American Economic Association
The European Sovereign Debt Crisis
Author(s): Philip R. Lane
Source: The Journal of Economic Perspectives, Vol. 26, No. 3 (Summer 2012), pp. 49-67
Published by: American Economic Association
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- Volume
26, Number
3- Summer
2012- Pages49-68
JournalofEconomic
Perspectives
The
Philip
European
Sovereign
Debt
Crisis1
R. Lane
capacityof the euro-membercountriesto withstandnegativemacroeconomicand financialshockswasidentifiedas а majorchallengeforthesuccess
The
of the euro fromthe beginning(in thisjournal, forexample,see Feldstein
1997; Wyplosz1997; Lane 2006). By switchingoffthe option fornational currency
devaluations,a traditionaladjustmentmechanismbetweennationaleconomies was
eliminated.Moreover,the euro area did not matchthe designof the "dollarunion"
of the United Statesin keyrespects,since the monetaryunion was not accompanied bya significant
degree of bankingunion or fiscalunion. Rather,itwas deemed
forfinancialregulationand fiscalpolicy.
feasibleto retainnationalresponsibility
On the one side, the abilityof national governmentsto borrowin a common
currencyposes obviousfree-rider
problemsifthereare strongincentivesto bail out
a countrythatborrowsexcessively(Buiter,Corsetti,and Roubini 1993; Beetsmaand
Uhlig 1999). The originaldesign of the euro soughtto address the over-borrowing
incentiveproblem in twoways.First,the Stabilityand GrowthPact set (somewhat
arbitrary)limitson the size of annual budget deficitsat 3 percentof GDP and the
stockof public debt of 60 percentof GDP. Second, the rulesincluded a "no bailout"
clause, with the implicationthat a sovereigndefault would occur if a national
governmentfailedto meet itsdebt obligations.
On the otherside, the eliminationof national currenciesmeant thatnational
macroecofiscalpolicies tookon additionalimportanceas a tool forcountercyclical
nomic policy (Wyplosz1997; Gali and Monacelli 2008; Gali 2010). Moreover,since
■ PhilipR. Lane is Whately
Professor
of PoliticalEconomyat TrinityCollegeDublin,
Dublin, Ireland,and Research
London,United
Fellow,Centre
PolicyResearch,
forEconomic
His
email
address
is
( [email protected]
).
Kingdom.
+ToaccesstheAppendix,
visit
doi=10.1257/jep.26.3.49
http://dx.doi.Org/10.1257/jep.26.3.49.
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50
JournalofEconomic
Perspectives
individual governments
banking regulation remained a national responsibility,
continuedto carrythe risksofa bankingcrisis:both thedirectfiscalcosts(ifgovernmentsend up recapitalizingbanks or providingotherformsof fiscalsupport) and
also the indirectfiscalcosts since GDP and tax revenues tend to remain low for
a sustainedperiod in the aftermathof a bankingcrisis(Honohan and Klingebiel
2003; Reinhartand Rogoff2009) .
There are three phases in the relationshipbetween the euro and the Eurodesignof the euro plausibly
pean sovereigndebt crisis.First,the initialinstitutional
increasedfiscalrisksduringthe pre-crisisperiod. Second, once the crisisoccurred,
these design flaws amplified the fiscal impact of the crisis dynamicsthrough
imposed by monetaryunion also shape
multiplechannels. Third, the restrictions
the durationand tempo of the anticipatedpost-crisisrecoveryperiod, along with
in place forcrisis
Europe's chaoticpoliticalresponseand failureto have institutions
in
the
next
three
We
take
these
three
majorsectionsof this
management.
up
phases
article,and thenturnto reformsthatmightimprovethe resilienceof the euro area
to futurefiscalshocks.
As will be clear fromthe analysisbelow, the sovereigndebt crisisis deeply
intertwinedwith the banking crisis and macroeconomic imbalances that afflict
the euro area. Shambaugh (2012) providesan accessible overviewof the euro's
broadereconomic crisis.Even ifthecrisiswas not originallyfiscalin nature,itis now
a full-blown
sovereigndebt crisisand our focushere is on understandingthe fiscal
dimensionsof the euro crisis.
Pre-Crisis Risk Factors
Public debt for the aggregateeuro area did not, at least at firstglance,
to
appear be a loomingproblemin the mid 2000s. During the previousdecade, the
euro area and theUnitedStatessharedbroadlysimilardebt dynamics.For example,
the ratioof grosspublic debt to GDP in 1995 was about 60 percentforthe United
Statesand 70 percentforthe set of countriesthatwould laterformthe euro area,
based on mycalculationswithdata fromthe IMF Public Debt Database. In both the
UnitedStatesand theeuro area, thedebt/GDP ratiosdeclined in thelate 1990s,but
had returnedto mid 1990slevelsby2007. The debt/GDP ratiosthenclimbedduring
thecrisis,growingmore quicklyforthe United Statesthanforthe euro area.1
However,the aggregateEuropean data maskconsiderablevariationat the individualcountrylevel.Figure1 showsthe evolutionof public debt ratiosforseven key
euro area countriesover1982-2011. These countrieswerechosen because Germany,
France, Italy,and Spain are the four largestmember economies, while the fiscal
crisisso farhas been mostseverein Greece, Ireland,and Portugal(of course,Italy
1Fora detailed
sector
debtacross
theseseven
ofpublic
breakdown
oftheevolution
country-by-country
available
online
with
thispaperat(http://ejep.org).
seetheAppendix
countries
from
1992-2011,
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PhilipR. Lane
51
Figure1
The Evolutionof Public Debt, 1982-2011
: Datafrom
IMFPublic
Source
DebtDatabase.
and Spain have also been flaggedas fiscallyvulnerablecountriesduringthe crisis).
debt histories.
Clearly,thesecountrieshave quite different
In one group, both Italyand Greece had debt/GDP ratiosabove 90 percent
since the early1990s;thesecountriesneverachievedthe 60 percentdebt/GDP limit
specifiedin the European fiscalrules. Ireland, Portugal,and Spain each achieved
significantdeclines in debt ratiosin the second half of the 1990s, dipping below
the 60 percentceiling.While the Portuguesedebt ratiobegan to climb from2000
onwards,rapidoutputgrowthin Irelandand Spain contributedto sizablereductions
in debt-outputratiosup to 2007. Finally,France and Germanyhad stabledebt/GDP
ratiosat around 60 percentin the decade prior to the onset of the crisis;indeed,
theirdebt ratioswere far above the correspondingvalues for Ireland and Spain
during2002-2007. Thus, circa 2007, sovereigndebt levelswere elevatedforGreece
and Italy,and the trendforPortugalwas also worrisome,but the fiscalpositionsof
Ireland and Spain looked relatively
healthy.Moreover,the low spreadson sovereign
debt also indicatedthatmarketsdid not expectsubstantialdefaultriskand certainly
not a fiscalcrisisof the scale thatcould engulfthe euro systemas a whole.
However,withthe benefitof hindsight,1999-2007 looks like a period in which
good growthperformanceand a benignfinancialenvironmentmaskedtheaccumulation of an arrayof macroeconomic,financial,and fiscalvulnerabilities(Wyplosz
2006; Caruana and Avdjiev2012).
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52
JournalofEconomic
Perspectives
Table1
PrivateCreditDynamics
Loanstoprivate
sector
domestic
banks
and
from
other
credit
institutions
(percent
ofGDP)
Greece
Ireland
Portugal
Spain
Italy
Germany
France
1998
2002
2007
31.8
81.2
92.1
80.8
55.7
112.2
81.0
56.5
104.4
136.5
100.1
77.3
116.7
85.6
84.4
184.3
159.8
168.5
96.5
105.1
99.3
Source:
World
BankFinancial
Database.
FinancialImbalances and Exteraal Imbalances
A keypredictorof a bankingcrisisis the scale of the precedingdomesticcredit
boom (Gourinchasand Obstfeld2012). Table 1 showsthe evolutionof credit/GDP
ratios for the seven euro area countries.The European peripheryexperienced
strongcreditbooms, in partbecause joining the euro zone meant thattheirbanks
- the eurocould raise fundsfrominternationalsources in theirown currency
ratherthan theirprevioussituationof borrowingin a currencynot theirown (say,
U.S. dollars or German marksor Britishpounds) and then hoping thatexchange
rates would not move against them. In related fashion,lower interestrates and
easier availabilityof credit stimulatedconsumption-relatedand property-related
borrowing(Fagan and Gaspar 2007) .
A related phenomenon was the increase in the dispersionand persistence
of currentaccount imbalances across the euro area. Table 2 shows that current
accountimbalanceswerequite smallin the pre-euro1993-1997 period. But,bythe
2003-2007 period,Portugal(-9.2 percentofGDP) , Greece (-9.1 percent), and Spain
(-7.0 percent)wereall runningverylargeexternaldeficits.Conversely,
Germanyran
external
of
while
5.1
the
overalleuro
verylarge
surplusesaveraging percent GDP,
area currentaccountbalance was close to zero.
To the extent that currentaccount imbalances accelerated income convergence by reallocatingresourcesfromcapital-abundanthigh-incomecountriesto
capital-scarcelow-incomecountries,thiswould be a positivegain frommonetary
union (Blanchard and Giavazzi 2002). Similarly,currentaccount deficitsmight
have facilitatedconsumptionsmoothingby the catch-upcountriesto the extent
that current income levels were perceived to be below future income levels.
However, if capital inflowsrather fueled investmentin capital that had little
effecton futureproductivitygrowth (such as real estate) and delayed adjustment to structuralshocks (such as increasing competition from Central and
Eastern Europe and emerging Asia in the production of low-margingoods),
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DebtCrisis 53
TheEuropeanSovereign
Table2
CurrentAccountBalances
(percent
ofGDP)
1993-1997 1998-2002 2003-2007 2008-2011
Greece
Ireland
Italy
Portugal
Spain
France
Germany
-2.0
3.4
2.1
-2.4
-0.6
1.1
-0.9
-5.9
-0.2
0.2
-9.0
-3.1
2.0
-0.3
-9.1
-2.6
-1.8
-9.2
-7.0
-0.2
5.1
-11.1
-1.6
-2.9
-10.5
-5.8
-1.9
5.7
Economic
Oudook
database.
Fund's
World
Source:
International
Monetary
then the accumulation of external imbalances posed significantmacroeconomic
and
risks (Blanchard 2007; Giavazzi and Spaventa 2011; Chen, Milesi-Ferretti,
Tressel forthcoming).
For countries running large and sustained external deficits,Blanchard
severalriskfactors.In termsofmedium-term
identifies
(2007)
growthperformance,
a currentaccount deficitcan be harmfulifincreasedexpenditureon nontradables
squeezes the tradablessectorbybiddingup wagesand drawingresourcesawayfrom
industriesthat have more scope for productivity
growth.This is especiallyrisky
inside a currencyunion, because nominal rigiditiesmean thatthe downwardwage
adjustmentrequiredonce the deficitepisode is overcan onlybe graduallyattained
througha persistentincreasein unemployment.
In addition,a large currentaccount deficitposes short-term
risks,if there is
a sudden stop in fundingmarketssuch thatthe deficitmustbe narrowedquickly.
Large and sudden capital flowreversalshave oftenprovencostlyin termsof output
contractions,risingunemployment,and assetprice declines (Freund and Warnock
2007) . A reversalin capital flowsis also associated witha greaterriskof a banking
crisis,especiallyif capital flowshave been intermediatedthroughthe domestic
bankingsystem.
The 2003-2007 Boom
The mostintensephase of the dispersionin creditgrowthand currentaccount
imbalances did not occur at the onset of the euro in 1999. Rather,there was a
discrete increase during 2003-2007 (Lane and Pels 2012; Lane and McQuade
2012). A complete explanation forthe timingof thissecond, more intensephase
of currentaccount deficitsand creditbooms is stilllacking,but the simultaneous
timingwith the securitizationboom in internationalfinancialmarkets,the U.S.
subprimeepisode, and the decline in financialriskindices suggestthatthe answer
may be found in the underlyingdynamicsof the global financialsystemand the
unusuallylow long-terminterestratesprevailingduringthisperiod.
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54
JournalofEconomic
Perspectives
The credit boom in this period was not primarilydue to government
borrowing.For Ireland and Spain, the governmentwas not a net borrower
during 2003-2007. Rather,households were the primaryborrowersin Ireland
and corporationsin Spain, withthe propertyboom fuelingdebt accumulationin
both countries.In Portugal and Greece, the governmentand corporationswere
both significantborrowers,but these negativeflowswere partlyoffsetduringthis
period bysignificantnet accumulationof financialassetsby the household sector
in these countries.
Failureto TightenFiscal Policy
Looking back, the failure of national governmentsto tightenfiscal policy
substantiallyduring the 2003-2007 was a missed opportunity,especiallyduring
a period in which the privatesectorwas takingon more risk.In some countries
(Ireland and Spain), the creditand housing booms direcdygenerated extra tax
and capital inflows
revenues,since risingasset prices, high constructionactivity,
boosted the take fromcapital gains taxes,asset transactiontaxes,and expenditure
euro membercountriesalso had inflationratesabove theeuro
taxes.Faster-growing
area average,whichalso boosted tax revenuesthroughthe non-indexationof many
tax categories.Finally,low interestratesmeant thatdebt servicingcostswere below
historicalaverages.However,these large-scalerevenuewindfallswere onlypartially
used to improvefiscalpositions,withthe balance paid out in termsof extrapublic
spending or tax cuts. Overall, fiscalpolicy became less countercyclicalafterthe
creationof the euro, undoing an improvementin cyclicalperformancethathad
been evidentin the 1990s (Benetrixand Lane 2012).
factorin the failureto tightenfiscalpolicywas the poor perforA contributory
offiscalpositions.
used to assessthesustainability
mance oftheanalyticalframeworks
In evaluating the cyclical conduct of fiscal policy from 2002-2007, domestic
authoritiesand internationalorganizationssuch as the IMF, OECD, and European
Commissionprimarilyfocused on point estimatesof the output gap in order to
estimatethe "cyclicallyadjusted" budget balance, withouttakinginto account the
of macroeconomic,financial,and fiscalrisksassociatedwiththe expandistribution
sion in externalimbalances,creditgrowth,sectoraldebt levels,and housingprices.
A more prudentialand forward-looking
approach to riskmanagementwould have
accumulate
buffersthatmighthelp ifor when
more
actions
to
aggressive
suggested
the boom ended in a sudden and disruptivefashion(Lane 2010).
For the euro periphery,the 2008 global financialcrisistriggereda major reasof rapid credit growthand large
sessmentamong investorsof the sustainability
externaldeficits.In turn,this took the formof significantprivatesector capital
outflows,the tighteningof creditconditions,and a shudderinghaltin construction
withnational bankingsystemsgrapplingwiththe twinproblemsof rising
activity,
estimatesof loan losses and a liquiditysqueeze in fundingmarkets.In turn,the
combined impact of domesticrecessions,banking-sector
distress,and the decline
in riskappetiteamong internationalinvestorswould fuelthe conditionsfora sovereign debt crisis.
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PhilipК Lane
55
The Financial Crisis and the Sovereign Debt Crisis
August2007 markedthe firstphase of the global financialcrisis,withthe initiation of liquidityoperationsby the European CentralBank. The high exposure of
majorEuropean banksto lossesin theU.S. marketin asset-backedsecuritieshas been
welldocumented,as has thedependence of thesebankson U.S. moneymarketsas a
source of dollar finance (McGuire and von Peter 2009; Acharyaand Schnabl 2010;
Shin 2012). The global crisisentered a more acute phase in September2008 with
the collapse of Lehman Brothers.The severeglobal financialcrisisin late 2008 and
early2009 shook Europe as much as the United States.
FromFinancialShock to SovereignDebt Crisis
Through 2008 and 2009, there was relativelylittleconcern about European
sovereigndebt. Instead,the focuswas on the actionsof the European CentralBank
to addresstheglobal financialshock.In tandemwiththe othermajorcentralbanks,
it slashed short-term
interestrates,providedextensiveeuro-denominatedliquidity,
and enteredintocurrencyswaparrangementsto facilitateaccess byEuropean banks
to dollar-denominatedliquidity.
But the global financialshock had asymmetriceffectsacross the euro area.
Cross-borderfinancialflowsdried up in late 2008, withinvestorsrepatriatingfunds
to home marketsand reassessingtheirinternationalexposurelevels (Milesi-Ferretti
and Tille 2011). This processdisproportionately
affectedcountrieswiththegreatest
reliance on external funding,especially internationalshort-termdebt markets.
Inside the euro area, Ireland was the moststrikingexample: the high dependence
of Ireland's banking systemon internationalshort-termfunding prompted its
governmentat the end of September2008 to providean extensivetwo-year
liability
to
its
banks
Lane
2010;
(Honohan
2011).
guarantee
More generally,the global financialcrisisprompted a reassessmentof asset
prices and growthprospects,especiallyfor those countriesthat displayedmacroeconomic imbalances.For instance,Lane and Milesi-Ferretti
(2011) show thatthe
current
account
deficit
and
rate
of
domestic
credit
pre-crisis
expansion are significant correlatesof the scale of the decline in outputand expenditurebetween2007
and 2009, while Lane and Milesi-Ferretti
(forthcoming)show that"above-normal"
currentaccount deficitsduring 2005-2008 were associated with sharp current
account reversalsand expenditurereductionsbetween2008-2010. The cessationof
the creditboom was especiallytroublingforIreland and Spain, since the construction sectorsin these countrieshad grownrapidly.The decline in constructionwas
a major shock to domesticeconomic activity,
whileabandoned projectsand falling
indicated
losses
forbanksthathad made too many
propertyprices
largeprospective
loans.
property-backed
Still,euro area sovereigndebt marketsremained relativelycalm during2008
and most of 2009. During thisperiod, the main focuswas on stabilityof the areawide bankingsystem,
withcountry-specific
fiscalrisksremainingin thebackground.
the
low
Furthermore, relatively pre-crisispublic debt ratiosof Ireland and Spain
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56
JournalofEconomic
Perspectives
gavesome comfortthatthesecountriescould absorbthelikelyfiscalcostsassociated
witha medium-sizebankingcrisis.Demand forsovereigndebt of euro area countrieswas also propped up by banks thatvalued governmentbonds as highlyrated
collateralin obtainingshort-term
loans fromthe European CentralBank (Buiter
and Sibert2006) .
In late 2009, the European sovereigndebt crisisentereda new phase. Late that
GDP
increasesin deficit/
year,a numberof countriesreportedlarger-than-expected
ratios.For example,fiscalrevenuesin Irelandand Spain fellmuchmorequicklythan
of tax revenuesto declines in construction
GDP, as a resultof the high sensitivity
In
and
asset
the
scale of the recessionand risingestimates
activity
prices. addition,
losses on bad loans in a numberof countriesalso had
of prospectivebanking-sector
a negativeindirectimpacton sovereignbond values,since investorsrecognizedthat
a deterioratingbankingsectorposed fiscalrisks(Mody and Sandri 2012).
However,the most shocking news originated in Greece. Afterthe general
election in October 2009, the new governmentannounced a revised2009 budget
deficitforecastof 12.7 percentof GDP- more than double the previousestimate
of 6.0 percent.2In addition,the Greek fiscalaccounts forpreviousyearswere also
revisedto show significantly
largerdeficits.This revelationof extremeviolationof
the euro's fiscalrules on the part of Greece also shaped an influentialpolitical
of
narrativeof the crisis,whichlaid the primaryblame on the fiscalirresponsibility
the peripheralnations,even thoughthe underlyingfinancialand macroeconomic
imbalancesweremore importantfactors.
These adverse developmentswere reflectedin risingspreads on sovereign
bonds. For example, the annual spread on ten-yearsovereignbond yieldsbetween
Germanyand countriessuch as Greece,Ireland,Portugal,Spain, and Italywas close
to zero beforethe crisis.Rememberthatsovereigndebts fromthese countriesare
all denominatedin a common currency,the euro, so differencesin expected yield
mainlyrepresentperceivedcreditrisksand differencesin volatility.
bond yieldsforseveneuro
ten-year
Figure2 showsthebehaviorofcountry-level
area countriesfromOctober 2009 throughJune 2012. Three particularly
problematic periods stand out. First,the Greek yield began to divergefromthe group in
early2010, withGreece requiringofficialassistancein May 2010. Second, there
was strongcomovementbetweenthe Irishand Portugueseyieldsduring2010 and
the firsthalfof 2011 (Ireland was next to requirea bailout in November2010, with
Portugalfollowingin May 2011). Third, the yieldson Italyand Spain have moved
together,withthese spreads at an intermediatelevel betweenthe bailed out countriesand thecore countriesof Germanyand France.For Italyand Spain, thespread
againstGermanyrose above 300 basis pointsinJuly2011 and remainedat elevated
In 2011, a visiblespread also emerges between the French and
levels thereafter.
2SeealsoGibson,
announcement
alsopointoutthattheGreek
Hall,andTavlas(2012).Theseauthors
such
fora debtmoratorium,
from
DubaiWorld
soonfollowed
wascoincidentally
request
bythesurprise
inOctober/November
deteriorated
2009.
ininternational
debtmarkets
thattheclimate
markedly
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TheEuropeanSovereign
DebtCrisis 5 7
Figure2
Yields on Ten-YearSovereignBonds, October 2009 toJune2012
)
(percent
Datastream.
Source:
Author's
calculations
basedondatafrom
of France is not pursued
Germanyields,althoughthe greaterrelativevulnerability
in thispaper.
CobblingTogethera Response to the SovereignDebt Crisis
Greece was the firstcountryto be shut out of the bond marketin May 2010,
withIrelandfollowingin November2010,and Portugalin April2011. (In June 2012,
Spain and Cyprusalso soughtofficialfunding.At the timeof writing,it is unclear
whetherSpain willrequire onlya limitedformof officialfundingto help it recapitalizeitsbankingsystemor a larger-scalebailout.)
In each of the threebailouts,joint European Union/IMF programswereestablished under which three-yearfundingwould be provided on condition that the
recipientcountriesimplementedfiscalausterity
packages and structuralreformsto
boost growth(especiallyimportantin Greece and Portugal) and recapitalizedand
deleveragedoverextendedbankingsystems(especiallyimportantin Ireland). The
scale of requiredfundingfarexceeded normalIMF lendinglevels,so the European
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58
JournalofEconomic
Perspectives
Union was the major providerof funding.At thattime,it was also decided to set
up a temporaryEuropean Financial StabilityFacilitythatcould issue bonds on the
basis of guaranteesfromthe memberstatesin order to provideofficialfundingin
Mechanism,which
anyfuturecrises.In addition,thepre-existing
European Stability
for
had previously
been
used
only
foreigncurrencysupportfor
balance-of-payments
non-euro membercountries,was adapted to also providefundingforeuro member
countries.
In principle,a temporaryperiod of officialfundingcan benefitall parties.For
the borrower,it can providean opportunityfora governmentto take the typically
thatconverges
unpopularmeasuresnecessaryto put public financeson a trajectory
on a sustainablemedium-termpath, while also implementingstructuralreforms
thatcan boost the level of potentialoutput. For the lender,avoidingdefaultcan
benefittheircreditorinstitutions
(especiallybanks), whileguardingagainstpossible
negativeinternationalspilloversfroma default.
The details of the fundingplans for Greece, Ireland, and Portugal largely
copied standard IMF practices,but theyfaced a number of potential problems.
Here are six issues,in no particularorder.
First,giventhe scale of macroeconomic,financial,and fiscalimbalances,the
plausible timescale formacroeconomicadjustmentwas longer than the standard
termof such deals. In particular,fiscalausterityby individualmember
three-year
countriescannot be counterbalancedby a currencydevaluation or an easing in
monetaryconditions,which is especiallycostlyif a countryhas to simultaneously
close both fiscaland externaldeficits.ByJune 2011, it was clear thatGreece would
need a second package,while it is also likelythatIreland and Portugalwillnot be
able to obtain fullmarketfundingafterthe expiryof theircurrentdeals. The slow
pace of adjustmentwas also recognizedin Summer2011 throughthe extensionof
the repaymentperiod on the officialdebt from7.5 yearsto 15-30 years.
Second, in relatedfashion,excessivelyrapidfiscalconsolidationcan exacerbate
weaknessesin the bankingsystem.Falling output and a risingtax burden shrinks
household disposable income and corporate profits,increasing private sector
defaultrisk.This was identifiedas an especiallystrongriskin the Irishprogramin
viewof the scale of household debt.
Third,thefiscaltargetswerenot conditionalon thestateof thewiderEuropean
economy.AsgrowthprojectionsforthewiderEuropeaneconomydeclinedthroughout
2011,thecountry-specific
targetslooked unobtainableforexternalreasons.
the
Fourth,
originalbailouts included a sizable penaltypremiumof 300 basis
points built into the interestrate,which is standardIMF practice.A penaltyrate
discouragescountriesfromthe moral hazard of takingsuch loans when not really
needed and also compensatesthe fundersforthe nontrivialdefaultrisk.However,
it also makes repayingthe loans harderand givesan appearance thatthe creditor
EU countriesare profiteeringat the expense of the bailed-out countries.This
penaltypremiumon the European componentof the officialloans was eliminated
inJuly2011, althoughtheinterestrateon the IMF-sourcedcomponentof thefunds
continuedto include a penaltypremium.
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PhilipК Lane
59
Fifth,the bailout funds have been used to recapitalizebanking systems,in
additionto coveringthe "regular"fiscaldeficits.So far,thiselementhas been most
importantin the Irishbailout,but itwas also a featureof the Greekand Portuguese
bailouts;it is also the primaryelementin the officialfundingrequestedbySpain in
June 2012. While publiclyfundedrecapitalizationof troubledbankscan ameliorate
is problematicifitraisespublic debt and sovereignrisk
a bankingcrisis,thisstrategy
to an excessivelevel (Acharya,Drechsler,and Schnabl 2010). Moreover,excessive
levels of sovereigndebt can amplifya bankingcrisisforseveralreasons: domestic
banks typicallyhold domestic sovereignbonds; a sovereigndebt crisisportends
additionalprivatesectorloan lossesforbanks;and a highlyindebtedgovernmentis
likelyto lean on banksto provideadditionalfunding(Reinhartand Sbrancia2011) .
Furthermore,the generallypoor health of major European banks and the crossborder nature of financialstabilityinside a monetaryunion means that national
governmentsare under internationalpressureto rescue failingbanks in order to
avoid the cross-bordercontagion risksfromimposing losses on bank creditors.3
Despite these internationalexternalities,at least until mid 2012, the only typeof
European fundingforbank rescueswas plain-vanillaofficialloans to the national
sovereign,withfixedrepaymentterms.Under thisapproach, the fatesof national
sovereignsand nationalbankingsystemsremaincloselyintertwined.
The sixthissue involvesa standardIMF principlethatfundingis onlyprovided
ifthesovereigndebt levelis consideredto be sustainable.Ifitis not sustainable,the
traditionalIMF practicehas been to require privatesectorcreditorsto agree to a
reductionin the presentvalue of the debt owed to them.Under thejoint EU- IMF
programs,such "privatesectorinvolvement"was not initiallydeemed necessaryin
the threebailoutsof 2010 and 2011.
The argumentagainstrequiringprivatesectorinvolvementis thatit can spook
an already nervous sovereigndebt market.For example, when the prospect of
requiringprivatesectorinvolvementwas broached in October 2010 (in the FrancoGerman "Deauville Declaration"), interestrate spreads immediatelyincreased,
to avoid a bailoutcame
especiallyforGreece,Ireland,and Portugal.Ireland'sefforts
in earlyNovember2010. European banksalso had increased
to a haltsoon thereafter
in raisingfunds,especiallythe local banks in the troubledperiphery,in
difficulties
line withthe increasein the perceivedriskinessof theirhome governments.
The March 2012 agreementto provideGreece witha second bailout package
did require thatprivatesectorcreditorsaccept a haircut,whicheventuallyturned
out to be about 50 percentofvalue,whichis equal to 47 percentof GreekGDP.4But
3The
costofrescuing
hasalsoincreased
thefiscal
bankresolution
ofEuropean
regimes
poordesign
bonds
ofthesenior
banksandimpose
lossesonholders
sinceitisdifficult
toshutdownfailing
banks,
issued
banks.
by
4
thesecond
hasbeendisputed
theplausibility
ofthisprojection
commentators,
bymany
Although
isofficially
todeliver
a Greek
GDPratioof120percent
bailout
debt/
by2020,which
package
projected
See also
euromember
countries.
ofthesomeoftheothertroubled
is a shadeabovethedebtratios
oftheGreek
crisis.
andCaselli(2012)foranaccount
Ardagna
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All use subject to JSTOR Terms and Conditions
60
JournalofEconomic
Perspectives
as thisrequirementwas discussedduringthe course of 2011, it contributedto the
sharpwideningof the spreadson Spanish and Italian debt.
in thiswaymaymake the European responseto
Listingsome of the difficulties
itssovereigndebt issuesappear more coherentthanit has actuallybeen. Instead,it
to addressitssovereigndebt problemas
maybe fairto characterizeEurope's efforts
makeshift
and chaotic,at least throughthe middle of 2012.
Risksof MultipleEquilibriawhenSovereignDebt is High
in euro
A significantfactorduringthe crisishas been the increased volatility
area sovereigndebt markets.A countrywitha highlevelof sovereigndebt is vulnerable to increasesin the interestrate it pays on its debt (Calvo 1988; Corsettiand
Dedola 2011). This riskcan giveriseto self-fulfilling
speculativeattacks:an increase
in perceptionsof defaultriskinduces investorsto demand higheryields,whichin
turnmakes defaultmore likely.In contrast,if defaultriskis perceived to be low,
interestrates remain low, and default does not occur. This multiple equilibria
currencyunion,
problemmayhave greaterforcein the contextof a multicountry
sincea smalladverseshiftin thefundamentalsofone individualcountrycan trigger
a large decline in demand forthe sovereigndebt of thatcountryas investors"run
forthe exit"and switchto sovereigndebt of othersafereuro area countries.
Whatpoliciesmightencourage the"good" equilibrium?One optionis to create
a firewallthroughtheavailability
of an officialsafetynet.This would reduce the risk
of the "bad" equilibriumarisingbecause investorswould not need to fear thata
defaultbyan inabilityto rolloveritsdebt.As
countrywillbe pushed intoinvoluntary
ofmid 2012, theavailablefundingthroughthe European FinancialStability
Facility
and its successor,the European StabilityMechanism,was only enough to address
the bailouts of Greece, Ireland, and Portugal- and thus not nearlysufficientto
offersubstantialsupportto Spain and/or Italy.Proposals to create a large firewall
fund are politicallyunpopular in creditorcountriesfor many reasons, including
fearoftakinglosses,and concernsthatsuch a fundwould temptpoliticiansin at-risk
countriesto postpone or avoid toughfiscaland structuralreformdecisions.
The European CentralBank's programto purchase sovereignbonds can also
be viewedas a wayto reduce the riskof the "bad" equilibrium.BetweenMay2010
and October 2010, about 65 billion euro of bonds were bought by the ECB; a
further125 billioneuro werecommittedduringthemarketturmoilbetweenAugust
2011 and November 2011 such that the cumulativebond holdings grew to over
200 billioneuros (about 2 percentof euro area GDP) . The ECB has takenpains to
emphasisethatthesepurchasesare not monetizingdebt because liquiditycreatedis
canceled out throughoffsetting
sterilization
operations.Instead,the programseeks
to provideliquidityand depthwhen certainsovereigndebt marketsare troubled.A
usefulanalogyhere is to the modern argumentforcurrencymarketinterventions.
Such interventions
do not tryto fixassetvalues; instead,limitedinterventionby a
centralbank can be temporarily
stabilizingbybreakingmomentumdynamics.
There have also been calls for the European Central Bank to take further
steps to stabilize the sovereigndebt market (for example, De Grauwe 2012). At
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TheEuropeanSovereign
DebtCrisis 61
one level,it could increase the firepowerof the European StabilityMechanismby
allowing it to borrowfromthe ECB. Going further,the ECB could announce a
ceilingto the interestrate itwould tolerateon the sovereigndebt of countriesthat
meet certainfiscalcriteria(such as takingcredible steps to ensure debt declines
to a safe level over the medium term),and guarantee to buythe debt at thatprice
ifneeded.
Even more controversially,
outrightdebt monetizationmightbe viewedin some
quartersas preferableto outrightdefaultbylarge membercountriesifit becomes
clear thatsolvencyconcernsare so greatthatmarketfundingwillnotbe availablefor
an extended period. While debt monetizationexceeds the currentlegal mandate
of the European CentralBank,debate overtheseproposalsmightheat up ifa more
acute and severe phase of the crisiswere to take hold. At least for now,it is hard
to envisagethatsuch a change would be supportedbyall membercountriesof the
euro area. However,it is also importantto appreciate thatthe reservecapacityto
monetizedebt is commonlycited as the reason whyhighlyindebted governments
such as Japan, the United Kingdom,and the United Statesare stillable to borrow
at low interestrates.
Prospects for Post-Crisis Reduction in Sovereign Debt
The legacyof the euro area sovereigndebt crisisis thata numberof countries
willhave dangerouslyelevatedpublic debt ratios,while otherswillhave debt levels
thatare lowerbycomparisonbut stillhighrelativeto long-termnormalvalues.Even
if currentausterityprogramsare sufficientto stabilizedebt ratios,there remains
thepost-crisis
adjustmentchallengeof graduallyreducinggovernmentdebt to safer
levels.This medium-term
challenge is viewedwithtrepidationin European circles.
Consider four reasons whythe underlyingfundamentalsfor reducing the debt/
GDP ratioare not promising.
First,growthin nominal GDP is likelyto be low. Debt/GDP ratiosare stickier
in high-incomecountriesthan in emergingeconomies in partbecause thereis less
scope forrapidoutputgrowthin theformergroup of countries.There is nothingto
suggestthatreal growthratesforadvanced economies should exceed a long-term
annual averageof about 2 percent.Indeed, real annual growthof 2 percentmaybe
optimisticgivenseveralfactors:the erosion of human capital fromthe prolonged
unemploymentof the last fewyears (DeLong and Summers2012); the likelihood
of tax increases and reduced public investment;and the historicalpatternthat
output growthcan be compromisedfor a decade in the aftermathof a banking
crisis(Reinhartand Rogoff2010). For the most-indebtedcountries,nominal GDP
is unlikelyto grow much fasterthan real GDP. The European Central Bank has
a 2 percent aggregate inflationtarget (approximately), and the most indebted
membercountriesare likelyto have averageinflationsubstantially
below thatlevel
in viewof the correlationbetweendomesticdemand and the price levelof nontradables (Lane and Milesi-Ferretti
2004).
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62
JournalofEconomic
Perspectives
Second, the political economy environmentis likelyto be challenging.The
highlyindebted countrieswill need to be led by governmentsthat must impose
spending cuts and tax increases withno short-term
prospect of fiscalrelaxation.
can
set
it
difficult
to sustain long-termfiscal
in, making
Adjustmentfatigue
austerity.
Third,thepossibilitiesforfinancingat leastsome ofthesovereigndebt through
"financialrepression"are limited.This approach uses tightregulationson domestic
- includingbanks,pension funds,and others- so thatthese
financialinstitutions
institutions
are pressuredto put a greaterportionof theirassets than theywould
otherwisechoose into sovereigndebt (Reinhartand Sbrancia 2011). However,the
principleof open capitalmarketsacrossthe European Union means thatcountries
have fairlylimitedscope forfinancialrepressionin comparisonto whatwas historicallypossible.
Fourth,riskpremia will likelyremain nontrivialfor most indebted member
countries.The large losses experienced by privatesectorinvestorsin Greek sovereign debt underline that the sovereigndebt of euro area member countriescan
no longer be categorizedas risk-free
investments.Indeed, the historicalevidence
that
further
rounds
of
debt
willformpartof the adjustment
suggests
restructuring
also
the discussionbyReinhart,Reinhart,and Rogoffin thisissue).
process (see
the medium-term
outlook suggeststhatsovereigndebt is likelyto
Accordingly,
for
pose significant
policychallenges theeuro area overthenextfewyears.The next
sectionoutlinessome possiblereformsthatcould help to alleviatethe situationand
avoid a similardisasterin the future.
Reforms to Address Sovereign Debt Concerns
The high outstandingsovereigndebt levels and the importanceof avoiding
futurefiscalcrisesin the euro area have induced reformsto the fiscalrulesforthe
euro area, witha new Fiscal Compact Treatythatis scheduled to go into effectat
thestartof 2013 (ifitis ratifiedby12 membersof the euro area bythen). The Fiscal
Compact requires that the new fiscalprinciplesbe embedded in each country's
national legislation.These fiscalgovernancereformsare based on twoprinciples:
first,high public debt levelspose a threatto fiscalstability;and, second, the fiscal
balance should be close to zero "overthe cycle."
The operation of the pre-crisisfiscal rules focused on the overall budget
balance, witha maximum annual budget deficitset at 3 percent of GDP, while
therewas no strongpressureon highlyindebted countries (such as Greece and
Italy) to reduce debt levelsbelow the specified60 percentceiling.Even on itsown
terms,thisapproach had twomain defects:it did not adequately allow forcyclical
variationin budget positions,and it did not providemuch disciplineforcountries
inside the limit.
In contrast,the new systemfocuses on the structuralbudget balance, thus
strippingout cyclical effectsand one-offitems. A structuralbudget balance
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PhilipК Lane
63
targetencourages a governmentto bank cyclicalrevenuegains duringupturnsin
exchange for a greaterslippage in the overall budget balance during recessions.
Under the new system,there is a specifiedtime framefor reducing public debt
below the ceilingof 60 percentof GDP, withthe excess above the ceilingeliminated
each year.
at an averagerateof "one twentieth"
This new approach faces several implementationproblems. For example, a
based on structural
measurementprobfiscalframework
budgetbalance facesknotty
to differentiate
betweencyclical
lemsbecause itrequiresmacroeconomicforecasters
fluctuationsand trendfluctuationsin output almostin real time.For thisreason,
the Fiscal Compact requires that governmentsenact a mechanism that requires
adjustmentsif the forecasterrorsfor the structuralbudget balance cumulate over
level.In theGermanfiscallaw,forexample,a cumulative
severalyearsto a significant
overshootabove 1.5 percentofGDP requiresa gradualcorrectionbyrunningtighter
structural
budgetsuntilthe excess is eliminated(Bundesbank2011).
Anotherpotentialissue is that,in contrastto the originalStabilityand Growth
Pact, the primarysource of fiscaldisciplineis intended to be national. The Fiscal
Compact requiresthatthe fiscalrulesare writteninto domesticlegislationand that
nationalindependentfiscalcouncilsbe createdto monitorthe compliancewiththe
specifiedfiscalrules.The hope is thatnational-leveldisciplinewillbe more effective,
since itshould have greaterpoliticallegitimacythanexternalsurveillance.However,
externalsurveillanceand the threatof externalsanctionsremainas a "second line
of defense"againstfiscalmisbehavior.
In recognitionthatfiscalstability
can be quicklyundone byfinancialand macroeconomic shocks,the Fiscal Compact is accompanied bynew European regulations
thatgo beyond narrowfiscalgovernancein monitoring"excessiveimbalances."A
wide range of riskindicatorswillbe tracked,includingcreditgrowth,house price
indices, and external imbalances. The intentionis that a countryexperiencing
severeimbalances should respond withpolicyinterventionsto mitigatecrisisrisks
and improveresilience.However,it remainsunclearwhethernationalgovernments
have the capacityto identifyexcessiveimbalances accuratelyor to deploy policy
in managingsuch riskfactors.
instruments
thatcan be effective
Given the limitednature of these initiatives,more extensivereformsare also
under discussion.A partiallistof such proposals includes the following.Firstand
foremostis the creation of a banking union, since the diabolic loop between
national banking systemsand national sovereignshas been central to the fiscal
crisis.The ingredientsofbankingunion are well-known
and include European-level
regulatoryresponsibility,
deposit insurance,bank resolutionpolicies, and a joint
fiscalbackstopin the eventthatfiscalresourceswere deemed necessaryto stabilize
the bankingsystem(Allen, Beck, Carletti,Lane, Schoenmaker,and Wagner 2011;
Brunnermeieret al. 2011; Marzinotto,Sapir,and Wolff2011). A partial move in
thisdirectionwas announced at theJune 2012 European Council meeting,which
also opened up the possibilityof the European StabilityMechanismmakingdirect
equityinjectionsinto troubledbanks. However,the detailsof these new plans have
yetto be ironed out.
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64
JournalofEconomic
Perspectives
A second step is the introductionof common areawide "eurobonds,"withthe
goal ofavoidingthedisruptiveimpactofdestabilizingspeculativeattackson national
sovereigndebt marketsinside the euro area (Favero and Missale 2012). Fiscally
strongermemberstatesmightsupporteurobonds ifit is cheaper than the alternativesforreducingdefaultrisk,for instancewithbiggerbailout funds.To prevent
thesecould be
weakermemberstatesfromusingeurobonds to overborrow,
fiscally
restrictedin variousways.One option is to limiteurobonds to shortmaturities,so
thatill-disciplinedcountriescould quicklybe denied access to funding(Philippon
and Hellwig2011); anotheroption is to limiteurobond fundingonlyforsovereign
debt up to 60 percentof GDP, withthe excess stillrequiringfundingthroughthe
issuanceof nationalbonds (Delpla and Von Weizsäcker2011); or eurobonds could
be limitedto countriesthat satisfycertaincriteriafor good macroeconomic and
fiscalfundamentals(Muellbauer 2011). 5
Brunnermeieret al. (201 1) pointout thatmanyoftheadvantages
Alternatively,
of eurobonds can be obtained even if sovereigndebt remainsa national responsibility.In particular,a European Debt Agency could be established that would
buyup large quantitiesof national sovereignbonds (up to a limitof 60 percentof
GDP in each case). This agencywould be funded by the issuance of twotranches
of bonds- European Safe Bonds and European Junior Bonds- with the latter
havingthe primaryexposure in the eventof defaultson the underlyingportfolio
of national sovereignbonds. Accordingly,
the senior European Safe Bonds should
be safe assets,which in turn should make them preferredcollateral for central
bank liquidityoperations. Since this proposal does not requirejoint backing of
sovereigndebt issues, it avoids the moral hazard problems that plague the eurobond proposals.
Third,Europe mightseek a deeperleveloffiscalunion, agreeingto share certain
taxstreamsor spendingprogramsin a waythatwould be delinkedfromfluctuations
in national-leveloutput. In related fashion,enhancedcoordination
ofnationalfiscal
policieswould also be helpful,therebyenabling the collectivefiscalpositionof the
euro area to be appropriatelycalibrated in relation to the prevailingmacroeconomic conditions.
Manyof thesepolicyproposalswould requirechangesin the treatiesgoverning
increasein thelevelofpoliticalintetheEuropean Union and implya transformative
gration.Paradoxically,the European crisishas generatedsevere political tensions
acrossthememberstates,whileat the same timepromptingmuch discussionof the
of more extensivetypesof politicalunion. In thisdebate, the parallels
desirability
withthe historicaldevelopmentof fiscalfederalismin the United Stateshave been
well-flagged(Henning and Kessler2012; Sargent2012).
5A
CouncilofEconomic
hasbeensuggested
bytheGerman
Experts
temporary
typeofeurobond
ajointly-backed
Debt
andWeder
diMauro2011).Underthisproposal,
Feld,Franz,
Schmidt,
(Bofinger,
ofGDP,thereby
therolltheexcessdebtabove60percent
Fundwouldrefinance
relieving
Redemption
the
Oncedebtlevels
fallbacktothe60percent
countries.
overpressures
ceiling,
facing
highly-indebted
Fundwould
bewound
DebtRedemption
up.
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TheEuropeanSovereign
DebtCrisis 65
In conclusion, the origin and propagation of the European sovereigndebt
crisiscan be attributedto the flawedoriginaldesignof the euro. In particular,there
was an incompleteunderstandingof the fragility
of a monetaryunion under crisis
in
the
absence
of
conditions,especially
bankingunion and other European-level
buffermechanisms.Moreover,the inherentmessinessinvolvedin proposingand
crisismanagementresponses on the fly
implementingincrementalmulticountry
has been an importantdestabilizingfactorthroughoutthe crisis.
The most benign perspectiveon the European sovereigndebt crisisis that
it providesan opportunityto implementreformsthat are necessaryfor a stable
monetaryunion but thatwould not have been politicallyfeasible in its absence.
A more modest hope is thatthe unfoldingreformprocess willdelivera monetary
union thatcan survive,even if it remainsvulnerableto recurringcrises.However,
the alternativescenario in which the single European currencyimplodes is no
longer unthinkable,even if it would unleash the "motherof all financialcrises"
(Eichengreen2010). The stakesare high.
■ I thankMichael Curran
, Michael OfGrady,and ClemensStruckfor diligentresearch
assistance.I am grateful
tomyfellowmembers
oftheeuro-nomics
groupformanyinsightful
the
euro
crisis
and
Claudio
Borio
Giancarlo
discussions
,
Corsetti,
of
JordiGali,PaoloMauro,
AshokaMody,MauryObstfeld,
and the]Y£editors
forhelpful
suggestions.
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