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Journal of Regulation & Risk - North Asia Volume II, Summer/Fall edition 2010

Journal of Regulation & Risk - North Asia Volume II, Summer/Fall edition 2010

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The Journal of Regulation & Risk - North Asia is a B2B quarterly publication focusing on governance, risk management and compliance issues within financial services.
It is published out of Hong Kong and distributed widely to professional in North East Asia and globally.
Please note, this is a pre-print Edition and still contains a few errors, the actually fully proof print edition will be hosted later on this website.
The Journal of Regulation & Risk - North Asia is a B2B quarterly publication focusing on governance, risk management and compliance issues within financial services.
It is published out of Hong Kong and distributed widely to professional in North East Asia and globally.
Please note, this is a pre-print Edition and still contains a few errors, the actually fully proof print edition will be hosted later on this website.

More info:

Published by: Christopher Dale Rogers on Sep 03, 2010
Copyright:Attribution Non-commercial


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Prof Christian Fahrholz & Dr Cezary
Wójcik examine the implications of the
global fnancial crisis for the euro area.

the unprecedented globally co-ordi-
nated stimuli programmes in the after-
math of the 2008 fnancial crisis averted
an economic depression on par with that
of the 1930s. however, such huge inter-
vention, much of it with borrowed funds,
has led to a secondary crisis, this time
focused on sovereign debt as countries
begin the onerous task of slashing public
expenditure in order to release funds to
service national debt repayments.

The challenges associated with this pro-
cess are particularly acute in the Euro-zone
bloc of countries, with one of its members,
Greece, struggling to avoid defaulting on its
debt repayments. This issue has resulted in
a domino effect afficting Portugal, Ireland,
Italy, Spain and Greece itself and marks the
greatest challenge the European Monetary
Union (EMU) has faced since its inception.
In this paper, the authors examine the
current nature of the Greek debt crisis and
how this informs the constitution of the
EMU and its future development if the Euro
is to survive another 10 years.
Governments the world-over reacted

to the fnancial crisis by sharply increas-
ing public defcits to fund major stimulus
packages, with many of these same coun-
tries seeing their national defcits rise above
six per cent of GDP. In the more advanced
western economies whose fscal stimuli pro-
grammes were more aggressive debt levels
rose to some nine per cent – compared with
an average of four per cent for developing
economies (cf. IMF 2010).
Concurrent with these massive govern-
ment interventions, many central backs
across the world adopted a near zero inter-
est rate policy, whilst also easing access to
their liquidity windows by accepting a much
broader class of assets for their open mar-
ket operations for longer time frames than
prior to the crisis. Other unusual methods
adopted to stave off catastrophe included the
introduction of quantitative easing by the US
Federal Reserve and the Bank of England –
where by both institutions have engaged
directly in purchasing government bonds.
As a consequence of all this monetary eas-
ing, central bank assets ballooned to all-time
record fgures as seen in fgure 2 overleaf.
This monetary policy thus far has not

Journal of Regulation & Risk North Asia


Figure 1. Fiscal balance, 2000-2014 (projected)

Source: World Economic Outlook, IMF, October 2009

Figure 2. Total assets/liabilities of selected central banks (US$ billions),
May 2006-April, 2010

Sources: Bank of England, Bank of Japan, European Central Bank, US Federal Reserve

Journal of Regulation & Risk North Asia


created too many infationary forces due to
the fact that a large proportion of the funds
have been utilised to restore commercial
banks balance sheets in order to prevent a
defationary rout – although it remains to be
seen if such actions will result in infationary
pressures. However, fscal problems have
already surfaced in some economies, with
many of these adopting austerity measures
to prevent a sovereign debt run in the mar-
kets and as such, now threaten the nascent
global recovery as countries cut back on

Nowhere is this currently better illus-
trated than in the European Union, specif-
cally the Euro bloc of nations, with one of its
own members, Greece, verging on the brink
of a sovereign debt default – this despite mas-
sive European Central Bank interventions.
Many commentators have even suggested

that Greece’s current woes could result in the
implosion of the Euro and the collapse of the
EMU which poses a signifcant risk not only
to Europe, but to the global economy itself
as highlighted by Fahrholz and Kern in 2009
and Fell in 2010.
The current Euro and Greek crisis thus
begs four important questions, namely:
What are the roots of the current Greek
problems within EMU? What is the short-
term response of EMU countries to such a
Greek-type crisis? What does the Greek
crisis tell us about the construction of the
EMU? What should be done to safeguard
the EMU and the euro in the long-run?
With regard to the frst question, it is
important to note that while the global crisis
has been a trigger, the Greek problems are
primarily home-grown. Accor ding to the
latest European Statistical Offce estimates,

Figure 3. Spreads of Greek, Irish, Spanish and Polish government bond yields over
German government bond yields, 1998-2009

Source: Bloomberg

Journal of Regulation & Risk North Asia


Greece’s fscal defcit reached a whopping
13.6 per cent of GDP last year. As a result,
the overall public debt is currently running at
some 115 per cent of GDP. At the same time,
GDP growth remains in a negative trajectory
as the country remains uncompetitive with
its major trading partners vis-a-vis the EU. In
the past two years alone, its unit labour costs
increased by more than 20 per cent relative
to its main trading partners, with its current
account defcit increasing to some 12 per
cent of GDP.

EMU shortcomings

Greece’s problems, though, cannot entirely
be blamed on its own actions, particularly
given numerous shortcomings in the EMU
framework, specifcally with regard to the
Stability Pact, which, in theory at least, should
work pre-emptively to mitigate against a
Greek-style debt problem – this plainly not
being not the case in this instance.
Moreover, current developments can be
partly traced back to a speedy catch-up pro-
cess, that coupled with EMU membership
led to the risk premium in peripheral EU
countries, such as Greece, to drop to excep-
tionally low levels. Again, revert to fgure 2.
The resultant low costs of funding, in
turn, led debtors and creditors to engage in
excessive lending and indebtedness. This
applies equally to the public and the private
sector and is certainly not limited to the
European sphere.
As a member of the EMU, member coun-
tries have limited scope for active policies to
correct this problem, specifcally by resorting
to a currency devaluation to help ease any
fscal adjustments and restore international
competitiveness. As such, member countries

are forced to adopt a painful internal pro-
cess of devaluation, such as the lowering of
nominal wages.

Ratings downgrade

As a consequence of this ongoing defation-
ary process, Greece has been hit by several
downgrades of its government debt ratings
since the beginning of 2010, with markets
showing considerable unease to the extent
that the yield spreads of Greek government
bonds skyrocketed to above 1,000 basis
points relative to German yields – this being
considerably higher than spreads on those
Eastern European countries who have yet to
join the EMU (see fgure 2).
This leads us to the second question:
what is the short-term response of the EMU
countries to a Greek-type crisis?
Despite the crisis, it took the European
Commission, ECB and Euro-bloc mem-
ber countries a signifcant period of time
to agree on any emergency bail-out efforts,
and only then in co-operation with the IMF.
The resultant agreed package of emergency
assistance extends to funds from both EU
members and the IMF, ameliorated with
an exceptional credit guarantee line – the
Special Purpose Vehicle – amounting to €750
billion (approximately US$ 995 billion).

Stabalisation plan

The three-year stabilisation plan includes
€60 billion provided by the European
Commission, €440 billion provided in
bilateral loans and guarantees by euro area
members, as well as €250 billion from the
International Monetary Fund (IMF). In addi-
tion, the European Central Bank committed
to the direct purchase of government bonds

Journal of Regulation & Risk North Asia


on the open market. Economists disagree
vehemently as to whether this is the correct
prescriptive course to follow and question
why Greece and other crisis-prone coun-
tries should, or should not be bailed out at
all, specifcally if it relates to a monetisation
of public debt? Some commentators (e.g.,
Frankel 2010, Issing 2010, Wyplosz 2010)
have argued that providing any form of
fnancial support would be a policy mistake,
as it would undermine the very foundations
of the EMU, and jeopardise the stability of
the euro in the long-run by creating moral
hazard in the future.

Default fears

In contrast, others argue that letting Greece
default could cause a domino effect within
the periphery members thereby threatening
to break-up the Euro and unleashing “the
mother of all fnancial crises”(Eichengreen
2010). Hence, in their view, Europe needs to
create a strong emergency fnancing mecha-
nism that is even tually backed by a higher
degree of political integration.
Irrespective of what should or should
not be done at the European level, its at least
now possible to attempt an evaluation of the
root cause of the current crisis on theoreti-
cal grounds by means of a game-theoretic,
political economy model of default exter-
nalities in a monetary union with incom-
plete political integration – as in the case
of a Greek-type crisis. This can be done by
reviewing some of the basic features found
in this type of analysis (for further details see
Fahrholz and Wójcik 2010).
As to the general set-up, there are two
representative agents involved in the game.
We assume that within the EMU there are a

couple of ‘twin defcit’countries which suffer
from the twin problems of public debt sus-
tainability and external debt sustainability
– for example in Greece, as well as in Spain
or in Portugal. The second group of countries
– for example, Germany – is charac terised
by current account surpluses within the
euro area and more sustainable public debt

Lack of integration

Furthermore, there is incomplete political
integration among the agents, with Euro-
bloc countries having different incentives to
being an EMU member, with each member
facing different constitu ency constraints,
combined with the fact there is no auto-
matic emergency fnancing mechanism for
unwinding severe fscal and macroeconomic
imbalances in the EMU. Hence, EMU has
been a hotchpotch of compromises since
negotiations began in the 1970s, with this
informing the direction of fscal affairs until
the present day.

EMU advantages

Both ‘camps’are generally interested in pre-
serving the smooth functioning of the EMU.
From the viewpoint of a country like Greece,
membership in the euro area is advanta-
geous as it helps to provide access to fnan-
cial markets and to real external resources,
whilst paradoxically, leading to a loosen-
ing of budgetary constraints for periphery
members. At the same time, member ship
in the euro area is benefcial for a country
like Germany, as it supports its export-ori-
ented production and respective economic
policy stance. Against the backdrop of these
rationales for an EMU membership, ‘EMU

Journal of Regulation & Risk North Asia


stability’is a public good whose deterioration
in the course of one member’s default would
make both camps worse off.
This particularly holds true when a con-
tagion presents itself within the EMU, with
the resultant possibility of a disorderly dis-
integration process in terms of increasing
protectionism, reversing production process,
growth slack and overall welfare losses.
Hence, although individual motivations
differ, the interest to preserve the smooth
operation of the EMU is shared by all agents.
Accordingly, both camps have some willing-
ness-to-pay for preserving EMU stability
and their membership within EMU.

Reciprocated mutuality

The mutual willingness-to-pay for ‘EMU
stability’constitutes the foundations of
bargaining for redistribution of actors’cost
shares within EMU. In this context, a country
like Greece may resort to brinkman ship, as
its potential default would create a negative
externality, i.e. a Damocles sword hanging
over the rest of the EMU members. This is to
say that if a ‘twin defcit’country experiences
a sovereign debt crisis, such a crisis would
almost certainly put the smooth operation of
EMU at risk.

As a consequence of this fragility, such
countries are likely to exhibit brinkman-
ship. Namely, if a ‘twin defcit’country’s
encounters an adverse economic situation,
it may ease the burden of adjustment to its
constituency, thus, putting the success of the
euro area at risk. In doing so, the twin def-
cit country may elicit other EMU members’
actual willingness to pay for ensuring the
provision of the public good, ‘EMU stability’,
in the long run. Importantly, above all factors

there is the risk of an overall worst outcome
for such manouvering on the brink – i.e. for
example, an EMU break-up – thus constitut-
ing a threat, which is not under full control
by the actors. As soon as it turns out that
the threat is indeed credible brinkmanship

Negative externality

By assuming the above structure – which
seems to be in line with what one can now
observe in Europe – the analysis predicts that
a threat of default by one member, creating
a negativity externality for the whole mon-
etary union, must result in sharing the costs
of economic adjustment by the rest of the
members, i.e. a bail-out. Importantly, this is
the direct consequence of the current insti-
tutional set-up of EMU, of the sui generis
nature of EMU that it cannot easily escape.
Interestingly, the analysis shows that
such a bail-out does not necessarily need to
cause an excessive moral hazard problem.
The bargaining process is so ‘tight’that the
bailed-out country will abstain from further
attempts to promote a hazardous fscal pol-
icy stance and will behave well. Moreover,
current account surplus countries’willing-
ness to pay for contributing to the public
good, ‘EMU stability’,will be exhausted.

EMU construction

This brings us to the third question: What
does the Greek crisis tell about the construc-
tion of the EMU? What’s wrong?
The delineated analysis indicates that the
current EMU problems do not only ensue
from the Greek fscal problems alone, but
from the interactions of these problems with
the actual political-economic confguration

Journal of Regulation & Risk North Asia


of EMU. To put it differently, the sheer fact
that countries share the same currency does
not necessarily lead to negative spill-overs
between them. If this was the case then
fscal problems in Ecuador, a dollarised
country, would produce a threat to the dol-
lar – evidently this is not the case (see more
Balcerowicz 2010). In the EMU, however,
precisely such spillover – the negative exter-
nality – allows twin defcit countries such as
Greece to take hostage the whole EMU and
thus poising a signifcant threat to the euro.

An analogy

Think of the following business analogy –
imagine two companies: In the frst company,
unexpected sick leave of one of the ordinary
employees severely disrupts the production
process. In the second company, even unex-
pected sick leave of one of the key managers
does not infuence day-to-day operations.
What makes the difference is that the second
company excels at better proce dures: in case
of an event where all know what to do and
who substitutes whom.
The EMU is an example of the frst
economy. It is telling that a problem in one
very small country like Greece has a dispro-
portionately greater impact on the stability of
the whole area than this is the case in the US
monetary union where fscal woes of even
such big states as California do not wreak
even a smaller amount of such havoc.
Moreover, Europe is a highly integrated
economic area in real terms. It goes without
saying that allowing for the inter-temporal
exchange of goods and services is a prereq-
uisite for reaping welfare benefts stemming
from higher productivity (i.e. specialisation
in production). At the same time, the current

macroeconomic imbalances within Europe
refect the concurrent building-up of claims
and liabilities regarding future production
(usually in the form of holding government
bonds within the banking sector).

Major pitfall

Against this backdrop, one of the major
pitfalls of the EMU set-up is that it neither
provided incentives for curtailing excessive
lending and indebtedness, nor for converting
the fnancing of external resources into real
investments, i.e. future produc tion. As a result,
pending claims might turn irrecoverable,
which, in turn, may severely impair the for-
mation of the real economy, especially within
export-oriented economies of the EMU.
Apparently, the question is: what are the
‘procedures’that the US monetary union has
and the European one does not? Basically, it
is greater policy co-ordina tion through big-
ger central budget allow ing for fscal transfers
and federal bonds helping to fnance it at a
low cost – it goes without saying that greater
labour mobility and fexibility of markets is
also conducive to economic adjustments.

US comparisons

However, here we concentrate on econo mic
management tools. In essence, these tools in
the US internalise the cost-sharing mecha-
nism. If economic growth in California goes
down, the Federal Govern ment transfers
funds to social security expenditure that
work as automatic stabilisers. Federal gov-
ernment can also issue federal bonds that
can fnance these expenditures at lower
interest rates that a given state would be able
to negotiate at fnancial markets.
Against this background we shall look

Journal of Regulation & Risk North Asia


at the last question: What should be done to
make the EMU and the euro more sustain-
able in the long-run?
An ideal solution might be, of course,
creating similar tools in Europe as the ones
present in the United States. However, it
is naïve to think that this can be achieved
quickly because it would require a far greater
degree of political integration, to which the
degree of policy co-ordination is endog-
enous. Policymakers in Europe know very
well that stepping-up political integration
takes a frustratingly long time. At present,
it may even make some steps backwards,
given that the future EMU enlargement will
further increase the political and economic
heterogeneity of the euro area.

A rock and a hard place

Being squeezed between the undesir-
able now and the desirable future, the EMU
needs to develop some intermediate solu-
tions that would help to cross the bridge. The
sketched analysis above suggests at least
possible avenues: If a bail-out is unavoidable
in the current state of political-economic
confguration of the EMU than it should be
made rule-based and explicit.
In order to decrease the scope of the
negative externality effect, EMU countries
should specify the conditions and proce-
dures for leaving the EMU, along the costs
and legal requirements of such an operation.
The frst solution would clearly save all the
haggling and uncertainty in the course of
such events resulting in lower risk premium
which is associated with such uncertainty
(see Bini Smaghi 2010 who makes a similar
case in context of fnancial markets).
The second solution would also stabilise

market reaction, should we experience a next
wave of rumours about potential default or
exit. Since markets would know exactly
what conditions and form it would take,
there would be much less room for uncer-
tainty and volatility in fnancial markets.
Importantly, a clear-cut delineation of costs
would serve as a deterrent to any form of

Issues of sucession

It would be evident to all that no cost shar-
ing will take place should an exit occur. By
increasing the perceived costs of leaving
relative to the short-term political costs of
economic adjustment, it could defuse future
threats of leaving and stimulate fscal disci-
pline and, hence, considerably decrease the
scope for the negative externality.
The latter solution is not new. It draws on
the history of some national states struggling
with preserving internal integration. Their
experience suggests that when secession
is not permitted, pressure for it rises. When
secession is openly allowed many would-be
secessio nists cease to press so hard for it – or
for a bail-out as is the case with the Greek-
type crisis.

Concluding remarks

As a concluding remark, one can look at the
EMU crisis from two perspectives: on the one
hand, one can see it as a moment of disaster;
on the other hand, one can see it as an oppor-
tunity to push ahead with inevitable reforms.
For the time being – as the ‘United States of
Europe’seems to be politically unfeasible –
one may consider bringing fnancial markets
back in to the arena. Measures of reas serting
the moni toring function of fnancial markets

Journal of Regulation & Risk North Asia


may eventually curb the debtors’ability to
demand ‘too much’debt fnan cing as less
investors will fock to ever-riskier govern-
ment bonds. In this respect, most notably,
one has to dampen any ambiguity of lender-
of-last-resort facili ties to curtail creditors’
moral hazard concer ning a dispropor tionate
supply of credit-fnancing.
A rule-based, auto matic resolu tion
regime comparable to insolvency proceed-
ings for the private sector – instead of yet
another dis cre tionary intervention as has
been the case with Greece – would limit
debtors’moral hazard. Any reform steps
towards this direction would help stressing
market agents’personal liability again, which
generally is a prerequisite for smooth opera-
tion of markets and may thus guarantee
fnancial stability within the euro area in the

Despite the current bashing of fnancial
market agents and the fractious debates on
fnancial mechanisms for dealing with the
debt crisis, Europe may seize the opportu-
nity to preserve the euro and avoid a messy
disintegration. It is obvious that the recently
implemented credit guarantee line repre-
sents only a delay of inevitable economic

In addition, such emergency fnancing
mechanism rather invites tumbling coun-
tries to skirt economic adjustment pro-
cesses as their constituency pressures build.
Notwithstanding, an advantage of European
‘cacophony’is the potential to develop –
slowly but surely – a multitude of possible
ways out of its sovereign-debt crisis.
We have hence suggested the direc-
tion of an intermediate solution in terms
of crafting an improved institutional set-up

of the EMU. As regards global economic
recovery, we would be intrigued to see how
the issue of the ‘credit hangover’ will be
solved on a global scale. It is hard to per-
ceive all economies in the world exhibiting
productivity leaps and exporting – and thus
paying their due liabilities in real terms – at

the same time. •


Balcerowicz Leszek, 2010, “Sovereign Bankruptcy in the EU

in the Comparative Perspective”, paper presented at the

XII Travemünde Symposium zur ökonomischen Analyse

des Rechts, Travemünde, 24-26 March 2010, http://www.

emle-hamburg.de/ _data/ Balcerowicz.pdf

Bini Smaghi, Lorenzo, 2010, “It is better to have explicit

rules for bail-outs”, Financial Times, 16 March 2010.

Eichengreen Barry, 2010, “Europe’s Trojan Horse”, Project

Syndicate, http://www.project-syn di cate. org/commentary/

eichengreen14/English, 15 February 2010.

Fahrholz, Christian and Cezary Wójcik, 2010, “Modeling

Default Externalities in EMU: Understanding the Impact of

a Greek-type Crisis on the Euro Area”, mimeo.

Fahrholz, Christian and Andreas Kern, 2009, “When

Economics is Crushing Big Fat Greek Wedding Plans:

A Greek Tale of Full-Blown Drama”. Paper published at

Atlantic Community, Berlin, http://www.atlantic-commu-

nity.org/ index/Open_Think_Tank_Article/A_Big_Fat_

Greek_Financial_Wedding, last update: 8 December 2009.

Fell, Charlie, 2010, “Euro zone currency crisis is only begin-

ning”, Irish Times, 23 April 2010.

Frankel, Jeffrey, 2010, “Let Greece Go to the IMF”, Jeff

Frankels Weblog, http://content.ksg. harvard.edu/blog/


11 February 2010.

IMF, 2010, “World Economic Outlook – Rebalancing

Growth”, Washington, D.C., International Mone tary Fund,

April 2010.

Issing, Otmar, 2010, “A Greek bail-out would be a disaster

for Europe”, Financial Times, 16 February 2010.

Journal of Regulation & Risk North Asia



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