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CRISIL Young Thought Leader 2011

WILL EU SURVIVE THE SECOND DECADE OF THE NEW MILLENNIUM?

Pankaj Thakur
Final Year, IIFT, Delhi

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Executive Summary
The European project was started with the backdrop of Second World War and collapse of Soviet Union to foster closer economic and political cooperation within Europe. The high point of the project was the formation of Eurozone and adoption of the common European currency in 1999. This led to the formation of common markets and stronger intra-EU trade which led to period of increased growth and prosperity in Europe from 1999-2008. The European project was hailed as success. This success led to reckless spending by many European nations which built up huge debt levels. Starting with Greece, when these issues were exposed to the global markets, money started flowing out and weaker economies started collapsing resulting in the current crisis. The crisis, however, is not limited to Europe in the current interconnected globalised world and is threatening to push the entire global financial system into a great depression. In this scenario, there is a hot ongoing debate of what should be done to prevent the crisis from spilling any further as well as speculation on what is going to happen if the ongoing efforts do not yield the desired result. Any solution to the Euro zone problems should take the current global complexities in mind and should be workable as well as acceptable to all parties. This paper discusses the background and causes of the crisis in some detail as well as presents the potential scenarios going into the future and their impact on the world economies. This paper concludes by giving out some recommendations for an early resolution of the crisis.

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1. Introduction
The Euro zone crisis that started in 2009 is showing no sign of abating despite so much discussion and plethora of steps (including the just concluding EU crisis summit at Brussels). What started off as a small problem in fringe European countries is now showing signs of turning into a contagion and threatening to engulf entire global economy into a depression. The Global Markets are fast losing confidence in the European countries. The yields on European government bonds are the highest they have ever been. And the problem is that the issue is so mired in political intransigencies, conflicting economist and public opinions that it is near impossible to find a workable solution to Eurozone problem. It is imperative that a workable solution to the crisis is found soon to restore confidence in global economy and avoid the imminent double dip recession. In the next segments we discuss how and why the crisis happened, what are the likely future scenarios and the possible solution to the crisis.

2. Background to the Europe Crisis

Examining the steps leading to the crisis in Europe:

2.1 Formation of the Eurozone

The Maastricht Treaty, signed in 1992, marked the establishment of the European Union paving the path for monitory and fiscal integration of Europe. The European Monetary Union was launched with 11 member states with a common Euro Currency. Greece joined the Union in 2001. The Union allowed financially weaker countries like Portugal, Italy, Ireland, Greece and Spain to borrow money at same rates as stronger Germany and France giving them a strong incentive to borrow money to fund various government welfare programmes. This Union also benefitted Germany as they got access to common European market and their exports became cheaper globally due to moving from the strong Deutsch Mark to relatively less strong Euro. However, during the boom period of Europe (2001-2008) foundations of the crisis were also laid: Availability of low interest rates led more and more people and governments to buy on credit The provisions in Maastricht Treaty regarding debt levels and Govt deficit were ignored

2.2 Beginning of the Crisis

In 2008, U.S. Financial Crisis started with the Collapse of Lehmann Brothers. This crisis had huge impact throughout the globe with economic outputs decreasing and global sentiments becoming bearish. In Europe, it led to European banks parking their capital in safe Government bonds, including those of Italy and Greece. By 2010, European banks had invested 700 billion in bonds of the five crisis stricken countries. Financial crisis was also accompanies by bursting of housing bubbles everywhere including Ireland and Spain. Irish Govt assumed the debt of its banks and became a part of the PIIGS. In Spain, Italy and Portugal too the debt situation steadily worsened. In 2009, the rating agencies downgrade

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Greeces creditworthiness after it reports that its current account deficit is actually 12.5 percent of its GDP. There was a flight of capital from Greek bonds. The spread on Greek bonds increased and the spiral down the rabbit hole started.

2.3 Contagion Effect

The crisis of confidence soon spread to other European Currencies. Yields on Italian Govt bonds started to rise reaching a level more than 7 percent. Moodys cut Portugals credit rating to Junk status. Ireland also required a rescue package. Spain currently faces high debt, high unemployment and low growth. By the end of 2013, the total financial need of PIIGS stands at 795 billion. While the problem has been continuously worsening, the European policy response to deal with it remains inadequate. The contagion now threatens to spread to France, then even Germany and then to rest of the world.

Figure 1: Timeline of Euro Crisis

3. Pieces of the Puzzle

Although the magnitude and seriousness of the problem is clear to everyone, the problem remains intricately complex and seemingly unsolvable. No two experts agree on how to deal with the crisis. The reasons for the complexity are:

3.1 Size of the Debt

Debt as a proportion of GDP has been rising for most European nations and is at alarming levels for PIIGS. To service the total debt of PIIGS might require total aid to the tune of 1.3 trillion while the current commitment is only 600 billion.

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Figure 2: Debt of PIIGS

Also, banks and other financial institutions of Eurozone are already overleveraged and also have significant exposure to the tune of over 700 billion in distressed government securities. A sovereign default may push many of these banks to seek bailout.

3.2 Structural Weakness of the Euro

The biggest problem of Europe is that the flaws in Euro zone are systemic in nature. Euro zone was designed as a monetary union leading to establishment of a fiscal union, but the fiscal union never materialized. Consequently, while individual countries are unable to tweak monetary policy to value or devalue their currency, there is no system in place to balance the structural trade deficits/ surpluses of the periphery and the Core. Also, the euro is a currency without political protection, without a uniform fiscal policy, and without the ability to defend itself against speculative attacks. There is also no central authority with power to ensure strict fiscal discipline.

3.3 Political Issues

The problems with Euro zone are also deeply political in nature. There is a difference of opinion between different members of the Union as to the future of Euro zone leading to acrimonious debates, constant meetings and a general lack of consensus and direction. There is also a divide between strong northern countries and weak southern countries. Germany seeks greater austerity by the PIIGS as a cost of bailout which is deeply unpopular in those countries. At the same time German people are resentful having to foot the bills of their more profligate neighbours. There is also crisis of confidence in leadership in some countries with both Italy and Greece under unelected Prime Ministers. Also, there are conflicting opinions regarding the priorities of ECB. Germans dont want inflation to rise under any condition while southern countries are more concerned about growth.

4. Steps Being Taken

Since the beginning of the crisis, leaders of Europe have tried various steps to contain and reverse the crisis with mostly inadequate results. Some of the steps taken with their effectiveness are:

4.1 Bailouts and Fiscal Austerity

Eurozone leaders initially responded to the crisis by giving country specific bailouts on the condition of implementation of severe austerity measures. Greece and Ireland were the first

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countries to receive bailouts with initial packages of 45 billion and 67.5 billion respectively which were subsequently revised. Portugal also received 78 billion bailout package. However, these austerity programs have achieved little more than killing off growth by putting limits to Government spending. In distressed countries, where public sentiments and confidence in markets are extremely low, government spending is necessary to boost consumption and investment to boost up growth. Without corresponding growth in the economy a country like Greece will never be able to service its debts despite bailout packages.

4.2 European Financial Stability Facility (EFSF)

EFSF was established in May 2010 by EU to provide financial assistance to distressed European states. EFSF can issue bonds and other securities in market and has a 440 billion lending capacity guaranteed by the Eurozone countries' governments. It financed 17.7 billion of the total 67.5 billion rescue package for Ireland and contributed one third of the 78 billion package for Portugal in May 2011. However, EFSF in its current form, rather than containing the crisis may only be helping in spreading the contagion. EFSF is a collateralized debt obligation (CDO) type instrument which does not solve the debt problem, just transfers and postpones it. Ultimately, it may lead to same consequences as its American brother.

4.3 European Financial Stability Mechanism (EFSM)

EFSM was established in Jan 2011 to raise further funds from financial markets. It is guaranteed by European commission using budget of EU as collateral and has authority to raise up to 60 billion. The problem with EFSM is similar to EFSF in that it is a short term stop gap solution and does not address basic structural problems in the Eurozone.

4.4 Interventions by the ECB

European Central Bank has taken several steps to address volatility in the markets including open market operations in the form of buying government securities to the tune of 200 billion and refinancing loans of weaker countries of Eurozone. However, ECB under German stewardship has been focused more on combating inflation even at the risk of throttling growth in weaker Eurozone countries.

4.5 Brussels Treaty

In the recently concluded Brussels Summit on 8th and 9th December 2011, Eurozone leaders agreed to work together for greater unity. They agreed to a new tax and budget pact to deal with the Eurozone Crisis. However, fault lines in Eurozone became even sharper as Britain refused to join the pact due to objections to new financial regulation. However, despite many summits in recent months, there is no clear coherent policy to deal with problems in Eurozone. There is still no clarity as to if the Eurozone will survive this crisis and how. In the remainder of this paper, we discuss some possible scenarios of the future of Eurozone and how they will impact the economies of various countries as well as some more possible solutions that lead to the good outcomes.

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5. Probable Scenarios and their Impact

The following chart illustrates the possible outcomes of the Euro crisis. The Y-axis indicates the nature of economic outcome and X-axis indicates the fate of the Euro.

Figure 3: Various Possible Scenarios of Future

(Source: http://www.bbc.co.uk/news/business-16098582)

5.1 Euro Recovers and Rebounds

Scenario: This is the best possible scenario for Europe.

Probability: Very unlikely at this point. Will be difficult for all Eurozone countries to adopt stricter loan conditions; no guarantee that austerity will not stifle growth; difficult to regain and sustain market confidence. Impact: Definite positive impact on all global economies. Greece and Italy will survive. Recovery in Europe will help US and global recovery. Economic boom period will start.

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5.2 European Fiscal Union

Scenario: This is the direction that current leaders in Europe seem to be heading towards.

Probability: Possible but not very likely. Nations unwilling to give up their sovereignty; Germans unwilling to foot the bills of profligate Greece and others; political stability of such a Union will remain questionable; will take a long time to implement. Impact: Will have a net positive impact on global economy though there might be turmoil and uncertainty initially. An integrated Europe may emerge as a strong player globally. Impact on US and Indian economies uncertain initially but beneficial in long run due to greater trade and better sentiments.

5.3 Transfer Union

Scenario: This might be the end result if current situation continues.

Probability: Likely. Might be necessary to balance surplus and deficits; Current situation in Europe with bailouts already resembling a transfer union; more likely than fiscal union; Peripheral countries more likely to agree as this does not involve loss of sovereignty; Germans strictly opposed to such a situation. Impact: Will stabilize volatility in Eurozone. Germans will have to constantly foot the deficits of weaker Euro nations. Global financial markets will stabilize. Will stop flight of capital to US bonds; good situation for India.

5.4 Inflation Situation

Scenario: Situation similar to transfer union but with bad outcome for Europe.

Probability: Less likely than transfer union situation due to German anathema to rise in inflation; but still very much possible as given current rate of bailouts, printing money might become only option left to ECB leading to inflation.

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Impact:

Negative impact on global economy; recession will be prolonged. European crisis will continue throughout the decade; global economic recovery will be delayed; Indian growth will be lower than potential due to less investment inflow.

5.5 Euro Stays, Economic Depression

Scenario: Prolonged economic depression in Europe.

Probability: Unlikely but possible if current Eurozone policies and logjams continue without moving towards closer fiscal union; Possible outcome of current movement of crisis towards core of Europe. Impact: Will be devastating for Europe and will worsen economic situation across the globe. Europe will find it very hard to recover. All countries including US, China and India will be severely affected.

5.6 Smaller Monetary Union

Scenario: Peripheral countries leave Eurozone, smaller core Europe remains.

Probability: Somewhat likely; especially if divide between Core and Peripheral Europe exacerbates; this solution will likely be considered if other solutions to save the Eurozone are exhausted. Impact: Global impact uncertain depending on how unbundling of Eurozone and the devaluation of weaker currencies is handled. However, result for countries like Greece likely to be bad.

5.7 Coordinated Breakup of Eurozone

Scenario: All Eurozone members agree to dissolve Union; move to individual currencies.

Probability: Unlikely, far off possibility if the crisis in Europe keeps on worsening.

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Impact:

Same as above.

5.8 Unravelling of Eurozone

Scenario: Countries start leaving one by one, Eurozone unravels.

Probability: Unlikely but possible if the crisis in Europe keeps on worsening. Impact: Disastrous for European countries and global economy. Recession likely to worsen.

5.9 Collapse of Eurozone

Scenario: Total collapse of the Eurozone.

Probability: Unlikely right now but a distinct possibility because politicians have been singularly inept at handling the crisis till now. Impact: Doomsday scenario for Europe and global economy. Will result in Great Depression.

6. Conclusion
As seen from above discussion, there are no easy solutions to the Euro crisis. In conclusion, we discuss some steps which should be taken to avoid a protracted crisis while preserving the monetary union and the euro. Dealing with the Debt: There are three ways of dealing with the debt, paying off the debt, restructuring (accepting large cuts) and inflating it away. Inflation is not an option for the ECB. It has to be a combination of the first two in the form of a large scale intervention by the ECB by printing Eurobonds to prevent credit spreads from worsening. Fiscal or Transfer Union: To correct structural issues in the Eurozone, the trade imbalance between Eurozone countries has to be corrected. It can either be done through a fiscal union that would involve transfer of fiscal powers from the states to the centre or at least a transfer union mechanism which can take the accumulated surpluses of some regions and invest them in the deficit regions. This will help finance the deficit regions and over the long run will also generate higher profits for the surplus region.

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Banking Sector Reforms: Much of the European problem can be traced to their unregulated and overleveraged banks. European banks need to be regulated by a strong, central regulator which has the power to recapitalize banks as well as set and enforce common rules.

7. References
1. "How the Euro Became Europe's Greatest Threat" Der Spiegel. 20 June 2011. 2. State of the Union: Can the euro zone survive its debt crisis? Economist Intelligence Unit. (2011) 3. Colignatus and Genootschap (September 2011), High Noon at the EU corral. An economic plan for Europe, MPRA 4. Varoufakis and Holland (2011), A modest proposal for overcoming the euro crisis 5. "Timeline: The unfolding eurozone crisis". BBC News. 9 December 2011. 6. The Ticking Euro Bomb:How a Good Idea Became a Tragedy, The Spiegel International. 5 December 2011 7. WR Cline (2011), Alternative Strategies for Resolving the European Debt Crisis, petersoninstitute.org 8. A less punishing, more forgiving approach to the debt crisis in the Eurozone, Centre for European Policy Studies (Brussels, Belgium), 2011 9. K Featherstone (2011), The Greek sovereign debt crisis and EMU: a failing state in a skewed regime, JCMS: Journal of Common Market Studies 10. http://www.voxeu.org/index.php?q=node/5008 11.http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&plugin=0&language=en&pcode=tsieb090 12. http://www.bbc.co.uk/news/business-16098582 13. http://www.bbc.co.uk/news/business-13856580
14. http://www.protesilaos.com/2011/10/full-analysis-of-euro-crisis.html

15. http://hbswk.hbs.edu/item/6884.html