Category Archives: Eurozone

The Euro At Twenty: Mody’s EuroTragedy

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The euro will mark its twentieth anniversary in 2019. Is this a cause of celebration and congratulations? Or a case of a well-intentioned policy gone awry? Ashoka Mody in his new book , EuroTragedy: A Drama in Nine Acts, offers an account that shows that the joint currency was flawed from the outset, and has been further weakened by poor policy choices.

Mody, a distinguished research economist at the IMF for many years, is currently the Charles and Marie Robertson Visiting Professor in International Economic Policy at the Woodrow Wilson School at Princeton University. His book is a combination of scholarship and storytelling, as Mody analyzes the background of the euro, its evolution and future prospects. He does a wonderful job in portraying the European figures who advanced the monetary union, often in the face of public indifference or opposition. At the end, he is deeply pessimistic about the viability of the common currency and its impact on the European economies that use it.

The decision to introduce the euro was based on political aspirations, not economic need. The history begins with the European Coal and Steel Community formed in 1951 by France, Germany, Italy, Belgium, the Netherlands and Luxembourg. This was followed in 1958 by the formation of the European Economic Community, a common market and customs union for the same six nations. These associations sought to bind together the economies of Europe, which had been shattered by two world wars and the Great Depression. However, national sovereignty over domestic policies, particularly taxes and government expenditures, was asserted by the leaders of the member countries from the very beginning.

The next step took place in 1969 when French President Georges Pompidou called for a European monetary union. Pompidou was motivated by a desire to end the chronic devaluations of the French franc against the German mark. Despite skepticism over the feasibility of a common currency, West German Chancellor Willy Brandt , whose main priority was the reunion of both halves of Germany, gave a tentative endorsement, based on an understanding that there would be “harmonization” of fiscal policies. But this was a conditional agreement, and the terms were left undefined. The consequences of that ambiguity have bedeviled the implementation of the euro to the current day.

Denmark, Ireland and the United Kingdom joined the original six nations in 1973, and more joined in the 1980s. The formation of the European Monetary System in 1978 to fix exchange rates amongst these nations was a step on the road to a monetary union. The currency crises of 1981 and 1982, however, showed the risks in such integration, and for much of the 1980s further progress seemed stalled. Mody tells well the story of the change in the position of Germany’s leader Helmut Kohl, who sought to unify Europe after his own country came together in 1989. Kohl’s endorsement ensured that there would be sufficient support amongst European leaders for the euro. Kohl, however, never overcame the doubts and concerns of German policymakers and business leaders over how a common currency would affect Germany itself. The Germans were particularly wary of the possibility that they would be required to come to the assistance of other less credit-worthy members.

In addition to German concerns about its responsibilities, there were flaws in the design of the euro. Those countries that join a monetary union lose the ability to use national monetary policy to stabilize their national economies. In theory, this vulnerability can be offset by fiscal transfers from a central source to the areas affected by asymmetric shocks that the union’s central bank does not address, much as the U.S. federal government can allocate funds to areas in emergency.  But such a redistribution mechanism was never established for the Eurozone, in large part due to opposition from Germany and other members. In addition, domestic fiscal policy is constrained by the Stability and Growth Pact (SGP), which puts a limit on budget deficits of 3% of GDP. Since an economic contraction lowers tax revenues, a government facing a recession will already be in danger of violating the SGP mandate, and therefore cannot increase its own spending to counter the downturn.

In addition to this fundamental flaw, the viability of the euro has been hampered by the policies of the European Central Bank (ECB).  The ECB has a single mandate: maintain price stability.  The limitations of that charge became quite clear during the global financial crisis, but were amplified by the unwillingness of ECB President Jean-Claude Trichet to acknowledge the depth of the crisis and formulate an adequate response. Federal Reserve Chair Ben Bernanke was much more aggressive in responding with unconventional policy moves such as Quantitative Easing. This timidity was compounded by premature calls for fiscal austerity during the slow economic recovery.

The Greek debt crisis amply demonstrated the division within the Eurozone over what obligations member governments have to come to the aid of another member in fiscal distress. Mody believes that Italy now poses the biggest current threat to the structure of the Eurozone. That country adopted the euro in the belief that it would act as a “vincolo esterno,” an external constraint that would impose sound policies on a fractious political system. But a common currency cannot improve low productivity growth due to poor governance and institutions.

The protracted pace of the recovery in Italy from the global crisis has frustrated its citizens, who have turned to populist parties—the Northern League and the Five Star Movement—that were once seen as fringe movements. The parties have dropped their opposition to the euro because of public sentiment. But the new government is determined to proceed with its fiscal plans, which include a flat tax rate and a universal income. The resulting deficit would violate the European Commission’s fiscal rules and raise Italy’s debt burden. The current public debt/GDP ratio of 131% is exceeded within the Eurozone only by that of Greece. While an Italian exit from the European Union seems impossible, the Italian government and the European Commission each seem determined to make the other side move first towards a compromise in an international game of chicken.  In such circumstances there is ample opportunity for miscommunication and misunderstanding. Given the size of the Italian economy, any rupture could be catastrophic.

Mody is not anti-European. Indeed, he calls for a renewal of the European identity of a group of nations that compete in the “marketplace of ideas,” and together form a European Republic of Letters. But the euro has not fostered that identity, and in is based on an inherent flaw:

“The original conundrum remains. A single monetary policy for diverse countries cannot operate effectively without a mechanism to share risks in crisis conditions. Eurozone leaders cannot agree to a risk-sharing mechanism based on a democratically legitimate political contract. Under pressure during the crisis years, they agreed on technical agreements to share risks. These arrangements can be undone politically at an inopportune moment.”  (Mody, p. 385)

Mody’s book provides an important lesson: policies imposed by political elites that are not endorsed by the public who are supposed to benefit from them have weak underpinnings. A crisis uncovers the flaws in the institutional architecture, and these exacerbate the impact of the crisis. The resulting tragedy affects everyone, not just those who promoted a solution to a problem that did not exist.

Greece, the IMF and the Euro

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Talk about possible trade wars with China and the Brexit negotiations has crowded the Greek debt crisis out of the headlines, but a new decision point is approaching. It is possible that this time the beleaguered Greek government will announce a withdrawal from the Eurozone, if only to drive home the point to other European governments that the status quo is not acceptable. But those governments, facing resistance from voters suspicious of foreign engagements, may not offer terms acceptable to the Greek government. Moreover, the IMF does not want to approve the next stage of a bailout agreement that it believes is not credible. Consequently, each side may feel pushed to accept an outcome it knows is not optimal. If that comes to pass, the consequences for the Eurozone will be far-reaching.

Greek economic performance, after years of contraction, has stabilized. The IMF projected that GDP, after stagnating in 2016, would increase in the current year by 2.8%. But the ratio of gross debt to GDP, according to the IMF’s projection in last fall’s Global Stability Report, was 183.4% last year, up from 176.9% in 2015 and 180.1% in 2014. Moreover, a draft report from the Fund projects continuing growth in the debt burden, ultimately reaching a crushing 275% in 2060.

The IMF’s concerns come as European governments are assessing Greek compliance with its current bailout agreement. Greece needs a successful review to qualify for disbursal of about $90 billion, which the government requires for debt repayments. Greece has met its recent fiscal targets, but the agreement calls for a 3.5% primary budget surplus target by 2018. The IMF fears that this is not achievable without a degree of fiscal austerity that would kill off the incipient recovery. Not everyone shares the IMF’s apprehensions, and the agency that administers the European Stability Mechanism has issued a positive assessment. But if the IMF does not approve the next stage of the bailout, at least some European governments will not want to proceed.

George Papaconstantinou in Game Over has provided an insider’s look at the outbreak of the crisis and the course of negotiations in the early years. Papaconstantinou, who earned a Ph.D. in economics at the London School of Economics, served first as Finance Minister and then Minister of Environment, Energy and Climate Change, in the government of Prime Minister George Papandreou from 2009 to 2012. He faced what he calls a “disconnect” between the demands from European ministers that the Greek government close the fiscal deficit and the realization at home what the abrupt change in the government’s fiscal position meant for the economy. There was a continuous refusal on both sides to address the reality of the situation and to temporize in the unfounded hope that the arrival of another day would deliver a solution—or at least delay any decision that would generate voter unhappiness, either at home or in the European electorate. But postponement only raised the cost of what became three bailout agreements. Among the lessons that Papaconstantinou draws: “time is expensive: the more you delay, the more you pay.”

The IMF was also facing challenges in its involvement in the crisis negotiations, as Paul Blustein recounts in Laid Low. The Fund joined the European Central Bank and the European Commission, representing the European Union, in an arrangement known as the “troika.” The IMF, however, was viewed as a “junior partner,” and had to negotiate with its partners as well as with the Greek government. This was a departure from past practice, and placed the IMF in the position of making compromises that it came to regret.

The principal violation of the Fund’s own practices took place early in the crisis when it approved “exceptional access” credit to Greece, i.e., an unusually large amount of credit. Such approval was supposed to be contingent on a high probability that the debt was sustainable. This condition had clearly not been met in 2010, but the IMF gave itself a loophole when it approved exceptional credit if there is a high risk of international systemic spillovers. The insertion of the systemic exception clause violated any notion of the IMF’s evenhandedness when dealing with members who required assistance, and reinforced the image of the Fund as an agency dominated by its richer members.

The IMF subsequently has sought to recover its reputation as an institution that has extensive experience in macro adjustment and is willing to “speak truth to power.” It eliminated the exceptional access provision in 2016. The Fund now admits that the fiscal policies imposed on Greece in the earlier bailout programs were contractionary. And in a statement it issued on Tuesday, the IMF called for more debt relief by the European creditor governments:

“Most Directors considered that, despite Greece’s enormous sacrifices and European partners’ generous support, further relief may well be required to restore debt sustainability.”

But in a highly unusual public statement, the IMF also announced that the Board was split on the feasibility of the new agreement:

“Most Directors agreed that Greece does not require further fiscal consolidation at this time, given the impressive adjustment to date which is expected to bring the medium-term primary fiscal surplus to around 1½ percent of GDP, while some Directors favored a surplus of 3½ percent of GDP by 2018.”

Could there be a better outcome? Joseph Stiglitz of Columbia University argues that the monetary union is inherently flawed in The Euro. He points out that the euro was justified on the premise that a single currency would facilitate trade and financial flows, and “…the resulting economic integration would improve societal welfare everywhere within the Eurozone.” In fact, there were winners and losers, and the latter were not compensated for their losses. Such a redistribution requires political integration, which does not automatically follow the establishment of economic integration.

Stiglitz does not want to abandon what he calls the “European project,” and offers several structural reforms to rescue the euro. But all of these require political resolution as well intellectual flexibility, and these are not qualities rewarded by voters. Upcoming elections in France and Germany will show whether their citizens approve of the attempts to maintain the viability of the euro. If they follow the examples of the U.S. and British electorates, then the days of the euro may be numbered.

The Challenges of the Greek Crisis

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The Greek crisis has abated, but not ended. Representatives of the “troika” of the European Commission, the European Central Bank and the International Monetary Fund returned to Athens for talks with the Greek government about a new bailout. This pause allows an accounting of the many challenges that the events in Greece pose to the international community.

The main challenge, of course, is to the Greek government itself, which must implement the fiscal and other measures contained in the agreement with the European governments. These include steps to liberalize labor markets as well as open up protected sectors of the economy. While these structural reforms should promote growth over time, in the short-run they will lead to layoffs and reorganizations. At the same time, Prime Minister Alex Tsipras must oversee tax rises and cuts in spending. The combined impact of all these measures, which follow the virtual shutdown of the financial sector during the protracted negotiations with the European governments, will postpone any resumption in growth that past efforts may have generated.

It is not clear how long the Greek public will endure further misery. Any form of debt restructuring may give policymakers some justification to continue with the agreement. New elections will clarify the degree of political support for the pact. But the possibility of an exit from the Eurozone has not been removed, either in the eyes of Greek politicians or those of officials of other governments.

The Greek crisis, however, is not the only hazard that the Eurozone faces. The Eurozone’s governments have yet to come to terms with the effects of the global financial crisis on its members’ finances. A split prevails between those countries that ally themselves with the German position that debt must be repaid and those that seek with France to find some sort of middle ground. Other European countries with debt/GDP ratios of over 100% include Belgium, Portugal, and Italy. Weak economic growth could push any of them into a situation where the costs of refinancing become daunting. How would the Eurozone governments respond? Would they bail out another member? If so, would the terms differ from those imposed on Greece? Would European banks be able to pass the distressed debt on to their own governments?

In the long-term, the governments of the Eurozone face the dilemma of how to reconcile centralized rule-making with national sovereignty. The ECB, for example, has been granted supervisory oversight of the banks in the Eurozone. It will exercise direct oversight of over 100 banks deemed to be “significant,” while sharing responsibility with national supervisors for the remaining approximately 3,500 banks. The ECB has a Supervisory Board, supported by a Steering Committee, to plan and executes its supervisory tasks, which supposedly allows it to separate its bank supervisory function from its role in setting monetary policy. All these agencies and committees must work out their respective jurisdictions and responsibilities. Meanwhile, the European Commission, which oversees fiscal policies, faces requests for exemptions from its budget guidelines by governments with faltering growth. But if it shows flexibility in enforcing its own rules, it will be derided as weak and ineffective.

The IMF has its own set of challenges. The IMF was sharply criticized for its response to the wave of crises that struck emerging markets in the last 1990s and early 2000s, beginning with Mexico in 1994 and extending to Turkey and Argentina in 2001. Critics charged that the IMF was slow to respond to the rapid “sudden stops” of capital outflows that set off and exacerbated the crises. When the Fund did act, it attached too many conditions to its programs; moreover, these conditions were harsh and inappropriate for crises based on capital outflows.

The global financial crisis gave the IMF a second chance to demonstrate its crisis-management abilities (for a full account, see here). The Managing Director at the time, Dominique Strauss-Kahn, seized the opportunity to redeem the IMF ‘s reputation, as well as reestablish his own political career in France. The IMF lent quickly to its members, attached relatively few conditions to the loans, and allowed the use of fiscal measures to stabilize domestic economies. The result was less severe adjustment, the avoidance of excessive exchange rate movements and a resumption of economic growth. By the time the global economy recovered, the IMF had proven that it could respond in a flexible manner to a financial emergency.

The IMF’s response in 2010 to the Greek debt crisis was very different. The IMF’s loan to Greece was the first to a Eurozone member; moreover, the loan was much larger than any the IMF had extended before, whether measured by the total amount of credit or as a percentage of the borrowing country’s quota at the Fund. To make the loan, the IMF had to overlook one of it own guidelines for granting “exceptional access” by a member to Fund credit. Such loans were to be made only if the borrowing government’s debt would be sustainable in the medium-term. Greece’s debt burden did not pass this criterion, so the Fund justified its actions on the grounds that there was a risk of “international systemic spillovers.”

The IMF’s involvement in the Greek program was also unusual in another sense: the IMF’s contribution, as large as it was, was still smaller than that of the European governments. The IMF was, in effect, a “junior partner.” While it had worked with other governments before (such as the U.S. when it lent to Mexico in 1994-95), this was the first time that the IMF was not in a lead position. This may have initially made it reluctant to disagree with the other members of the troika.

The subsequent contraction in the Greek economy far exceeded the IMF’s forecasts. The IMF later admitted that it underestimated the size of the multipliers for the fiscal policies contained in the program in a paper co-authored by the head of the IMF’s Research Department, Olivier Blanchard (see also here). The failure to properly estimate the impact of these conditions calls into doubt the basic premises of the 2010 and 2012 programs.

More recently, the IMF has challenged its European partners over their projections for the Greek debt, as well as the budget and fiscal targets contained in the latest agreement. The Fund claims that the debt projections are much too optimistic. Greece’s debt will only be sustainable if there is debt relief on a much larger scale than the European governments have been willing to undertake. Moreover, the IMF states that it will not be part of any new programs for Greece if debt relief is not a component.

The public admission of error and the rebukes of the European governments will only partially restore the IMF’s reputation. The generous treatment of Greece as well as Ireland and Portugal reinforces the belief that the European countries and the U.S. control the IMF. The members of the European Union have a total quota share of almost one-third, much larger than their share of world GDP. This voting share combined with the U.S. quota gives these countries almost half of all the voting shares at the IMF. The need for a realignment of the quotas to give the emerging market nations a larger share has long been acknowledged, but approval of the reform measures is mired in the U.S. Congress.

Another aspect of European and U.S. control of the “Bretton Woods twins”—the IMF and the World Bank—has been their selection of the heads of these organizations. All the Managing Directors of the IMF have been Europeans, and until the appointment of Ms. Lagarde, European males. All the heads of the World Bank have been U.S. citizens. Ms. Lagarde’s term expires next July, and the pressure to name a non-European will be tremendous. How the Europeans and U.S. respond to this challenge will go a long way in determining whether these institutions will be shunted aside by the emerging market nations in favor of institutions that they can control.

The last challenge of the Greek crisis comes for the Federal Reserve. Federal Reserve Chair Janet Yellen has been explaining that a rise in the Fed’s policy rate, the Federal Funds rate, is likely to occur later this year. This forecast, however, is contingent on continued economic growth and favorable labor market conditions. These plans could be threatened by any financial volatility that followed a disruption in the latest Greece bailout.

The Federal Reserve is also aware that a rise in interest rates would affect the dollar/euro exchange rate. The euro, which has been depreciating, could fall lower when the Fed raises rates while the ECB keeps its refinancing rate at 0.05%. A further appreciation of the dollar would threaten U.S. exports, thus endangering a recovery.

The Fed also faces concerns about the broader impact of its policy initiatives on the world economy. The IMF is worried about how a rate rise would affect the global economy, and has urged the Fed to hold off on interest rate increases until 20016. Companies that borrowed in dollars through bonds and bank loans will be adversely affected by the combined effects of an interest rate rise and a dollar appreciation.

Greece’s GDP accounts for only 0.4% of world GDP and about 1.3% of the European Union’s total output. But the global financial crisis demonstrated how financial linkages across sectors and countries can disrupt economic activity no matter what their source. The response to these incidents by national and international authorities can risk global stability if they are based on self-interest and organizational agendas. Commitments to cooperation disappear quickly when national concerns are threatened.

(A Powerpoint version of this post is available here.)

European Doldrums

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European economies are faltering.  The German economy contracted in the second quarter, as did those of France and Italy. Growth in Spain and the Netherlands was not enough to offset the slowdown in the Eurozone’s largest members.  An escalation in the confrontation with Russia would send shockwaves rippling from the Ukraine westwards that world worsen the situation.

The continuing slump confirms Jay C. Shambaugh’s observation (which appears in his paper in the new volume, What Have We Learned? Macroeconomic Policy After the Crisis) that much of what happened during the global financial crisis was consistent with standard international macroeconomics. For example, countries with flexible exchange rates were able to adjust more easily to the shock than those with fixed rates. Shambaugh also compares unemployment rates in the Eurozone with those across the U.S., and notes that while both the range and standard deviation of unemployment rates began to fall in the U.S. in 2010, the dispersion of national unemployment rates continued in the Eurozone. Labor conditions improved in some countries, but not others. Shambaugh cites this as evidence that there is a lack of adequate shock absorbers, such as labor mobility, within the Eurozone.

These structural problems have been exacerbated by fiscal austerity policies. Governments have sought to reestablish fiscal balance despite the impact on economic performance. The latest announcements of lowered growth have led to calls for relaxing fiscal constraints. But the incoming head of the EU Commission, Jean-Claude Juncker, shows little interest in relaxing the limits on fiscal policies, nor does German Chancellor Angela Merkel.

This leaves (once again) Mario Draghi and the European Central Bank as the focus of hope and attention. The central bank is waiting for the impact of policy measures announced in June to take place. But the disappointing economic news only reinforces calls for the ECB to enact a European version of quantitative easing.

The European GDP data have troubling implications for the larger issue of European debt. Last April, the IMF offered projections for the debt/GDP ratios this year and next:

 

2014 2015
France 95.8 96.1
Greece 174.7 171.3
Ireland 123.7 122.7
Italy 134.5 133.1
Spain 98.8 102.0
Eurozone 95.6 94.5

 

The new data will not improve the forecasts for these countries. Greece’s situation, in particular, appears as dire as ever. The Greek government hopes that a cyclically-adjusted fiscal surplus of 2.1% for 2013 will allow it some reduction in the interest rates it must pay and an extension of debt repayments. But the official targets for debt/GDP ratios of 124% in 2020 and 110% in 2022 appear unrealistic.

In a recent paper by Manuel Ramos-Francia, Ana María Aguilar-Argaez, Santiago García-Verdú and Gabriel Cuadra-García (all of the Banco de México) that appeared in the English edition of Monetaria, the authors compare the Latin American debt crisis with the European crisis. They point out that the macro imbalances and the magnitudes of the debt are larger in the peripheral European countries than they were in Latin America. Moreover, the Europeans are not able to rely on exchange rate devaluations to deal with the costs of fiscal austerity. They also remind us that the Latin American situation was finally resolved in 1989 by a reduction in debt and the issuance of “Brady bonds” (see Chapter 4 here), and suggest that some form of debt relief be granted in Europe.

It took seven years from the outbreak of the Latin American crisis for a resolution to be achieved. By that reckoning, European countries have several years of continued stagnation ahead. Political leaders who have seen their predecessors swept out of office by angry voters may not be willing to wait that long.

The ECB’s Daunting Task

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Mario Draghi, head of the European Central Bank, and the members of the ECB’s Governing Council are receiving praise for the initiatives they announced last week to avoid deflation (see here and here). The immediate impact of the announcement was a rise in European stock prices. But the approval of the financial sector does not mean that the ECB will be successful in its mission to rejuvenate the Eurozone’s economy.

The ECB is taking several expansionary steps. First, it has cut the rate paid on the deposits of banks at the ECB to a negative 0.1%, thus penalizing the banks for not using their reserves to make loans. Second, it is setting up a new lending program, called “Targeted Longer-Term Refinancing Operations (TLTROs),” to provide financing to banks that make loans to households and firms. Third, it will no longer offset the monetary impact of its purchases of government bonds, i.e., no “sterilization.” Moreover, Draghi’s announcement included a pledge that the ECB will consider further steps, including the use of “…unconventional instruments within its mandate, should it become necessary to further address risks of too prolonged a period of low inflation.”

Draghi’s promise to take further steps are reminiscent of his announcement in 2012 that the ECB was “…ready to do whatever it takes to preserve the euro.” That promise was successful in calming concerns about massive defaults and a break-up of the Eurozone. Consequently, the returns that sovereign borrowers in the Eurozone had to pay on their bonds began a decline that has continued to the present day.

But the challenges now facing the ECB are in many aspects more daunting. The current Eurozone inflation rate of 0.5% is an indicator of the anemic state of European economies.  Achieving the target inflation target of the ECB of 2% will require a significant increase in spending. The latest forecast for 2014’s GDP Eurozone growth from The Economist is 1.1%, which would be a pick-up from the 0.7% in the latest quarter, with an anticipated inflation rate for the year of 0.8%. Unemployment for the area is 11.7%, and this includes rates of 25.1% in Spain, 26.5% in Greece, and 12.6% in Italy.

More bank lending would encourage economic activity, but it is not clear that European banks are willing to make private-sector loans. Many banks are still dealing with past loans that will never be repaid as they seek to pass bank stress tests. And Draghi’s success in calming fears about sovereign default has (perhaps paradoxically) resulted in banks holding onto government bonds, which are now seen as relatively safe compared to private loans.

There is one other aspect of the European situation that can derail the ECB’s efforts: the distribution of financial wealth. The recent publication of House of Debt by Atif Mian and Amir Sufi has led to discussions of the deterioration of household balance sheets during the global financial crisis, and the economic consequences of the massive decline in household wealth. Larry Summers has praised the authors’ contribution to our understanding of the impact of the crisis on economic welfare by focusing on this channel of transmission.

Mian and Sufi have claimed that income distribution has a role in the response of households to policies that seek to boost spending. Low-income households, they point out, will spend a higher fraction of fiscal stimulus income checks than high-income households. They would most likely also spend a higher proportion of a rise in their financial worth. A concentration of such wealth in the hands of a small proportion of European households, therefore, limits the increase in spending due to higher asset prices.

The ECB, therefore, may find that the plaudits they have earned do not translate to a better policy outcome. The situation they face is not unique, and resembles in many ways the challenges that the Bank of Japan in has faced. Draghi and the ECB may have to follow their lead in devising new measures if European spending and inflation do not pick up.

As Time Goes By

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Depending on how the beginning of the European debt crisis is dated (2010? 2008? 1999?), it has been several years since the governments of several nations have sought to relieve investors’ fears regarding their debt. The governments of four countries (Cyprus, Greece, Ireland, Portugal) turned to the IMF and other Eurozone nations for assistance, while Italy and Spain have undertaken policies designed to avoid the need for external assistance. To paraphrase a former mayor of New York, how are those governments doing?

To answer that question, we can draw upon Jay Shambaugh’s insight that there are actually three interlocking crises: a macroeconomic crisis, a debt crisis and a banking crisis.

First, we examine current data for the prevailing (2013) macro conditions in the (in)famous PIIGS, as well as the entire Euro area and, for the sake of comparison, the U.S. and Japan. We exclude Cyprus as its crisis occurred more recently:

%

GDP Growth

 Unemployment Budget/GDP

Cur Acc/GDP
Greece

-4.0

 27.3 -2.4 0.1
Ireland

0.3

 13.2 -7.4

4.0
Italy

-1.8

 12.5 -3.3

0.4
Portugal

-1.8

 15.6 -5.9

0.3
Spain

-1.3

 26.6 -7.1

0.8
Euro Area

-0.4

 12.2 -3.0

1.9
U.S.

1.6

 7.3 -4.0

-2.5

Japan

 1.9 4.0 -8.3

1.2

In the Eurozone countries, only Ireland (barely) has avoided a negative growth rate, while both the U.S. and Japan are doing better. The unemployment rates reflect the depths of the continuing downturns. The budget balances continue to record deficits that largely reflect cyclical conditions; Greece and Italy have primary budget surpluses. The current accounts all register surpluses, unlike the U.S. Nikolas Schöll at Bruegel examined the data to uncover the sources of the reversals of the trade deficits, and pointed out that Ireland, Portugal and Spain recorded large increases in exports, while Greece had a dramatic drop in imports.

Will 2014 be any better? The IMF’s October 2013 World Economic Outlook forecasts a swing to positive growth rates in all of Europe except Slovenia. But, it warned, “Additional near-term support will be needed to reverse weak growth…” and called for further monetary easing. The ECB has obliged by lowering its refinancing rate to 0.25% in response to falling inflation, not a hopeful sign of recovery.

How do these countries do on their sovereign debt? We can compare the debt/GDP data for 2010 with this year’s and next year’s expected levels:

Debt/GDP

2010

2013

2014
Greece

148.3

 175.7

174.0
Ireland

91.2

 123.3

121.0
Italy

119.3

 132.3

133.1
Portugal

94.0

 123.6

125.3
Spain

61.7

 93.7

99.1
Euro Area

85.7

 95.7

96.1
U.S.

95.2

 106.0

107.3
Japan

216.0

 243.5

242.3

Several years of recession have pushed the ratios up despite fiscal constraint, and the IMF’s October 2013 Fiscal Monitor does not see any short-term improvement outside of Ireland. The increase in the U.S. ratio is not quite as large thanks to its economic recovery, while Japan continues to serve as an outlier. Charles Wyplosz thinks that Greece will require another debt rescheduling, and there are concerns regarding the need for another bailout in Portugal. Falling real estate prices in Spain continue to threaten its banks, while Italy’s largest burden is its politics. Ireland no longer needs external assistance, but it will take years to pay back the loans it received from the IMF and other European governments.

And interest rates? With the 10-year rate on German government bonds at 1.72%, the spreads for the other European countries last week were (in ascending order): Ireland 1.81%; Spain, 2.36%; Italy, 2.38%; Portugal, 4.29%; and Greece, 7.09%. The rates are not onerous despite mediocre economic conditions and steady debt burdens, and have fallen over the last year. What accounts for this remarkable sangfroid by investors?

The answer may be the status of the third crisis: banking. Last year the European Central Bank (ECB) under Mario Draghi instituted a new three-year Long-term Refinancing Operation (LTRO). Banks in southern Europe took the relatively cheap funds and bought the bonds of their own governments, which still carry zero-risk weights in the Basel capital regulations. As a result, according to Silvia Merler (also at Bruegel), banks in those European countries have “renationalized,” with domestic debt accounting for large proportions of their portfolios, and much of this debt consisting of government debt. Moreover, the ECB also announced that it would purchase a government’s sovereign bonds under its Outright Monetary Transactions program if necessary to maintain its target interest rate. Combine bank purchases of government debt with a guarantee of central bank intervention if markets deteriorate and the fall in yields is the obvious result.

All this has the appearance of a Rube Goldberg machine, with a feedback loop uniting the ECB, European banks and sovereign debtors. But is it sustainable? Must the ECB continue renewing the LTRO to keep the banks solvent? Will the European Banking Authority, currently undertaking stress tests of the banks, accept the arrangement? What if the fragile recovery turns out to be really fragile? And what will happen if/when the Federal Reserve does taper off its asset purchases? However many years this crisis has been going on, the exit is not visible yet.