For the Eurozone, much hinges on
self-discipline—and self-interest
Author: Jonathan Lemco, Ph.D.
Will the Eurozone survive its severe financial challenges?
Vanguard believes it is in the interests of both “have” and
“have not” members to preserve the European Union, but
this will be possible only with far greater fiscal discipline.
When long-simmering fiscal woes in Greece first
captured headlines and unnerved global financial
markets last year, calm was temporarily restored
and the damage appeared to be contained. Greece
negotiated a package of unpopular but necessary
austerity measures to qualify for a financial rescue
by the International Monetary Fund and European
Union (EU) members in spring 2010.
Amid swift-moving currents and market gyrations,
it can be difficult to maintain perspective. However,
regardless of what the current headlines may be,
we offer four observations regarding the short- and
longer-term outlook for the Eurozone:
Since then, the breadth and depth of the challenges
faced in other peripheral European countries—
leading, for example, to a “junk” rating for the
sovereign debt of Ireland, the former Celtic Tiger—
have again shaken global markets. And speculation
has mounted that the euro may not survive as a
common currency, and that the EU may break up.
• Whether Greece, or Portugal, or another country
actually defaults is less important than how the
default takes place and what follows it. We
believe it is unlikely that Greece or any other
member would decide to leave the EU.
The backdrop: The global recession of 2008–2009
exacerbated long-term structural economic issues in
several peripheral Eurozone countries, leading to recent
bailouts, a crisis of confidence, and plunging stock
markets.
The question: Can the Eurozone survive amid serious
ongoing economic challenges?
Vanguard conclusion: We expect the European Union
to survive, but the road will be bumpy. As always,
investor portfolios should be diversified across both
developed and emerging markets.
• The Eurozone crisis is likely to continue well
into the foreseeable future. Our best guess is
at least two more years, possibly much longer.
• For the longer term, there are two broad
scenarios for the possible fate of the EU.
We believe the more likely scenario is that the
EU will evolve toward a much more disciplined
fiscal union within a decentralized constitutional
structure. If such a fiscal structure cannot be
negotiated, then we believe an EU collapse
becomes more likely.
• Austerity measures and strict enforcement
of budgetary policies and guidelines must
be accompanied by economic growth and
investment, although spending cutbacks
will be a drag on growth.
Vanguard Investment Perspectives > 1
Figure 1.
The Eurozone sovereign-debt crisis: Rising costs of default insurance
The credit default swap spread can be viewed as the relative cost of insuring a debt security against a default or
restructuring event. This chart shows CDS spreads for the six peripheral countries versus Germany, considered
one of the soundest issuers in the region. The wide spread for Greece illustrates rapidly eroding confidence in
the country’s ability to repay bondholders.
Spreads of 5-year sovereign CDS relative to Germany: January 2, 2009–August 18, 2011
3,000
2,500
Basis points
2,000
1,500
1,000
500
0
Jan.
2009
July
2009
Greece
Italy
Portugal
Belgium
Jan.
2010
Ireland
Germany
July
2010
Jan.
2011
July
2011
Spain
Source: Thomson Reuters Datastream.
Rising borrowing costs, falling confidence,
and more bailouts
Since early 2010, there has been tremendous
uncertainty regarding the outlook for the economies
and sovereign debt of peripheral Eurozone members,
notably Greece, Portugal, Ireland, Spain, and Italy.
Belgium could be added to this list as well, because
of its political uncertainty and growing fiscal burden.
The global recession of 2008–2009 exacerbated longterm structural and economic issues in these countries,
including: public sectors that were excessively large
in relation to the overall economy, unsustainable
social entitlement programs, and fundamental
misalignments in wage and price levels relative to
more competitive members of the currency union.
In spring 2010, the situation came to a head in
Greece. This was followed by a global retreat from
the debt of the peripheral EU countries and by
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soaring interest rate spreads on their bond yields
and credit default swaps (CDS) relative to German
bunds (Figure 1). After a period of calm, spreads
widened again. They spiked dramatically in mid-July
2011 before the second Greek bailout was negotiated,
then fell back. The spread of 5-year Greek sovereign
CDS rates relative to Germany peaked in July at
about 26 percentage points.
Since spring 2010, supranational authorities and
policymakers in the Eurozone and elsewhere have
engineered major responses—first to rescue Greece,
then more recently to rescue Ireland, Portugal, and
Greece (again). Figure 2 summarizes the various
bailouts, standby programs, and policy actions
addressing the crises. A notable feature of the
second Greek bailout arrangement is that some
bondholders will shoulder part of the cost.
Figure 2.
Key responses to the Eurozone debt crisis
Response
Date AmountDescription
Bailout of Greece
May 2010
€110 billion€80 billion from Eurozone members and
€30 billion from the International Monetary
Fund (IMF).
Second bailout
July 2011
€109 billion
€59 billion from Eurozone members and the
of GreeceIMF. An additional €50 billion is expected to
come from the private sector.
Bailout of Ireland
November 2010
€85 billion€17.5 billion from Ireland (National Pension
Reserve Fund and the state’s cash reserves).
€22.5 billion from the IMF.
€22.5 billion from the EFSM (European
Financial Stability Mechanism).
€22.5 billion from the EFSF (European
Financial Stability Facility).
Bailout of Portugal
May 2011
€78 billion€26 billion from the IMF and €52 billion
from Eurozone members.
European Financial May 2010
€440 billion
The EFSF can make loans funded by floatingStability Facility (EFSF)rate debt that is guaranteed by Eurozone
member states. The EFSF is a temporary
mechanism that will be replaced by the
European Stability Mechanism (ESM) in
June 2013.
Expansion of EFSF
July 2011
Increased to
The EFSF’s lending capability was boosted,
€780 billionand it was given authority to intervene in the
secondary debt market.
European Central Bank Ongoing
(ECB) bond purchases
€110.3 billion The ECB purchases the debt issued by
since the program Eurozone nations as part of its open-market
was launched in operations.
May 2010
Bank stress tests and
July 2011
recapitalization
Of 90 banks, These tests aimed to assess the ability of
8 failed the stress the European banks to withstand financial
tests: 5 Spanish, shocks. Those that failed the test were
2 Greek, and
required to present recapitalization plans
1 Austrian.by September 31, 2011, and to be ready
to implement them within the following
three months.
Source: Vanguard.
The root cause of the problems in Greece and, to
a lesser extent, in Portugal, Ireland, Spain, and Italy
is spending beyond their means. As a precondition
to membership in the European Union, countries
pledged that their budget deficits would not exceed
3% of gross domestic product (GDP) and that
sovereign debt would not exceed 60% of GDP.
Over time, however, with lax enforcement, budget
deficits have become far greater—especially in
Greece, where the deficit as a percentage of GDP
turned out to be far worse than we were led to
believe: 15.4% for full-year 2009 and 10.5% in 2010
(see Figure 3, on page 4).
Vanguard Investment Perspectives > 3
Figure 3.
Fiscal retrenchment in the Eurozone
These key figures show the need for fiscal adjustment in the Eurozone. The deficit reduction targets are listed
in each country’s Growth and Stability Program, a document that EU members must submit annually. The targets
are based on cyclically adjusted GDP, meaning that the economic recovery is already built into assumptions about
government revenue. Germany and France, the largest members of the Eurozone economy, also have fiscal
retrenchment targets to meet, meaning that the overall adjustment for the region is substantial.
Country’s
share of
European Union
GDP (2010)
Real GDP growth
rate (Q1 2011
versus Q1 2010,
annualized rate)
Debt-to-GDP
ratio (debt as percentage of
GDP, 2010)
2010
budget deficit
(percentage
of GDP)
Germany
20.4%
2.7%
83.2%
3.3%
France
15.8 1.6
81.7
7.0
United Kingdom
13.8 0.7
80.0
10.4
Italy
12.6 0.8
119.0
4.6
Spain
8.7 0.7
60.1
9.2
Belgium
2.9 2.5
96.8
4.1
Greece
1.9 –5.5
142.8
10.5
Portugal
1.4 –0.9
93.0
9.1
Ireland
1.3 0.1
96.2
32.4
Sources: Eurostat (the statistical office of the European Union) and Bloomberg.
Short-term outlook: Deep fiscal cuts with
serious implications for growth
The governments of Europe’s peripheral economies
have shown notable commitment to addressing their
budget imbalances. As shown in Figure 3, several
countries’ budget deficits far exceed the membership
targets. In accordance with the European Union’s
Growth and Stability Program, most members have
now set a target of reducing their deficits to 3% of
GDP—the original EU standard—by 2013.
However, the essential fiscal austerity programs
that have been announced and implemented
to achieve that goal are a double-edged sword.
Instead of spending and engaging in fiscal stimulus
to support economic activity, governments across
the Eurozone are being forced to reduce spending
and cut stimulus programs, creating negative shocks
to spending and growth, with serious near-term
implications for the fragile European economic
recovery.
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In our view, the impact of these simultaneous
austerity measures is likely to reverberate across
the entire euro area in the short run. Even if the
cutbacks are spread out over several years, the
overall fiscal adjustment is large. And with GDP
growth already slowing significantly in Germany,
France, and elsewhere, we are cautious about
the near-term outlook for the Eurozone as a whole.
As stated earlier, we think it is reasonable to expect
the region to remain troubled for the foreseeable
future, most likely for at least two years and
conceivably for much longer.
A sovereign default?
For some time, the bond market has signaled an
expectation that Greece will default on its sovereign
debt. Greece’s ratio of total debt to GDP (143% in
2010—see Figure 3) is several standard deviations
worse than that of other peripheral European
countries—except Italy, which has the notable
advantage of being a more broadly diversified and
export-oriented economy, the third-largest in the EU.
Although it appears unlikely that Greece can avoid
default, what matters more is whether the default
will be “orderly”—that is, somewhat predictable and
orchestrated by EU leadership—or “disorderly,” with
surprises and unexpected contingencies. A disorderly
default could trigger an even more widespread and
severe sell-off in global stock and bond markets, and
would be more likely to spread to the bonds of
fiscally healthier European countries. Note that the
same analysis would apply regardless of which
beleaguered country defaults.
The EU Constitution allows a defaulting member
to voluntarily leave the union, but does not require
the member to do so. We believe that if Greece or
another country defaults, it will be in that nation’s
interest to remain within the EU—even though the
national economy might benefit from the resulting
devaluation of the local currency, which would make
exports more competitive. If Greece, for example,
severed ties with the EU, its government would need
to be ready for an immediate run on Greek banks, a
substantial decline in the standard of living—absent
EU financial support and access to credit markets as
an EU member—and other serious implications.
Long-term outlook: Fiscal union, or collapse?
In mid-August, French and German leaders proposed
a carrot-and-stick approach to reward countries that
effectively address their budget gaps. At the same
time, the prospect of an effective fiscal union—which
might ultimately lead to a centralized budgeting and
taxing authority—appeared to gain credence at least
among investors, as indicated by pricing and spreads
in the market for credit default swaps. Another
idea that has been discussed is the issuance of
Eurobonds, which would be joint obligations of all
EU members.
Senior leaders of core EU members do not embrace
the notion of a fiscal union, for reasons that include
reluctance to relinquish fiscal sovereignty and
aversion to further bailouts of reprobate members.
And the EU Constitution would have to be amended
before a fiscal union could be set up. However, if the
goal is to preserve the considerable benefits of
the EU—including trade efficiencies arising from
a common currency—there appear to be few
alternatives.
As a possible first step toward fiscal union, we
believe it is highly likely that meaningful enforcement
mechanisms will be put in place, sooner rather than
later, to encourage all members to adhere to budget
targets and to penalize them if they don’t. A logical
next step, and one that probably will be resisted by
politicians, would be establishing a bureaucratic
structure for making and enforcing budget and
spending decisions.
Absent a move toward strict enforcement of fiscal
discipline, a partial dissolution or even a total collapse
of the EU would appear more likely. “Muddling
through” with haphazard and idiosyncratic political
decisions that fail to address long-engrained habits
is no longer a viable option.
Growth must accompany austerity
Gaining control over budgets and spending is a
necessary but not a sufficient condition for fiscal
healing. Economic growth is also essential—and is
even more challenging to achieve in the face of sharp
cutbacks in spending. The key to economic growth is
meaningful investment by domestic and international
investors, who must gain confidence that Greece and
other nations are making genuine, tangible progress
in getting their fiscal houses in order by cutting back
on public services, reducing tax-avoidance, and other
measures.
Progress will take time, especially as the global
economic growth engine seems to be stalling
again. Meanwhile, investors should be mindful of
the potential for high volatility in both equity and
fixed income markets, including wide movements
in bond yields over short periods. We encourage
investors to diversify their portfolio holdings among
developed and emerging markets, making sure that
the proportions of each are consistent with risk
tolerance and investment objectives.
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