Self-Fulfilling Crises in the Eurozone: An Empirical Test. CEPS Working Document No. 366, 22 June 2012

This paper tests the hypothesis that government bond markets in the eurozone are more fragile and more susceptible to self-fulfilling liquidity crises than in stand-alone countries. We find evidence that a significant part of the surge in the spreads of the PIGS countries (Portugal, Ireland, Greece and Spain) in the eurozone during 2010-11 was disconnected from underlying increases in the debt-to-GDP ratios and fiscal space variables, and was the result of negative self-fulfilling market sentiments that became very strong since the end of 2010. We argue that this can drive member countries of the eurozone into bad equilibria. We also find evidence that after years of neglecting high government debt, investors became increasingly worried about this in the eurozone, and reacted by raising the spreads. No such worries developed in stand-alone countries despite the fact that debt-to-GDP ratios and fiscal space variables were equally high and increasing in these countries.

A simple model of multiple equilibria and default. CEPS Working Document No. 366, 16 July 2012

This Working Document by Daniel Gros presents a simple model that incorporates two types of sovereign default cost: first, a lump-sum cost due to the fact that the country does not service its debt fully and is recognised as being in default status, by ratings agencies, for example. Second, a cost that increases with the size of the losses (or haircut) imposed on creditors whose resistance to a haircut increases with the proportional loss inflicted upon them. One immediate implication of the model is that under some circumstances the creditors have a (collective) interest to forgive some debt in order to induce the country not to default. The model exhibits a potential for multiple equilibria, given that a higher interest rate charged by investors increases the debt service burden and thus the temptation to default. Under very high debt levels credit rationing can set in as the feedback loop between higher interest rates and the higher incentive to default can become explosive. The introduction of uncertainty makes multiple equilibria less likely and reduces their range.

Unholy compromise in the eurozone and how to right it. CEPS Policy Brief No. 277, 16 July 2012

This paper reviews the causes of the ongoing crisis in the eurozone and the policies needed to restore stability in financial markets and reassure a bewildered public. Its main message is that the EU will not overcome the crisis until it has a comprehensive and convincing set of policies in place; able to address simultaneously budgetary discipline and the sovereign debt crisis, the banking crisis, adequate liquidity provision by the ECB and dismal growth. The text updates and expands on his Policy Brief contributed in the run-up to the emergency European Council meeting at the end of June.

Can Italy and Spain survive rates of 6-7%? CEPS Policy Brief No. 279, 27 July 2012

The sentiment that the euro is now in real danger is based in large part on the widespread conviction that interest rates of 6-7% are simply unsustainable for both Italy and Spain., After taking a closer look at the fundamentals, however, Daniel Gros concludes in this new Policy Brief that both countries should be able to live with this level of interest rates for quite some time, but only if they mobilize domestic savings, which remain strong in both countries. For Spain, some debt/equity swaps are also needed.

The simple macroeconomics of North and South in EMU. Bruegel Working Paper 2012/12, 30 July 2012

The euro area today consists of a competitive, moderately leveraged North and an uncompetitive, over-indebted South. Its main macroeconomic challenge is to carry out the adjustment required to restore the competitiveness of its southern part and eliminate its excessive public and private debt burden. This paper investigates the relationship between fiscal and competitiveness adjustment in a stylised model with two countries in a monetary union, North and South. To restore competitiveness, South implements a more restrictive fiscal policy than North. We consider two scenarios. In the first, monetary policy aims at keeping inflation constant in the North. The South therefore needs to deflate to regain competitiveness, which worsens the debt dynamics. In the second, monetary policy aims at keeping inflation constant in the monetary union as a whole. This results in more monetary stimulus, inflation in the North is higher, and this in turn helps the debt dynamics in the South. Our main findings are: •The differential fiscal stance between North and South is what determines real exchange rate changes. South therefore needs to tighten more. There is no escape from relative austerity. •If monetary policy aims at keeping inflation stable in the North and the initial debt is above a certain threshold, debt dynamics are perverse: fiscal retrenchment is self-defeating; •If monetary policy targets average inflation instead, which implies higher inflation in the North, the initial debt threshold above which the debt dynamics become perverse is higher. Accepting more inflation at home is therefore a way for the North to contribute to restoring debt sustainability in the South. •Structural reforms in the South improve the debt dynamics if the initial debt is not too high. Again, targeting average inflation rather than inflation in the North helps strengthen the favourable effects of structural reforms.

spotlight europe 20120/05, August 2012: Confronting the crisis

The euro crisis has not gone away on holiday. In fact, it continues to generate a never-ending string of horrific headlines. Where is it all going to end? In this article we describe the proposed remedies that are currently being discussed, and what blue and red eurobonds, euro bills, FIRE and the debt redemption fund can actually achieve.

Intra-Euro rebalancing is inevitable, but insufficient. Bruegel Policy Contribution 2012/15, August 2012

Greece, Portugal and Spain face a serious risk of external solvency due to their close to minus 100 percent of GDP net negative international investment positions, which are largely composed of debt. The perceived inability of these countries to rebalance their external positions is a major root of the euro crisis. Intra-euro rebalancing through declines in unit labour costs (ULC) in southern Europe, and ULC increases in northern Europe should continue, but has limits because: The share of intra-euro trade has declined. Intra-euro trade balances have already adjusted to a great extent. The intra-euro real exchange rates of Greece, Portugal and Spain have also either already adjusted or do not indicate significant appreciations since 2000. There are only two main current account surplus countries, Germany and the Netherlands. A purely intra-euro adjustment strategy would require too-significant wage increases in northern countries and wage declines in southern countries, which do not seem to be feasible. Before the crisis, the euro was significantly overvalued despite the close-to balanced current account position. The euro has depreciated recently, but more is needed to support the extra-euro trade of southern euro-area members. A weaker euro would also boost exports, growth, inflation and wage increases in Germany, thereby helping further intra-euro adjustment and the survival of the euro.

The euro crisis: ten roots, but fewer solutions. Bruegel Policy Contribution 2012/17, October 2012

Many factors have contributed to the euro crisis. Some have been addressed by policymakers, even if belatedly, and European Union member states have been willing to improve the functioning of the euro area by agreeing to relinquish national sovereignty in some important areas. However, the most pressing issue threatening the integrity, even the existence, of the euro, has not been addressed: the deepening economic contraction in southern euro-area member states. The common interest lies in preserving the integrity of the euro area and in offering these countries improved prospects. Domestic structural reform and appropriate fiscal consolidation, wage increases and slower fiscal consolidation in economically stronger euro-area countries, a weaker euro exchange rate, debt restructuring and an investment programme should be part of the arsenal. In the medium term, more institutional change will be necessary to complement the planned overhaul of the euro area institutional framework. This will include the deployment of a euro-area economic stabilising tool, managing the overall fiscal stance of the euro area, some form of Eurobonds and measures to make euro-area level decision making bodies more effective and democratically legitimate.

What distinguishes the euro crisis from a ‘normal’ financial crisis? CEPS Commentary, 6 November 2012

This Commentary attempts to discern the distinguishing features between the present euro crisis and the financial crisis brought on in the US by the subprime lending disaster and the ensuing collapse of banks and other financial institutions in 2007-08. It finds that whereas the US was able to bring its crisis to an end by socialising the dubious debt and stabilising its valuation so that it could migrate to other investors capable of bearing the risk, this pattern can be only partly repeated in the eurozone, where both debt socialisation and a return to normal risk assessment are more problematic.. It concludes, nevertheless, that the crisis should now abate somewhat given that most risk-averse institutions have by now sold their holdings of peripheral countries’ sovereign debt and especially in light of the ECB’s assurances that it will not allow the euro to disintegrate.

The Prize is more Peace: The EU should consolidate its enlargement process. CEPS Commentary, 8 November 2012

The sovereign debt crisis and the threat of financial collapse of some EU member states have triggered fierce debate about the economic, social and political finalité of the Union and curbed the appetite for further enlargement. The European Commission needs to find new ways to consolidate the enlargement agenda, gain full support of the member states for its implementation and assure a consistent application of the pre-accession requirements. Arguably, more time, more money and greater expertise are needed to pursue the vocation recognised by the Nobel Committee.

When the rising dragon sees fading stars: China's view of the European Union. CEPS Special Report No. 73, 29 November 2012

This CEPS Special Report gives an overview of China’s perceptions of the EU and the protection of Chinese investments in Europe since the outbreak of the European sovereign debt crisis, especially since the more concrete talks in late 2011 on possible financial support from China. Although the top leadership of the communist party of China (CPC) changed in its recent handover, the perceptions described in this paper are likely to remain the same, just as the main tenets of China’s foreign policy are unlikely to change in the near future. The report argues that while the EU’s image has suffered greatly from the sovereign debt crisis and the way it has been handled, there is room to improve China’s view of Europe and for the EU to maintain a relatively strong negotiation position towards China.

Options for a Euro-area fiscal capacity. Bruegel Policy Brief 2013/01, January 2013

Europe has responded to the crisis with strengthened budgetary and macroeconomic surveillance, the creation of the European Stability Mechanism, liquidity provisioning by resilient economies and the European Central Bank and a process towards a banking union. However, a monetary union requires some form of budget for fiscal stabilisation in case of shocks, and as a backstop to the banking union. This paper compares four quantitatively different schemes of fiscal stabilisation and proposes a new scheme based on GDP-indexed bonds. The options considered are: (i) A federal budget with unemployment and corporate taxes shifted to euro-area level; (ii) a support scheme based on deviations from potential output;(iii) an insurance scheme via which governments would issue bonds indexed to GDP, and (iv) a scheme in which access to jointly guaranteed borrowing is combined with gradual withdrawal of fiscal sovereignty. Our comparison is based on strong assumptions. We carry out a preliminary, limited simulation of how the debt-to-GDP ratio would have developed between 2008-14 under the four schemes for Greece, Ireland, Portugal, Spain and an ‘average’ country.The schemes have varying implications in each case for debt sustainability