Will the Euro Survive?

Originally published by the Carnegie Endowment for International Peace
Participants: Uri Dadush, Jacob Kirkegaard, Desmond Lachman, Liliana Rojas-Suarez, Antonio de Lecea

With EU leaders scrambling to keep Greece afloat, rating agencies continuing to downgrade European sovereign credit, banks being pushed to the brink, and Europe likely slipping back into recession, time may be running out for the euro. Jacob Kirkegaard of the Peterson Institute for International Economics, Desmond Lachman of the American Enterprise Institute, Liliana Rojas-Suarez of the Center for Global Development, Antonio de Lecea of the EU Delegation to the United States, and Carnegie’s Uri Dadush offered their perspective on the crisis, how to resolve it, and the prospects for the euro.

Can the Euro Survive?

Panelists took opposing views regarding the future of the euro.

• A Smaller Eurozone: Lachman noted that lowering Greece’s public debt and restoring its competitiveness on international markets will require a long and deep recession. Rather than enduring this pain, Greece will likely default, exit the euro, and devalue. Portugal and Ireland could follow. Rojas-Suarez agreed, adding that resolving the euro crisis will require transfers from creditors to debtors. When political patience for transfers from Germany and other creditor countries to Greece wears thin, Greece will have no choice but to leave.
• Staying Together: Kirkegaard disagreed, arguing that Greece can default without leaving the euro, since the IMF and EU will fund Greece for as long as is necessary. Moreover, exiting the euro to devalue would bring little benefit: Greece exports represent only 8 percent of GDP.
• Political Will: De Lecea warned against underestimating the political will to hold the union together. While people realize that their countries have problems, most believe that those problems are more easily resolved in the eurozone.

Panelists agreed that preventing a bigger crisis would require restoring growth in Spain and Italy, the eurozone’s third and fourth largest countries.

• Italy: Italy has made little progress implementing the structural changes that will solve its growth problem, Kirgegaard noted. However, Lachman pointed out that Italy, despite its political problems, has a positive primary surplus (government balance excluding interest payments) and would be in reasonable shape if the external environment were stronger.
• Spain: Lachman said he was more worried about Spain, where external debts are high and the housing sector remains extremely weak. Kirkegaard argued that Spain has passed several important reforms, although further progress was unlikely until after the 2012 election.

The European Financial Stability Facility (EFSF)

With markets again growing concerned about Italy and Spain, immediate action is needed to improve the EFSF.

• Increased Flexibility: Since the EFSF’s creation in 2010, Europeans have already increased its lending capacity and enabled it to intervene in markets on a precautionary basis, de Lecea said.
• Increasing Funding: Lachman stressed that Europeans have no choice but to increase the European bailout fund. Given political constraints, it will have to be augmented by leveraging existing money rather than through new commitments, though the latter would be preferred. Lachman also cautioned policymakers that political bargaining over the EFSF would weaken its credibility.
• An Insufficient Mechanism: Rojas-Suarez stressed that the EFSF would be insufficient, no matter its size. She described the EFSF as a mechanism through which indebted European countries help other indebted European countries, arguing that as a result, investors will eventually abandon European bonds in favor of U.S. Treasuries, which remain the world’s safest asset. Europeans must therefore build their firewall with outside resources.

Stressing the importance the banking sector, Rojas-Suarez added that the policymakers should focus on ending the banking crisis. This requires two steps: first, banks must be recapitalized, through government interventions if necessary; second, debts should be written down, and banks have to take hit. This would represent the transfer from creditors to debtors that is necessary to resolve the crisis.

The European Central Bank’s Role

The euro crisis has put the European Central Bank (ECB) in an uncomfortable position. As a highly independent organization, it prefers to remain agnostic in political debates, but as the controller of the euro’s printing presses, it—and perhaps it alone—has the firepower to calm markets, Lachman said.

• Supporting the EFSF: Because governments are unlikely to do it, the ECB will probably step in and leverage up the EFSF’s lending capacity to around 2 trillion euros, said Lachman.
• A Goal of Reform: Kirkegaard underscored that, while the ECB could quickly calm markets by guaranteeing Italian and Spanish debt, this is not its goal. Instead, ECB officials are likely to push for stronger fiscal oversight and institutional reform in Europe while keeping their emergency lending facilities in place in case they must step in to save Italy or Spain if absolutely necessary.
• The Limits of Influence: Rojas-Suarez was skeptical of the ECB’s ability to stop contagion so quickly. If markets perceived that the ECB was in effect writing a blank check to Italy or Spain, they would flee the weakened euro for the dollar.
• More is Needed: De Lecea added that given the complex problems surrounding the euro crisis, one institution would not and could not solve it alone. All panelists noted that even large-scale ECB interventions would do little to resolve the underlying structural issues in many peripheral economies.

Long-term Fixes

If the eurozone survives this episode, new policies must be put in place to ensure that it is able withstand future crises.

• Remove Members: Lachman said that Europeans would likely have to reduce the eurozone to an optimal currency area, shaving off some peripheral members while keeping those in the core.
• Strengthen Institutions: De Lecea disagreed, but stressed the importance of using the crisis to strengthen the institutions that underpin the European Union. Kirkegaard added that while many Europeans identify more strongly with their country than with Europe, the crisis increases people’s willingness to form a stronger union. Politicians should oblige, first by implementing stricter fiscal rules through, for example, a EU veto of national budgets. Second, Europeans should establish a strong banking authority, similar to the Federal Deposit Insurance Corporation (FDIC) in the United States.

International Involvement

Given Europe’s enormous importance in the world economy, the crisis threatens countries around the world. Panelists discussed how global leaders should respond.

• Assistance: Rojas-Suarez noted that international policymakers should be prepared to help, once Europe is willing to turn to them. Lachman, however, said that advanced countries will be unable to provide much assistance. For example, the United States will not appropriate more funds to the IMF because of internal politics.
• Emerging Markets: Rojas-Suarez highlighted that emerging markets—particularly China—have the financial resources to help resolve the crisis, but it is not politically feasible for them to do so. The international burden will thus fall primarily on developed countries.
• A European Solution: De Lecea and Kirkegaard concluded that Europe will be able to manage the crisis on its own. The current situation is politically and technically challenging, but both expressed confidence that leaders would eventually resolve these problems.