The Euro Under Attack

Originally published by the Carnegie Endowment for International Peace
Participants: Angel Ubide, Desmond Lachman, Uri Dadush

Greek government bonds are under attack and credit risk indicators point to a serious loss of market confidence in the government debt of Portugal, Spain, and Ireland. These concerns, coupled with worries about lost competitiveness in southern Europe, threaten not only individual economies, but also the euro itself.

Carnegie invited two distinguished economists—Angel Ubide of the Tudor Investment Corporation and Desmond Lachman of the American Enterprise Institute—to discuss their opposing views on the prospects for Europe and the euro. Carnegie’s Uri Dadush moderated.

What’s the Problem?

Presently, Greece is at the epicenter of the emerging sovereign debt crisis. While Ubide argued that the country’s situation is the result of fiscal problems, Lachman highlighted the roles played by its fixed exchange rate vis a vis other Euro Area partners and lost competitiveness.

• Current Vulnerabilities: All major indicators in Greece point to vulnerability: as a percent of GDP, fiscal deficits, public debt, and current account deficits are all high. For example, its budget deficit is more than four times the Euro area standard.
• Continued Fiscal Strain: With around 10 percent of the country’s debt maturing by May and continuing budget obligations requiring additional spending, a liquidity crunch may be coming soon.
• Exchange Rate Inflexibility: Countries with an independent exchange rate can allow currency depreciation, partially offsetting budget cuts with a rise in exports. As long as Greece remains a part of the Euro area, however, it does not have this option.
• Loss of Competitiveness: Lachman noted that Greece has lost 30 percent of its competitiveness in relation to the rest of the Euro area, suggesting that fiscal adjustment will be even more difficult.

Many observers have claimed that, while the current crisis is in Greece, Spain, the Euro area’s fourth largest economy, poses a greater threat to the euro. Panelists’ views on this point were mixed.

• Ubide argued that the problems in Spain, though significant, are overstated. Internal structural failures—and not the country’s Euro area membership and fixed exchange rate—caused its housing bubble to burst and unemployment to rise.
• Lachman disagreed, noting that the lack of a flexible exchange rate has exacerbated all of Spain’s vulnerabilities, including internal ones. He also argued that, while the euro might have had a real chance of survival if Greece were the only country facing problems, troubles in Spain, Portugal, Ireland, and Italy significantly diminish the currency’s chances.

Countering the Crisis

Panelists agreed that Greece abandoning the euro is not a solution. The logistics of such a move would be daunting, and contagion would trigger a second global financial crisis.

Panelists also agreed that Euro area policy makers must find the courage and mobilize the political will to enact the necessary, but painful, adjustments. They disagreed, however, on the likely severity of these adjustments.

• Noting that Greece needs to reduce its budget deficit by over 10 percent of GDP and that tax revenue already accounts for 40 percent of GDP, Lachman argued that any attempt to bring the budget back to sustainable levels will spark a depression.
• In Lachman’s view, the more likely scenario is that policy makers will continue to delay substantial changes until default is inevitable.
• On the other hand, Ubide claimed that, if governments can muster the political will to pass credible budget cuts, the euro can be sustained.  Many European nations, including Greece, were living above their means; now is the time for policy makers to tighten. Furthermore, there is room for structural adjustment—Greece’s retirement age is low, for example—and tightening need not spark a depression.
• Antonio De Lecea, Minister of Economy and Finance of the Delegation of the European Union, agreed that Europe’s struggles are manageable. The euro has encountered numerous challenges but leaders have always worked to address them.

Lessons Learned

Though the problems in Europe are far from resolved, lessons have emerged from the crisis.

• Rebalancing Needed: Ubide stressed that this crisis illustrates the need for stronger policy coordination among members of the Euro area, particularly with respect to balancing surpluses and deficits across the region.
• Budget Sustainability: Additionally, De Lecea noted that the EU needs to develop criterion for budget sustainability during years of strong economic growth to mirror those that exist for tough times.

Though panelists agreed that the financial crisis has been the biggest test of the euro’s viability to date, they interpreted the results differently.

• Ubide and De Lecea agreed that, while the Euro area was not an optimal currency area when it was established, it has performed well overall and provided stability to the region throughout the crisis.
• On the other hand, Lachman suggested that it is too soon to draw conclusions from this crisis and pointed to several remaining weaknesses, including the Euro area’s exposure to Eastern Europe, which may further hurt the region.

Rest of the World

The rest of the world is also critically involved in this sovereign debt crisis. The ripples sent through global financial markets by Iceland’s actual and Dubai’s near default highlight the devastation that a default in Greece, where debt levels are much greater, would cause.

• Exports: In the wake of a global recession, all major economies are looking to export growth to drive their recovery. This will make export growth in Europe more difficult and adjustment more painful.
• China’s Role: Lachman argued that Chinese yuan appreciation would help the Euro area, but indebted countries should look to domestic reforms, not to China, for solutions.
• The IMF: Though the IMF could help address this emerging crisis, Ubide argued that the European Commission has sufficient expertise to deal with the Euro area’s problems, and will do so on its own.

In his concluding remarks, Dadush noted that he believed the crisis would be managed, but adjustments would take time. Dadush also stressed that GDP growth in heavily strained economies should be monitored closely moving forward. If heavily indebted economies are able to return to growth, then budgets can be adjusted; if growth stagnates, budget problems will only become worse, and vulnerabilities will reach dangerous levels.