1. The current situation of the euro crisis
Sitra’s Sustainable Economy Forum in Berlin – November 7, 2012
Joachim Scheide, Kiel Institute for the World Economy

2. The current situation of the euro crisis
- Outline -
1. The outlook: Recession now and poor prospects for long-term growth
2. Financial markets and economic policy: The crisis mode continues
3. Low growth and high debt: A “vicious cycle” must be avoided
4. The best solution: Budget consolidation and growth policies
5. If this does not work, there are only 3 options, all of them are costly
6. The policy of bailouts has reached its limits
7. Debt restructuring as the natural solution in a market economy
8. But governments seem to favor inflation – will the ECB give in?

3. 1. Recession now and poor prospects for long-term growth
● In order to assess the outlook for the crisis, we have to be clear about
the economic outlook, both in the short term and in the long term.
● There is no end of the recession in sight for the Euro Area before mid-2013,
and this even implies an optimistic view on expectations.
● For the medium term, we should not expect a buoyant upswing.
● The typical pattern after a crisis suggests that the recovery will be modest,
and that we will not return to the old trend: This time is not different!
● As an extreme example: Spain is especially hard hit – more on that later.

4. Business expectations will have to turn around soon
if the Euro Area should overcome the recession in 2013
2 Index
1
0
-1
Germany
-2
Euro Area without Germany
Euro Area
-3
-4
-5
2004 2005 2006 2007 2008 2009 2010 2011 2012

5. Divergence of unemployment rates:
Germany’s exceptional performance
14 Percent
13
12 Euro Area excl. Germany
11
10
9
Euro Area total
8
7
Germany
6
5
2006 2007 2008 2009 2010 2011 2012

6. Change of real GDP in the European Union:
Germany on top with just 1 % growth
Land 2006 2007 2008 2009 2010 2011 2012 2013
Germany 3.7 3.3 1.1 -5.1 4.2 3.0 0.8 1.1
France 2.7 2.2 -0.2 -2.6 1.5 1.7 0.1 0.5
Italy 2.2 1.7 -1.2 -5.1 1.5 0.4 -2.2 -0.8
Spain 4.1 3.5 0.9 -3.7 -0.1 0.7 -1.5 -1.1
Euro Area 3.3 3.0 0.3 -4.2 1.9 1.5 -0.4 0.3
Britain 2.6 3.6 -1.0 -4.0 1.8 0.7 -0.2 0.6
EU 27 3.5 3.2 0.7 -4.1 2.0 1.6 -0.2 0.6

7. Real GDP in the current situation: United States
The typical pattern after the crisis
115 Index
110
Trend
105
100
95
GDP
90
2005 2006 2007 2008 2009 2010 2011 2012

8. Real GDP in the current situation: Euro Area
Also the typical pattern (in some cases worse!)
115 Index
110
Trend
105
100
95
GDP
90
2005 2006 2007 2008 2009 2010 2011 2012

9. Real GDP in the current situation: Spain
Hit especially hard by the housing crisis and the debt crisis
120 Index
115
110 Trend
105
100
95
GDP
90
2005 2006 2007 2008 2009 2010 2011 2012

10. 2. Financial markets and economic policy: The crisis mode
continues
● Many indicators suggest that markets and policy are still in the crisis mode:
1. Yields on government bonds of crisis countries are still high.
2. So are the risk premiums for banks: Debt crisis = banking crisis.
3. Stress on financial markets is still high although it came down a bit.
4. BOP financing by the Eurosystem continues preventing adjustments.
● Besides, the ECB has been flooding the markets with liquidity.
So the crisis will be with us somewhat longer:
We may not have seen the beginning of the end of the crisis!

11. Bond yields in the crisis countries have come down modestly
20 Percent
Austria Belgium
Finland France
15
Germany Ireland
Italy Netherlands
Portugal Spain
10
5
0

12. Banking crisis: CDS premiums for European banks still high
600 Basis points
550
500
450
400
350
300
250
200
150
100
50

13. IfW-Indicator for financial market stress in the Euro Area
5 Index
First wave of
the crisis
4 (Lehman)
Second wave
3
2
1
0
-1
-2
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

14. National central bank Target balances against the Eurosystem
800
Euro bill. B.o.p. financing prevents adjustment Euro bill. 800 Germany
Netherlands
Luxembourg
600 600
Finland
Estonia
400 400 Malta
Slovenia
Slovakia
200 200
Cyprus
France
0 0 Belgium
Austria
Portugal
-200 -200
Greece
Ireland
-400 -400 Italy
Spain
-600 -600
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: Compilation by the ifo Institute.

15. 3. Low growth and high debt: “Vicious cycle” must be avoided
● Industrial countries have reached the highest debt ratio in peacetime.
● The ratio also went up in the Euro Area, even well before the crisis.
● This is the key to the solution of the crisis: The level of debt is so high –
above 90 % – that it may depress growth: This would be the “vicious cycle”.
● Looking at debt-to-GDP ratios of several countries, Spain does not look bad.
● But the main question is: Will Spain grow fast enough in the future?
This is important for the willingness of investors to hold government bonds.

16. Government debt in advanced economies since 1880:
The highest debt ratio in peacetime
140 Percent
120
100
80
60
40
20
0
1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

17. Government debt in the Euro Area reaching a critical level:
Was this really good for growth??? (Debt/GDP in %)
100 Percent
90
80
70
60
50
40
30
20
1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010

18. Debt-to-GDP ratios for selected economies in 2011:
Is Spain really so bad?
250 Percent
200
150
100
50
0
Japan Greece Italy Portugal Ireland United Iceland Belgium France United Spain
States Kingdom

19. 4. The best solution: Budget consolidation and growth policies
● Best strategy: Reduce budget deficits and support long-term growth
because only such a policy would tackle the causes of the problems.
● Needless to say, this is tough, but it is in the interest of the crisis countries.
● Main uncertainty, also for investors: What is the medium-term growth rate?
● This is especially difficult to assess for countries like Spain: For many years,
they had a boom which was not sustainable. Now we see the correction.
● Simulations show: Reducing the debt ratio is possible, but that may take
years – and it needs continuous efforts of future governments as well.

20. Real GDP in Euro Area countries 1999 – 2008:
In part, growth was unsustainable due to misallocations
160 1999=100
Ireland
150
140 Greece
Spain
130
120 France
Portugal/
110
Germany
Italy
100
90
1999 2008

21. Correction between 2008 and 2012:
But what is the sustainable level and growth rate???
160 1999=100
150
140 Ireland
130
Spain
120 France
Greece
Germany
110
Portugal
Italy
100
90
1999 2008 2012

22. Real GDP in the current situation: Spain
What is the income and the growth rate in the long run???
120 Index
115
110 Trend
105
100
95
GDP
90
2005 2006 2007 2008 2009 2010 2011 2012

23. Spain: Stabilization of the debt-to-GDP ratio is possible –
but this crucially depends on medium-term growth
Primary Interest Debt
Year GDP Inflation
balance rate to GDP
2012 -1.5 0.0 -3.4 3.9 77
2013 -0.1 0.3 -1.8 4.1 82
2014 0.8 0.7 0.0 4.3 84
2015 1.4 1.0 1.5 4.5 84
2016 1.8 1.2 3.0 4.7 83
2017 1.5 1.0 3.0 4.7 81
2018 1.5 1.0 3.0 4.7 80
2019 1.5 1.0 3.0 4.7 79
2020 1.5 1.0 3.0 4.7 77

24. Doing Business – World Bank Ranking (2012)
Indicator for the poor growth performance which can be changed!
Greece Italy Spain
Total 100 87 44
Starting a business 135 77 133
Construction permits 41 96 38
Getting electricity 77 109 69
Registering property 150 84 56
Getting credit 78 98 48
Protecting investors 155 65 97
Paying taxes 83 134 48
Trading across borders 84 63 55
Enforcing contracts 90 158 54
24
Closing a business 57 30 20

25. 5. If this strategy does not work, there are only 3 bad options
● While the Euro Area countries have decided to follow the strategy of
budget consolidation and growth promotion, there are still problems of
implementation: Political will, social unrest etc.
● Another reason is that incentives are perverse: We have rescue funds.
Policies relying on peer pressure are not as effective as market pressure.
● If the “ideal” strategy does not work, there are only three options:
1. Bailouts with ever larger transfers.
2. Insolvency or debt restructuring for countries and esp. for banks.
3. Inflation.

26. 6. The policy of bailouts has reached its limits
● The limits of the rescue philosophy have become more obvious.
● The big risk is that the burden for the creditor countries becomes too large.
As a result, their rating may deteriorate as well, and they will no be able
anymore to “rescue” others.
● And there is more and more resistance against an increase of the exposure:
Austria: 80 billion euros Finland: 51 billion euros
France: 578 billion euros Germany: 771 billion euros
Netherlands: 165 billion euros and so on …
… with a total of about 2200 billion euros.

27. Germany’s exposure has reached its limits!

28. 7. Debt restructuring is a normal solution in a market economy
● If we do not want to have more and more bailouts, we have to make a choice.
● To be sure, insolvency and restructuring of government debt will hurt
investors, but that would be better than imposing the costs on taxpayers.
● However, proposals of an orderly insolvency mechanism have been rejected
by European policymakers – the Greek case was declared an exception.
● But the risk is that countries will become insolvent anyway, and then
there will be chaos and turbulences since governments are not prepared.
The policy may not be sustainable, and the alternative is worse: Inflation!!!

29. 8. Governments seem to favor inflation – will the ECB give in?
● We have a big problem: Governments are excluding insolvencies,
and the ECB is excluding higher inflation. This is incompatible!
● The crisis management so far has brought us closer to the inflation scenario.
● Another step in this direction: The ECB announced they will buy government
bonds of crisis countries without limit. This looks like debt monetization.
● The ECB is not independent anymore. But the independence of a central bank
is the key to successful stabilization policy – look at inflationary episodes.
And: The independence of the ECB is a core principle of the Treaty!!!

30. 8. Governments seem to favor inflation – will the ECB give in?
● Many economists are saying that inflation is the logical solution.
Some even argue that is a good solution to have higher inflation for a while.
● For governments, it is also an easy way out: They don’t have to ask their
parliaments (the taxpayer) for more money for transfers to other countries.
● With inflation, the costs are not easy to calculate but are hidden.
● But experience shows: If a central bank loses its credibility, it has huge
economic and social costs to regain it (M. Draghi).
This could be the end of the Monetary Union!!!

31. The crucial question: What kind of Monetary Union do we want?
There is not yet any sustainable solution to the euro crisis.
One reason: Governments do not agree on a vision.
Two (extreme) positions:
Go back to Maastricht – or create a new “political union”.
Problem: A political union is interpreted quite differently.
Strong centralization and supervision is not a common goal.
But: Maastricht 2.0 is also not accepted because it is
a “German” solution.
So it is hard to see a way out.

32. Conclusions (1)
● The euro crisis is far from being over, we have not even seen the beginning
of the end of the crisis.
● Germany’s role is defensive for many reasons:
- Supposedly we benefit most from the monetary union.
- Supposedly, we even benefit from the crisis (e.g. low interest rates).
- The government is hesitant to “impose” its solutions on others.
● In the absence of a common vision for the Monetary Union, there is a strong
fraction in favor of more transfers (France, Italy, Spain, …). Germany is
almost isolated in the opposition but criticized for always saying “No!”.

33. Conclusions (2)
● Nobody wants a collapse of the Monetary Union, simply because nobody
wants to be blamed for the failure, neither any government, nor the ECB.
● This makes policy more difficult: What are the options if the conditionality is
not met? Germany cannot credibly say: We will leave if costs are too high.
● By continuing this type of policy (“The euro has to be saved at all costs”)
we run the risk of a collapse which would mean chaos.
It could either be the unwillingness of the taxpayers to come up
with more money, or it could be that inflation is too high.

34. What is sustainable in terms of European policy?
Currently, “muddling through” prevails and that is certainly not sustainable.
At the national level and esp. at the international level, certain rules and
principles must be established to ensure a stable environment for decisions.
In the absence of such rules, policymakers may return to ad-hoc decisions
which normally lead to undesirable outcomes: Inflation and other instabilities.
For the Euro Area, the major framework of rules is still the Maastricht Treaty.
But right now, these rules are ignored or even deliberately violated.
This is certainly unsustainable!!!