign   viability   are   not   otherwise   restored.   Would   Germany/the  core  double  down  and  try  for  another  year   of   Plan  A catalytic  finance  of  even   larger  size when   that  approach  has  already  failed  once  or  would  it  opt  for  the  preferable  Plan  B  (debt  restructuring,  eventual  exit)?   The  German  Assessment  of  the  Costs  and  Benefits  of  the  EZ   The  usual  argument  is  made  that  even  Germany   then  would  have  no  choice  to  again  backstop  Italy  and  Spain  as   the  alternative collapse  of  the  EZ would  be  even  more  costly  to  Germany  and  the  global  economy.  But  if  Plan   A assuming   that   Italy   and   Spain   are   illiquid   but   solvent   given   time,   financing   and   adjustment has   failed,   then   what   is   the   purpose for   Germany/the   core   or   even   the   international   community   (IMF/the   U.S./the   BRICs)   of   doubling  down  on  a  failed  strategy?   Germany  and  the  ECB  have  so  far  hoped  that  their  view  of  the  crisis  is  correct:  The  periphery  is  in  trouble  because   of   a   lack   of   fiscal   discipline   and   structural   reforms.   So,   fiscal   discipline   and   structural   reforms   are   the   necessary   solutions  even  if  they  imply   painful  adjustment   and  sacrifices   for  the  periphery  for  a   number  of  years.  Germany   and   the   ECB   may   turn   out   to   be   right,   but   this   paper   suggests   that   the   painful   medicine   will   be however    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 16. ECONOMIC  RESEARCH   16   necessary  over  the  medium  term too  painful  and  recessionary  in  the  short  run  and  for  long  enough  that  it  will   not   be   viable.   Also,   the   fundamental   loss   of   competitiveness manifesting   itself   in   now   Page  |  16   unsustainably  large  current  account  deficits requires  a  real  depreciation  that  will  not  be  achieved  quickly  enough   with  reforms  and  deflation  that  depress  output  for  too  long  before  they  restore  growth.  Thus,  debt  reductions  and   real  depreciation  via  an  EZ  exit  and  a  return  to  national  currencies  will  become however  costly unavoidable  and   less  painful  than  the  alternative  of  recessionary  deflation.     Then,  if  this  analysis  is  correct,  Germany  will  eventually  have  to  make  tough  choices:  Either  allow  a  strategy  that   changes  the  nature  of  the  ECB  and  restores  growth  through  a  weaker  euro  and  higher  inflation  in  Germany  for  a   period   of   time;   or   permanently   subsidize   the   depressed   EZ   periphery;   or   allow   the   debt   reductions   of   most   periphery   members   and   their   exits   from   the   EZ.   Again,   if   only   a   small   Greece   and/or   Portugal/Cyprus   exits,   the   process   would   be however   costly   and   ugly in   spite   of   all   current   adjustment  and  financing  efforts Italy  and/or  Spain,  Germany/the  core  EZ  could  find  that  further  backstopping  of   Italy/Spain   would   be   too   costly   and   mission   impossible   make  it  more  successful.   Indeed,  soon  enough,  Germany   would  have  to   worry  about   its  own   fiscal  sustainability  and  the  risks   involved  in   endlessly  backstopping  more  EZ  members.  Today,  its    But  even   Germany  has  a  large  fiscal  deficit  and  a  large  stock  of  public  debt.  And,  given  the  ageing  of  its  population,  it  also   has   additional   implicit   long-­‐term   fiscal   debts/liabilities.   Add   to   that   the   fiscal   cost   of   recapitalizing   many   of   its   insolvent  or  near-­‐insolvent  financial  institutions:  The  Landesbanken,  IKB,  West  LB,  Commerzbank  and  others.  The   German   taxpayers   money   is   now   also   partially   backstopping   the   public   debt   of   Greece,   Ireland   and   Portugal   through  the  IMF,  EFSF,  EFSM  and  ECB.     300  billion.  The  public  debt  of  Italy  and  Spain  is  close  to   3  trillion,  or  10   times   that   of   Greece.   Germany   will   now via   the   expanded   and   levered   EFSF partially   guarantee   part   of   the   Italian  and  Spanish  debt.  But  about   200  billion  of  the  implicit  liabilities  of  a  levered  EFSF  is  already  a  large  risk  for   an  overleveraged  Germany.  If,  a   year  from  now,  the  bazooka  of  the  levered  EFSF  has   not   worked  to  restore  the   sustainability  of  Italy  and/or  Spain,  the  idea  that  Germany  would  accept  taking  an  additional   3  trillion  credit  risk   by   fully   backstopping   Italy   and   Spain   is   quite   far-­‐fetched.   Since   Germany   needs   to   consider   that,   under   some   to  exit,   Germany  must  protect  itself  now  for  the  fallout  that  a  disorderly  break-­‐up  of  the  EZ  would  entail.     And   some   of   the   caution   that   Germany   has   shown   in   terms   of   committing   more   financial   resources   to   backstopping   the   periphery   has   to   do   with   the   German   need   to   save   some   precious   bullets or   some   dry   powder in  case  all  goes  wrong  and  the  EZ  breaks  up.  Using  all  of  its  chips  now  to  backstop  the  periphery  would   not  be  rational  for  Germany,  even  if  doing  so  raises  the  odds  of  Italy  and  Spain  eventually  getting  out  of  the  woods.   Keeping   some   powder   dry   for   the   extreme   tail   scenarios   is   a   rational   strategy   for   Germany   and   the   core   as   the   financial  and  economic  fallout  and  costs  of  a  break-­‐up  would  also  be  severe  for  them.     Cost-­‐Benefit  Analysis  of  EZ  Membership  for  the  EZ  Periphery     A  similar  cost-­‐benefit  analysis  of  staying  in  the  monetary  union  applies  to  the  periphery  members.  Currently,  none   of  them  not  even  hopeless  Greece is  seriously  considering  exiting  the  monetary  union.  But,  as  we  have  argued   above,  if  Germany/the  ECB  insist  on  an  adjustment  that  is  deflationary/recessionary,  the  social/political  backlash   against   that   depressionary   adjustment   may   become   overwhelming.   Already   in   Greece,   daily   demonstrations,    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 17. ECONOMIC  RESEARCH   17   strikes  and  other  popular  resentment  against  the  austerity  may  lead  the  government  to  collapse  in  the  next  few   months;  and  this  scenario  is  becoming  more  likely  as  there  will  now   be  a  referendum  on  the  austerity  measures,   Page  |  17   with  all  the  attached  risks.  Then,  if  Greece  goes  even  further  off  track  in  terms  of  its  commitments  to   troika creditors  (the  IMF,  EU  and  ECB),  the  troika  would  have  to  pull  the  plug  on  Greece  and  a  disorderly  default  and  exit   from  the  union  would  become  inevitable.  Even  if  exit  is  postponed  for  another  year,  chronic  and  ever-­‐deepening   recession  will  sooner  rather  than  later  trigger  a  government  collapse  and  a  possible  exit  from  the  EZ.   Also,  the  alleged  benefits  of  remaining  in  the  EZ  may  now  be  less  convincing  for  most  periphery  members:  Initially,   the  EZ  led  to  interest  rate  convergence  when  market  discipline  was  not  operational;  this  was  a  significant  benefit   as   nominal   and   real   interest   rates   were   low   and   falling   and   making   the   cost   of   debt   for   both  private   and   public   sectors  low.  Now,  with  market  discipline  in  full  swing  and  sovereign  spreads  high  and  rising,  this  major  benefit  of   the   monetary   union   has   disappeared   and   has   rather   become   a   major   cost/burden.   Worse,   remaining   in   the   EZ   implies  ceding  from  now  on  a  significant  part  of if  not  all fiscal  autonomy  to  the  core:  Soon  enough,  the  troika   will   decide   most   of   the   taxation   and   government   spending   in   the   periphery,   including   social   safety   nets,   social   security   systems   and   the   matters   and   details   of   the   privatization   of   public   assets.   Germany/the   core   may   also   effectively  take  over  part  of  the   financial  systems  if  the  only  way  to  recapitalize  periphery  banks  is  by   using  EFSF  resources.  Also,  the   monetary  and  exchange  rate  policies  have  now  clearly  gained after  over  a   decade   of   experience an   anti-­‐growth   and   an   anti-­‐competitiveness   bias,   focusing   instead   on   the   strict   achievement  of  price  stability.  When  national  currencies  existed,  rising  differentials  in  competitiveness because   of  differentials  in  unit  labor  costs could  from  time  to  time  be  remedied  through  nominal  and  real  depreciation  of   national  currencies.  Now,  that  benefit  is  gone  and  only  recessionary  deflation  is  available.     Cost  of  EZ  Membership  May  Eventually  Outweigh  Benefits,  Thus  Triggering  Exit   So,  what  are  the  alleged  benefits  of  staying  in  the  monetary  union  if  the  costs  seem  to  be  rising  while  the  benefits   are   shrinking?   Periphery   members   are   still   blinded   by   the   potential   stigma   of   an   embarrassing   exit,   especially   policy  makers  who  would  lose  power  if  a  shameful  exit  that  suggests  failure  were  to  occur.  So,  they  are  desperately   avoiding   even   the   thought   of   exit   rather   than   seriously   and   rationally   considering   its   benefits   as   well   as   its   considerable but   manageable costs.   But   populations   will   not   meekly   accept   year   after   year   of   sacrifices,   job   losses,  rising  unemployment  and  hopelessness  about  an  economic  recovery.  If  there  is  no  light  at  the  end  of  the   tunnel  or  the  only  light  is   from  the  approaching  train  wreck  of  a  deflationary  recession  with  no  hope   of  a   short-­‐ term   recovery,   debt   reductions   and   exits   from   the   monetary   union   will   become   necessary,   desirable   and   unavoidable.   Options  and  Scenarios  for  the  EZ  (see  map  below)   In  a  recent  RGE  piece  ( The  Last  Shot  on  Goal:  Will  Eurozone  Leaders  Succeed  in  Ending  the  Crisis?,  co-­‐authored   with  Megan  Greene),  we  outlined  three  possible  scenarios  for  the  EZ  in  the  next  12-­‐24  months.  In  Scenario  1,  the   current   EZ   plan   somehow   works   and   Italy   and   Spain   are   successfully   ring-­‐fenced   via   the   levered   EFSF   and   exogenous   factors   that   restore   growth   after   a   2012   recession.   Then   Greece   and/or   Portugal/Cyprus   experience   debt  reductions  and  possibly  exit  the  EZ,  but  the  EZ  survives  if  Italy  and  Spain  survive  and  thrive.  In  Scenario  2,  Plan   A  does  not  work  and,  once  the  levered  EFSF  bazooka  has  run  out  of  money  and  pressure  on   Italian  and  Spanish   spreads   has   not   abated   as   recession   becomes   entrenched,   Italy   and   Spain   may   have   to   experience   debt   restructuring   and   eventually   even   exit   the   EZ.   Even   in   Scenario   2,   once   Plan   A   has   failed   a   year   from   now,   Germany/the  core/the  ECB/the  international  community  could  still  double  down  on  keeping  Italy  and  Spain  afloat   even   if   that   becomes   unlikely   and   very   expensive   if   Plan   A   (catalytic   finance)   has   failed.   In   Scenario   3,   things    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 18. ECONOMIC  RESEARCH   18   unravel   for   the   EZ   inside   12   months   as   a   disorderly   collapse   of   Greece   prevents   Plan   A   (buy   time   on   Greece   by   keeping  it  on  life  support  until  Italy  and  Spain  are  successfully  ring-­‐fenced  and  then  pull  the  plug)  from  even  being   Page  |  18   tried,  before  it  is  given  a  chance  to  succeed  (Scenario  1)  or  fail  (Scenario  2).       In  terms  of  the  four  options  in  this  paper,  Option  4  is  analogous  to  Scenario  3  (widespread  defaults  and  the  break-­‐ up  of  the  EZ),  which  in  our  view  will  become  more  likely  over  time.  Scenario  1  is,  in  our  view  likely  to  succeed  only   if  Option  1  (macro  policy  reflation  of  the  EZ)  is  implemented  soon,  yet  Germany/the  core/the  ECB  want  to  achieve   Scenario   1   by   implementing   Option   2   (deflation,   austerity   and   reforms).   We   have   argued   that   Option   2   is   very   unlikely  to  lead  to  Scenario  1  for  most  EZ  periphery  members  as  it  will  lead  to  entrenched  recession  that  will  last   for  years  and  a   too-­‐slow  restoration  of  competitiveness.   Option  3  is  not   politically   feasible  as  it   implies  that  the   core   accepts   both   a   massive   capital   levy   on   its   current   claims   on   the   periphery   and   an   additional   permanent   notional   Scenario  4  to  which  we  assign   a  near-­‐zero  probability  in  our  scenario  analysis.     Of  course,  among  the  six  eurozone  countries  in  trouble  so  far  (Greece,  Portugal,  Ireland,  Cyprus,  Spain  and  Italy),  a   subset  of  them  will  experience  restructurings  and  reductions  of   their  public  debts  and  private  debts  as  a   way  to   resolve  their  stock  imbalances.  And  a  different  subset  of  these  six  countries  may  also  eventually  decide  to  exit  to   resolve   their   flow   imbalances.   So,   many   different   permutations   and   combinations   of   outcomes/scenarios   are   possible.   But   our   four   options   and   the   related   policies   associated   with   them   provide   a   map   of   how   one   can   potentially  resolve  stock  and  flow  imbalances  in  the  EZ.  And  our  three  scenarios  provide  a  timeline  of  how,  over   the   next   12-­‐24   months,   economic   and   financial   conditions   will   evolve   in   the   EZ.   Some   countries   will   for   sure   restructure  their  debts  and  some  will  most  likely  exit  the  EZ.  If  enough  of  them  restructure  and  exit especially  the   two  big  ones  in  the  periphery  (Italy  and  Spain) this  would  effectively  represent  a  break-­‐up  of  the  EZ.    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.    
  • 19. ECONOMIC  RESEARCH   19   Our  point  is  that  we  cannot  rule  out  Option  4  becoming  more  likely:  i.e.  Scenarios  2  and/or  3  materialize,  so  the   next  steps  of  these  scenarios  are  widespread  debt  restructuring  and  eventual  exit  from  the  EZ  of  enough  member   Page  |  19   states  such  that  a  break-­‐up  of  the  EZ  turns  out  to  be  necessary  and  unavoidable.  In  terms  of  this  non-­‐linear  set  of   scenarios,  the  periphery  will  push  for  Options  1  or  3  as  a  way  to  avoid  Option  4;  but  if  Germany/the  core/the  ECB   stick  with  Option  2,  Scenarios  2  or  3  rather  than  1  will  materialize  and  the  EZ  will  eventually  end  up  with  Option  4,   i.e.  debt  reductions,  exit  from  the  monetary  union  and  the  break-­‐up  of  the  monetary  union.     This  paper and   its  companion   piece outlines  the  options  available  to  the  EZ,   the  accompanying  policy  actions   and  the  scenarios  that  will  result  from  the  complex,  dynamic,  high-­‐stakes  game  being  played.  Various  options  are   available   at   each   node,   with   the   chosen   policies   leading   to   a   variety   of   different   outcomes,   grouped   under   our   three  main  scenarios.                                       The  above  content  is  offered  for  the  exclusive  use  of  RGEs  clients.  No  forwarding,  reprinting,  republication  or  any  other  redistribution  of  this  content  is  permissible   without  expressed  consent  of  Roubini  Global  Economics,  LLC.  All  rights  reserved.  If  you  have  received  access  to  this  content  in  error,  RGE  reserves  the  right  to  enforce   its   copyright   and   pursue   other   redress.   RGE   is   not   a   certified   investment   advisory   service   and   aims   to   create   an   intellectual   framework   for   informed   financial   decisions  by  its  clients.  This  content  is  for  informational  purposes  only  and  does  not  constitute,  and  may  not  be  relied  on  a s,  investment  advice  or  a  recommendation   of   any   investment   or   trading   strategy.   This   information   is   intended   for   sophisticated   professional   investors   who   will   exercise   their   own   judgment   and   will   independently  evaluate  factors  bearing  on  the  suitability  of  any  investment  or  trading  strategy.  Information  and   views,  including  any  changes  or  updates,  may  be   made  available  first  to  certain  RGE  clients  and  others  at  RGEs  discretion.  Roubini  Global  Economics,  LLC  is  not  an  investment  adviser.   For  questions  about  reprints  or  permission  to  excerpt  or  redistribute  RGE  content,  or  for  a  PDF  version,  clients  should  contact  their  RGE  account  representative.    NEW  YORK  -­‐  95  Morton  Street,  6th  Floor,  New  York,  NY  10014  |  TEL:  212  645  0010  |  FAX:  212  645  0023  |    LONDON  -­‐  174-­‐177  High  Holborn,  7th  Floor,  London  WC1V  7AA  |  TEL:  44  207  420  2800  |  FAX:  44  207  836  5362  |  |  ©  Roubini  Global  Economics  2011    All  Rights  Reserved.  No  duplication  or  redistribution  of  this  document  is  permitted  without  written  consent.