The PIIGS that won't fly
A guide to the euro-zone's most troubled economies
Mar 31st 2010 | From The Economist online
AT A summit in Brussels on March 25-26th, leaders of the 16 member countries of the
euro area finally agreed on a last-resort financial rescue mechanism for Greece, whose
massive stock of public debt and yawning budget deficit have fuelled fears that it may
default. The markets’ reaction to the deal was lukewarm, suggesting that investors have
yet to be convinced that Greece will be able to continue to service its debts. Yet beyond
Greece there are questions over several other euro-area countries: the five so-called
PIIGS, which face many of the same economic challenges as well as the ability to cause
headaches in Brussels (and Berlin). The interactive graphic below tells the story; click on
the map for country-specific information and charts.
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Greece's deepening debt crisis
The wax melts
Worries about Greece’s ability to roll over its maturing debt are giving
way to bigger fears
Apr 8th 2010 | ATHENS AND LONDON | From The Economist print edition

GEORGE PAPANDREOU may have spoken too soon. On April 6th, just three days after the
Greek prime minister claimed ―the worst is over,‖ the yield on Greek ten-year government
bonds leapt from 6.5% to above 7%. Yields remain at alarming levels. On April 7th the
spread over their German equivalents stood at more than four percentage points, the
highest since Greece joined the euro in 2001. The D-word (default) is increasingly on the
lips of analysts. The cost of insuring Greece’s bonds surpassed that of Iceland’s this week;
Greek banks have asked to tap a government liquidity scheme. Far from coming to an
end, the Greek debt crisis seems scarcely to have begun.

On the face of it, this week’s renewed bond-market jitters were caused by growing doubts
that an emergency-aid package patched together by European Union leaders last month
offers Greece much help. Under the terms of the EU deal, any short-term support would
have to be approved by all of the 16 countries in the euro zone. German anger at
Greece’s profligacy could easily delay the cash it would need should bond markets close.

Any rescue package would be co-financed by the IMF, which may be good for €12 billion
($16 billion) of swift support. But the stipulation, insisted on by Germany, that EU cash
would only be furnished at near-market rates meant the deal failed to provide an interest-
rate ceiling for Greece’s public debt, leaving the country to suffer every turn in market
sentiment. Senior EU sources say a formula is being discussed to address this flaw. The
interest- rate benchmark would be set over a long period, so it would not be unduly
influenced by immediate market stresses. Rates paid by countries with a credit rating
similar to Greece’s would also be a factor.

Optimists are still confident that the government can raise enough funds in the next six
weeks to stave off default, though at a high cost. The government has more than €13
billion in cash, enough to refinance maturing debt and fund the budget deficit during April.
It needs to raise another €10 billion-12 billion in May. The likely borrowing requirement
for the remainder of the year, around €25 billion, is spread more evenly. ―If we can get
over the May borrowing hump, it’s a relatively smooth cruise for the rest of the year,‖
says one trader in Athens.

That is a big ―if‖, say pessimists. In the six months since the Socialists were elected,
spreads have jumped by more than two percentage points. Greece can no longer risk
holding an auction for a new issue of bonds for fear that it fails. Its Public Debt
Management Agency has resorted to syndicated-bond sales managed by big international
banks. But the pools of spare cash that Greece can tap seem to be drying up.

Subscriptions for a new seven-year bond on March 29th reached only €6.2 billion, just
above the target of €5 billion. Two previous issues this year were heavily oversubscribed,
even if the investors who were allocated bonds are now cursing their luck. On March 30th
Greece failed for the first time to raise a targeted amount when it offered a fresh slug of
an existing, but illiquid, 20-year bond. In an auction restricted to local market-makers just
€390m was subscribed against a target of €1 billion. The bond was reopened in part to
accommodate hedge funds that wanted to cover short positions. Some may subsequently
have bought the bonds they needed more cheaply elsewhere. But for many observers this
was a clear signal that Greece will need a bail-out soon.
George Papaconstantinou, the finance minister, plans to lead a roadshow to America in
the last ten days of April. He hopes to persuade American investors, including emerging-
market funds, to buy $5 billion-10 billion worth of a new dollar-denominated bond. It
would be a heavy irony if Greece, a member of the euro club, were temporarily reprieved
by loans in dollars. But the fear is that investors will stick to buying the bonds of genuine
emerging markets, which have much more solid growth prospects.

It is not yet clear what Greece’s fallback plan will be if American demand is weak. ―The
roadshow will be decisive. If it doesn’t fly, the alternative is either a wave of T-bill issues
at very high interest rates, or a rescue package,‖ says a senior Greek banker. Mr
Papaconstantinou insists that Greece does not plan to fall back on support from the EU
and IMF. But he also accepts that the government cannot go on borrowing at such high
interest rates.

Even at lower interest rates, however, Greece will struggle to keep borrowing. Previous
analysis of the country’s debt dynamics by The Economist, based on fairly benign
assumptions, concluded that Greece’s public debt would stabilise above 150% of its GDP.
That burden is probably too much to bear for a small country with such ropy economic
prospects: it also implies that a much bigger bail-out pot is needed than the one currently
being mooted. Some buyers of Greek debt may still think the interest rewards on offer are
worth the default risk, but they seem to be a diminishing band. The bigger worry for
Greece is not its immediate funding hump, but that investors are starting to lose faith that
the country will be able to sustain its growing indebtedness.
Three years to save the euro
The bail-out for Greece has merely bought some time. Europe’s
governments must use it wisely
Apr 15th 2010 | From The Economist print edition

FOR all her promises to stand firm against a subsidised rescue for Greece, Germany’s
Angela Merkel wobbled as soon as financial markets gave off a whiff of serious panic. On
April 11th, after spreads on Greek debt had soared and the first signs emerged of a
possible run on its banks, euro-area leaders agreed to offer the beleaguered Greek
government up to €30 billion ($41 billion) of three-year loans, at an interest rate of 5%.
That is not cheap, but it is much less than private investors were demanding. Add in a
further €15 billion that the IMF is likely to provide, and Greece has been promised enough
help to cover its financing needs for 2010.

Does this mean the Greek debt crisis is over? European Union officials argue that the
amounts are big enough to give Greece the liquidity it needs to get it through its fiscal
adjustment. Arming Greece with a large financial bazooka may have taken a while to
arrange, but the Europeans hope such a show of financial firepower will be enough to
deter speculative attacks by dispelling any chance of a Greek default.

Unfortunately this hope does not stand up to scrutiny. The bail-out, which was certainly
bigger than the markets had expected, has all but eliminated the risk of default this year.
But Greece still faces a deep medium-term solvency crisis. Anyone who looks hard at
Greece’s debts and the interest rate it is paying on them can only conclude that, unless
growth rebounds unexpectedly strongly, an eventual restructuring of Greek debt remains
highly likely (see article). The rescue package has merely bought time—three years, in
effect, to contain the adverse consequences of a possible Greek default.
Grim figures
Begin with the numbers. Greece’s medium-term debt outlook is darker than either its
government or the EU admits. This newspaper’s calculations suggest that even with a
fiscal adjustment worth 10% of GDP over the next five years, Greece will either need
more official loans for longer than the current rescue package promises or will have to
―restructure‖ its debts (ie, defer payment on some loans or pay back less than it owes).
Even on optimistic assumptions, we reckon Greece will need €67 billion or more of long-
term official loans in the next few years. Its debt burden will peak at 150% of GDP in
2014, a level exceeded now only by Japan. If growth turns out to be weaker than
expected, or Greece fails to cut spending or raise taxes enough, the figures will be a lot

Such a sombre conclusion invites the question of whether this week’s bail-out makes any
sense. After all, the history of emerging-market debt crises, especially Argentina’s in
2001, suggests that, if default is overwhelmingly likely, it is better to get it over with
rather than put it off with quixotic rescue packages. But this is not true in the Greek case,
for two reasons that have less to do with Greece than with the rest of the euro area.

First, a Greek default now would carry a serious risk of triggering debt crises in Portugal,
Spain and even Italy, the other euro-area countries suffering from some combination of
big budget deficits, poor growth prospects and high debt burdens. The EU does not have
the firepower to cope with these.

Second, a default now could also have calamitous effects on the fragile European banking
system. Euro-area banks hold €120 billion of exposure to Greece, of which we reckon
perhaps €70 billion is Greek sovereign debt. French and German banks account for 40%
of the total. Many European banks might well require more government help if they lost a
lot on Greek debt. Indeed, the sums involved might easily be greater than the German
and French contributions to the Greek rescue loans. And if contagion then pushed Spain
and Portugal to a crisis, the entire European banking system could implode.

No time to lose
This prospect is sufficiently worrying to make it right to buy time by providing a bail-out
for Greece. But that calculation could change rapidly if the time is not used well—by
Greece and, even more, by other euro-area countries.

Greece’s to-do list is now well-known. A country that spent years mismanaging and
misreporting its public finances must tighten its belt dramatically for a long time. To boost
competitiveness and growth, as well as improve the budget, it must embrace radical tax
changes, cuts in public-sector pay and pension reforms. Bold adjustment, which to its
credit the new Greek government has already begun, will reduce the risk of Greece finding
its debts unpayable in three years’ time.

Even then, it is not hard to see circumstances in which the Greeks might think they would
be better off defaulting. So the euro area’s other vulnerable economies must also use the
next few years to convince the markets that they are not like Greece. That will also
demand fiscal austerity. But even more important are structural reforms to improve
competitiveness and boost growth. Without the option of a currency devaluation,
countries such as Spain, Portugal and Italy have no alternative but to restrain labour costs
and bring in supply-side reforms that raise productivity, especially through the freeing of
labour markets. These reforms, long overdue, are now essential. It would be a mistake for
the leaders of Spain and Italy to assume that if they got into trouble they might be bailed
out like Greece: neither the EU nor the IMF could afford it.

Nor is the to-do list confined to Europe’s southern rim. Germany must help by doing more
to boost its domestic demand. Financial regulators everywhere must push banks to clean
up their balance-sheets and bolster their capital. The European Central Bank must avoid
creating an incentive for banks to load up on Greek debt and then offer it as collateral for
liquidity from the ECB, by (controversially) offering less cash for government bonds with
lower credit ratings. And governments must start putting in place a mechanism for
managing sovereign-debt restructurings within the single-currency zone.

This to-do list is alarmingly long, which is why European politicians are deluding
themselves if they think the Greek crisis has been resolved with this week’s rescue.
Because Greece was small enough to bail out, they have bought a temporary reprieve.
Now they must use the time wisely.

reece's sovereign-debt crisis
Still in a spin
A rescue by the European Union and the IMF has given Greece some
breathing space. But much more may need to be done to avert eventual
Apr 15th 2010 | From The Economist print edition

TWO months ago the governments of the euro zone agreed in principle to offer
emergency loans to Greece. A near-panic in the bond markets has now forced them to
spell out the terms of support for their stricken colleague, should it be needed. If push
comes to shove, the other 15 euro-zone countries are willing to provide Greece with up to
€30 billion ($41 billion) of three-year fixed- and variable-rate loans in the first 12 months
of any support programme. The announcement was made by Olli Rehn, the European
Union’s economics commissioner, and Jean-Claude Juncker, chairman of the Eurogroup of
finance ministers, after a telephone conference of the Eurogroup on April 11th.

The chief obstacle in previous negotiations had been the interest rate to be charged for
the rescue loans. Germany had insisted on ―market rates‖—ie, with no element of subsidy.
That made little sense: if a backstop were provided only on such terms, what would be
the point of it? Eventually a formula was found that both met Greece’s needs and satisfied
the Germans. The interest rate for emergency aid will be 3.5 percentage points above the
benchmark ―risk-free‖ rates for euro loans. That works out at around 5% for a fixed-rate
loan, which is less than markets were asking of Greece before the deal was struck but still
steep. Portugal and Ireland, the next-riskiest borrowers in the euro area, pay less than
half as much for three-year money. Germany pays a mere 1.3%.

The IMF is expected to chip in €15 billion, at interest rates that are likely to be a little
kinder to the Greeks. The resulting package of €45 billion would be enough to finance
Greece’s budget deficit for the rest of this year as well as repay its maturing debts. Yet
Greece is likely to need far more support than this as it struggles to put right its public

Cracks in the masonry
An earlier analysis by The Economist (―Safety not‖, March 27th) suggested that Greece
would need at least €75 billion of official aid. We based this figure on several
assumptions: that Greece would need five years to stabilise its ratio of debt to GDP; that
it could take the pain of a brutal fiscal retrenchment; that private investors would still be
willing to refinance existing debts, at an interest rate of 6%, if a rescue fund covered the
country’s new borrowing; and that the economy would start to grow again in 2013.
An updated set of projections is set out in table 1. We have made two changes so the
analysis is a bit rosier. We now assume that Greece cuts its budget deficit, as a share of
GDP, by four percentage points this year, as planned, so it has less to do later. We also
assume that the interest charged on all maturing and new borrowing is 5%, in line with
the cost of the aid offered by Greece’s euro-zone partners. With those changes, we reckon
Greece would need to cut its primary budget deficit (ie, excluding interest costs) by 12
percentage points to cap its debt burden—a slightly less fierce adjustment than in our first
simulation. On that basis Greece will run up an extra €67 billion of debt by 2014, by which
time its debt will stabilise at a scary 149% of GDP. That sum is less than our previous
estimate, but still half as much again as the amount on offer.

Some will see this scenario as too pessimistic. It is far gloomier, for instance, than that
envisaged in the EU retrenchment programme, which assumes that Greece will get its
deficit below 3% of GDP in three years and that the economy can continue to grow as it
does so. However, even with a more benign assumption about growth, Greece’s debts
would still be very large. For instance, suppose that any losses in nominal GDP during
recession are quickly recovered. Debt would still then stabilise at 142% of GDP.

It will be hard for Greece to make such savage cuts in its budget and emerge from
recession at the same time. Furthermore, prices and wages will have to fall if Greece is to
regain the cost competitiveness needed for sustained economic growth. That will drag
down nominal GDP in the short term, and make budget cuts more difficult to carry out.
Our analysis may even be too optimistic. If economic growth does not return, deficit
reduction proves too painful or interest rates are much higher than we assume, the debt
ratio is likely to spiral upwards until default becomes all but inevitable. Even if that is
avoided, Greece’s rescuers may have to shoulder more of the financing burden than we
have estimated, should private investors reduce their exposure to Greece.

They have plenty of reasons to do so. On April 9th, two days before the euro-zone rescue
package was announced, Greek government bonds were downgraded by Fitch, a credit-
rating agency, to BBB-, just a notch above junk status. As Greece’s debt mountain grows,
investors are increasingly likely to shun its bonds in favour of those of other, more
creditworthy, euro-zone countries. Though IMF cash is welcome, private investors know
that the fund is first in the queue when money has to be paid back. A euro-zone rescue
party may also demand priority.

The bolder sort of investor may reckon that the high yields on offer are ample reward for
the risk that Greece may be unable to repay all it has borrowed. But some will be more
cautious. And others may judge that an interest rate big enough to compensate for the
risk of default would only add to the pressure on Greece, making default more likely.
Mohamed El-Erian, the head of PIMCO, the world’s biggest bond fund, said on April 12th
that his firm was steering clear of new Greek bonds. ―Based on what we know right now,
we would not be a buyer,‖ he told Reuters television. Asian central banks that want to
balance their dollar holdings with euros may choose to park their cash in France or
Germany and save themselves any worries about Greece and its politics.

The signs are not encouraging. An issue of Greek six-month and one-year bills on April
13th was hailed as a sign of robust private demand because the auction, which raised
€1.6 billion, was heavily oversubscribed. The interest rate that investors demanded told a
different story. Greece had to pay 4.55% to borrow for six months, just two days after the
Eurogroup had all but promised to refinance Greece for the next year and at a time when
central-bank interest rates are a paltry 1%. A day later yields on ten-year Greek bonds
rose to 7%, 3.9 percentage points more than those on comparable German Bunds.

Greece’s euro-zone partners could find themselves with a large and open-ended
commitment to roll over the country’s existing debts and to provide cash to cover its
budget deficits. The rescue package announced this week may over time evolve into a
rolling series of soft loans, at ever-lower interest rates and increasing maturity, designed
to prop up Greece and keep default at bay. Such loans—in effect, grants—would amount
to a kind of fiscal drip-feed. That could spur a political backlash, and perhaps legal
challenges, in the countries supplying the funds.

Our debts, your problem
Yet the alternative to a bail-out—default—is too grisly to contemplate, not least because
of the dire consequences for Europe’s banking system. Banks in Greece hold €38.4 billion-
worth of the government’s bonds, according to Deutsche Bank. This amounts to almost
8% of their total assets. A big write-down in the value of those bonds would leave the
banks crippled. But around 70% of Greek government bonds, €213 billion-worth, are held
abroad, mainly elsewhere in Europe.

There are no solid figures on how much of this is held by banks but it is possible to make
rough guesses. The Bank for International Settlements (BIS) provides figures for foreign
banks’ lending to the Greek government, Greek banks and the private sector combined.
Furthermore, according to analysts at the Royal Bank of Scotland, banks bought a bit less
than half of the Greek bonds sold between 2005 and 2009. Based on these figures, table
2 contains our estimates of which countries’ banks own Greek public debt.

The ―low‖ figure is calculated using the weight of each country’s total exposure to Greece
in the BIS figures. For instance, French banks account for a quarter of all foreign-bank
loans to Greece. If we assume that half (ie, €106 billion) of the €213 billion of Greek
government bonds owned outside Greece are held by banks, and that French banks have
a quarter of that, their share is €27 billion. On the low estimate, euro-zone banks own
€62 billion of Greek government bonds.

The true exposure is probably a bit higher, perhaps €70 billion. It is more likely that
holdings within the euro area are weighted more towards commercial banks than pension
and insurance funds, because banks are able to use Greek government bonds as collateral
for cash loans from the European Central Bank (ECB). The ―high‖ estimate assumes public
debt accounts for all the foreign banks’ lending to Greek entities in BIS data. This is surely
an overstatement, but the exposure of German banks, for instance, is likely to be much
closer to our high estimate, €30 billion, than the low one. As Laurent Fransolet of Barclays
Capital points out, Hypo Real Estate, a state-owned German bank, has already reported
an €8 billion exposure to Greek sovereign bonds.
Given the pain that a Greek default would inflict on the euro area’s banks, it is perhaps
not surprising that the currency club’s governments have rushed to announce firmer
details of a bail-out. A default that would reduce Greece’s debt burden to, say, 60% of
GDP would cut the value of its bonds by half. Because banks are still fragile, euro-zone
governments would probably have to cover their losses, at a cost of at least €31 billion
(ie, half of €62 billion). A €30 billion loan that gives Greece a chance to right its public
finances looks good value compared with a €31 billion loss for bailing out banks should
Greece fail. Euro-area governments are thus ready to lend money to Greece so that it can
repay euro-area investors, many of them banks that are backed by the same
governments. In effect, they are offering to bail themselves out.

There are other good reasons to try to postpone any reckoning. The world economy will,
with luck, be stronger in a few years. A rescue package buys time, and not just for
Greece. There is a risk that contagion could affect Ireland, Italy, Portugal or Spain, the
other euro-area countries with some mixture of big budget deficits, poor growth prospects
and high debts.

Of these, Portugal and Spain have most in common with Greece, because of their reliance
on foreigners’ savings. Italy draws more from domestic resources to finance its debt and
deficits. It has a worryingly large debt burden, around 120% of GDP, but is closer to a
primary budget balance than the others. Perversely the sheer size of its debt is a
strength. Italy’s bond market is the third largest in the world and is thus very liquid.
Ireland is also less reliant on foreign savers and has a better record of deficit-cutting than
most countries. And as one of the euro zone’s more flexible economies, its medium-term
growth prospects seem less dire.

Were Portugal and Spain to get into the same sort of trouble as Greece, the resulting
problem might be too big even for the deep pockets of Germany, France and the IMF. So
Europe has a direct interest in making sure trouble does not spread to Iberia. Foreign
banks’ exposure to Greece, Portugal and Spain combined comes to €1.2 trillion. European
banks have lent most of this. German banks alone account for almost a fifth of the total
(see chart 3).

Spain is a much bigger worry than Portugal, because it has a much bigger economy. Its
public finances are not in as poor shape as Greece’s, thanks to good fiscal discipline
during its boom years. Spain’s debt burden is half that of Greece: last year government
debt was 54% of GDP. Even so, its debts are rising too quickly for comfort. The European
Commission expects the budget deficit will be 10% of GDP this year. A bigger fear is that
Spain will not recover from recession with any vigour because, like Greece, it is hampered
by high wage costs and a rigid economic structure.

Optimists point out that the problem of cost competitiveness is exaggerated. Even during
its long consumer boom, Spanish exporters maintained their share of world markets,
unlike their French and Italian rivals. Yet Spain’s export sector is too small to spur a
recovery and the high cost of laying off permanent workers in dying industries means it is
hard to shift resources to exporting firms. The rapid expansion of temporary work
contracts since the 1990s has given the Spanish economy more flexibility. But this came
at a cost. Firms have little incentive to train the young temps whom they will soon lay off,
and that has contributed to Spain’s dismal record of productivity growth.

The trouble engulfing Greece ought to startle Spain’s policymakers out of a dangerous
complacency. The euro-zone rescue package for Greece, to which the Spanish would
contribute, buys Spain time to secure bond investors’ trust. The government has said it
will press for reforms to the country’s complex system of wage agreements. These are
urgently needed to ensure that pay responds to changes in business conditions. The gap
between the two tiers (permanent and temporary workers) in Spain’s job market needs to
be tackled, to boost productivity and speed up the flow of workers to rising industries.
Regulations should be dismantled to make it easier for firms to challenge stodgy
incumbents, particularly in services.

The offer of support for Greece is worthwhile if it gives the country a chance of getting its
house in order and if other members of the euro area make the most of the chance to
carry out growth-enhancing reforms. Yet there is a risk that the rescue is treated as an
opportunity to relax.

A further danger is that measures to help Greece now may complicate matters in the
years ahead. The head of the ECB, Jean-Claude Trichet, confirmed on April 8th that the
central bank would continue to take bonds rated BBB- or above as collateral for its cash
loans to commercial banks. Although low-rated private asset-backed bonds will be subject
to bigger discounts after this year, government bonds will not. So banks will be able to
get ECB cash in exchange for Greek government bonds as easily as for Bunds.

This change in policy was surely designed to send a signal. If Greek bonds are good
enough for collateral at the ECB, they ought to be good enough for private investors, too,
whatever the (mostly American) rating agencies say. The trouble is, the policy only
encourages a greater concentration of Greek bond holdings among European banks. That
will increase the vulnerability of Europe’s financial system to concerns about a Greek
sovereign default.

The default option
Is such a thing imaginable? Conventional wisdom has it that sovereign defaults are always
messy and painful. In fact the lesson of such defaults over the past decade or more is that
this is not necessarily so. More than a dozen emerging economies have restructured their
sovereign debt in the past decade without huge losses of output and without paying
enormous penalties in exclusion from capital markets or higher spreads. With a few
exceptions (notably Argentina) the process has been much quicker than in earlier
sovereign restructurings, and governments and creditors have managed to work together.
Governments sometimes negotiated a restructuring with creditors before formally missing
a payment of interest or principal—a process known, in the jargon, as ―pre-emptive‖
restructuring. Legal innovations to encourage creditors to take part in restructurings and
make it harder for holdouts to litigate have helped.

In 2003 Uruguay restructured all its domestic and external debt, exchanging old bonds at
par and at the same coupon rate for new ones but stretching maturity dates by five years.
The country returned to capital markets a month later. The ―haircut‖, or loss to
bondholders, was small (13.3%, in net present value), as were the amounts restructured
($5.4 billion), but it showed that orderly sovereign workouts are possible. Countries such
as Jamaica and Belize have had orderly restructurings recently.

Greece is different because it has much more debt outstanding and because bondholders
may face a more severe haircut—although with sufficient fiscal consolidation a more
modest restructuring could be feasible. Sovereign-debt lawyers say that in some ways a
restructuring of Greek debt would be easier than many people think. But other things
would be new and harder, especially the complexity caused by credit-default swaps, which
have not yet played a big role in any sovereign-debt restructurings. It is uncertain, for
instance, whether a pre-emptive restructuring would trigger the default clause in credit-
default swaps. But Lee Buchheit, a leading sovereign-debt lawyer, says that the biggest
risk in most debt-restructuring cases is governments that try to put off the inevitable. ―By
far the greater risk is pathological procrastination by the debtor in the face of an obviously
untenable financial situation,‖ he argues, in which a country pursues frantic and ruinously
expensive emergency financing in the lead-up to an eventual restructuring.

Would a defaulting country have to leave the euro? No. It is perhaps natural to conflate
default with devaluation because they often occur together. But a euro member has no
currency to devalue. Nor is there a means to force a defaulter out, since membership is
meant to be for keeps. A new currency would have to be invented from scratch, a
logistical nightmare. All contracts—for bonds, bank deposits, wages and so forth—would
have to be switched to the new currency. The changeover to the euro was planned in
detail and in co-operation. The reverse operation would be nothing like as orderly. A
country that had lost the faith of investors in its public finances would find it hard to
reconstruct a sound monetary system. Default by a member would be a body blow to the
euro’s standing. But it need not spell the end of the currency.

Sticks and bail-outs
European leaders have been incoherent over whether to punish or help
Apr 15th 2010 | From The Economist print edition

IN JANUARY the clever talk in Brussels was about how to rush European Union money to
Greece (and thereby save the euro). A popular idea involved speeding up billions in EU
―structural funds‖, or aid for poor regions, earmarked for Greece. Now the clever talk in
Brussels is about making governments clean up their budgets and reform their economies
(and thereby save the euro). And one idea is to threaten errant countries with the
suspension of EU structural funds.

A niftier move would be to combine the two. The European Commission might front-load
the payment of structural funds and a Eurocrat (chosen for his stocky build and personal
honesty) could fly to Athens with a suitcase full of cash. Then EU finance ministers could
suspend the funds by a majority vote (with Greece denied its say)—and the cash-toting
Eurocrat could turn round and catch the flight straight back home.

As this little story suggests, the Greek crisis has hardly shown the European Union at its
most coherent. One reason has been denial. In January the German government was ―not
considering‖ financial aid to help Greece out of its budgetary hole. At an EU summit in
February, the German chancellor, Angela Merkel, agreed that countries of the euro area
should take ―determined and co-ordinated action‖ to defend Greece, but blocked
discussions of what that meant (and opposed any role for the IMF).

A month later Mrs Merkel said countries that repeatedly broke the rules of the euro should
face expulsion, pleasing German voters enraged by the idea of bailing out a country that
has lied about its budget deficit and allows favoured workers to retire at 50. A week later,
at yet another summit, Mrs Merkel set harsh conditions for a rescue, though this time she
insisted that the IMF should be involved after all. Greece would have to pay market rates
for loans from EU neighbours, but could get them only if borrowing from markets was

This hard German line was partly political (a big state election looms in May) and partly
legal (a Greek bail-out could be challenged in Germany’s constitutional court for breaching
the no-bail-out terms of the Maastricht treaty). Yet it was also, in the words of a senior
official, ―not realistic‖. EU leaders promised Greece (a small economy) that it would not be
abandoned. France, Italy and Spain were determined to honour this pledge. A telling
detail is that German banks are big holders of Greek debt.

Now Germany is on the hook for its share of a €30 billion ($41 billion) package of bilateral
loans for Greece, unveiled on April 11th. This is not a bail-out, German officials insisted.
At their suggestion, the IMF would add its own money, and although the cost of borrowing
would be below market rates, it would still be painful. They even added, valiantly but
surely vainly, that Greece might never need the loans.

European politicians are also in denial about the role of markets, at least in public.
Leaders such as Nicolas Sarkozy of France endlessly declare that the financial markets are
acting as ―speculators‖: ie, not as rational or legitimate actors. In late January the
Spanish and Greek prime ministers murmured darkly that sinister political and financial
interests were picking on Greece to try to destroy the euro.

Yet when euro-area governments agreed to lend money to Greece at a hefty premium
over the benchmark rate paid by Germany, they were implicitly conceding both that
markets had a legitimate point (ie, that not all governments are equally creditworthy) and
that market forces can be useful (higher borrowing costs are a vital tool to discipline
Greece). Some speculators have certainly aimed at Greece. The Belgian finance minister,
Didier Reynders, boasted that his country would ―turn a profit‖ on the billion euros it is
due to lend Greece by borrowing the cash at rates below those Greece would have to pay.
Perhaps speculation is not wicked when governments indulge in it.

EU leaders now call for a new system of ―European economic governance‖ to spot
instabilities in the euro area. Sensible things are in the air, like EU audits of national
accounts and fiscal surveillance to spot problems sooner. There are calls to discuss
imbalances that threaten the whole zone, such as weak domestic demand in some
countries, an addiction to credit-fuelled consumption in others or big losses of
No great leap forwards
Yet this is not the leap to closer European political integration that some have excitedly
hailed. In reality the EU is planning the same things as before—strict budget discipline and
policies aimed at convergence—but with more conviction. Is that credible? It does not
help that the two countries calling loudest for discipline are France and Germany, which
were responsible for gutting the euro area’s stability-pact rules on budget deficits a few
years ago when they were threatened by them.

EU governments are sure to present any Greek bail-out as a triumph of political will over
markets. But in truth, markets may offer the most credible assurance that discipline could
actually bite. EU leaders have repeatedly blustered to conceal their divisions over a Greek
bail-out. Markets forced them to say what they meant. Greece has been paying twice as
much as Germany to borrow money. That is a sanction more painful than anything the EU
would ever have the will to impose.

Even as Brussels types debate the theology of economic governance, the commission is
limbering up to rebuke a string of countries for running excessive deficits. The markets
will be paying attention as never before, with real consequences for national borrowing
costs. Markets are not always right or fair. But market pressures are real and unflagging.
Judging by the Greek crisis so far, that is more than can be said of the EU’s political will.

Learning From Greece

The debt crisis in Greece is approaching the point of no return. As prospects for a rescue
plan seem to be fading, largely thanks to German obduracy, nervous investors have
driven interest rates on Greek government bonds sky-high, sharply raising the country’s
borrowing costs. This will push Greece even deeper into debt, further undermining
confidence. At this point it’s hard to see how the nation can escape from this death spiral
into default.

It’s a terrible story, and clearly an object lesson for the rest of us. But an object lesson in
what, exactly?

Yes, Greece is paying the price for past fiscal irresponsibility. Yet that’s by no means the
whole story. The Greek tragedy also illustrates the extreme danger posed by a
deflationary monetary policy. And that’s a lesson one hopes American policy makers will
take to heart.

The key thing to understand about Greece’s predicament is that it’s not just a matter of
excessive debt. Greece’s public debt, at 113 percent of G.D.P., is indeed high, but other
countries have dealt with similar levels of debt without crisis. For example, in 1946, the
United States, having just emerged from World War II, had federal debt equal to 122
percent of G.D.P. Yet investors were relaxed, and rightly so: Over the next decade the
ratio of U.S. debt to G.D.P. was cut nearly in half, easing any concerns people might have
had about our ability to pay what we owed. And debt as a percentage of G.D.P. continued
to fall in the decades that followed, hitting a low of 33 percent in 1981.

So how did the U.S. government manage to pay off its wartime debt? Actually, it didn’t. At
the end of 1946, the federal government owed $271 billion; by the end of 1956 that
figure had risen slightly, to $274 billion. The ratio of debt to G.D.P. fell not because debt
went down, but because G.D.P. went up, roughly doubling in dollar terms over the course
of a decade. The rise in G.D.P. in dollar terms was almost equally the result of economic
growth and inflation, with both real G.D.P. and the overall level of prices rising about 40
percent from 1946 to 1956.

Unfortunately, Greece can’t expect a similar performance. Why? Because of the euro.

Until recently, being a member of the euro zone seemed like a good thing for Greece,
bringing with it cheap loans and large inflows of capital. But those capital inflows also led
to inflation — and when the music stopped, Greece found itself with costs and prices way
out of line with Europe’s big economies. Over time, Greek prices will have to come back
down. And that means that unlike postwar America, which inflated away part of its
debt, Greece will see its debt burden worsened by deflation.

That’s not all. Deflation is a painful process, which invariably takes a toll on growth and
employment. So Greece won’t grow its way out of debt. On the contrary, it will have to
deal with its debt in the face of an economy that’s stagnant at best.

So the only way Greece could tame its debt problem would be with savage spending cuts
and tax increases, measures that would themselves worsen the unemployment rate. No
wonder, then, that bond markets are losing confidence, and pushing the situation to the

States of Risk
Nouriel Roubini


LONDON – The Great Recession of 2008-2009 was triggered by excessive debt
accumulation and leverage on the part of households, financial institutions, and even the
corporate sector in many advanced economies. While there is much talk about de-
leveraging as the crisis wanes, the reality is that private-sector debt ratios have stabilized
at very high levels.

By contrast, as a consequence of fiscal stimulus and socialization of part of the private
sector’s losses, there is now a massive re-leveraging of the public sector. Deficits in
excess of 10% of GDP can be found in many advanced economies, and debt-to-GDP ratios
are expected to rise sharply – in some cases doubling in the next few years.

As Carmen Reinhart and Ken Rogoff’s new book This Time is Different demonstrates, such
balance-sheet crises have historically led to economic recoveries that are slow, anemic,
and below-trend for many years. Sovereign-debt problems are another strong possibility,
given the massive re-leveraging of the public sector.

In countries that cannot issue debt in their own currency (traditionally emerging-market
economies), or that issue debt in their own currency but cannot independently print
money (as in the euro zone), unsustainable fiscal deficits often lead to a credit crisis, a
sovereign default, or other coercive form of public-debt restructuring.

In countries that borrow in their own currency and can monetize the public debt, a
sovereign debt crisis is unlikely, but monetization of fiscal deficits can eventually lead to
high inflation. And inflation is – like default – a capital levy on holders of public debt, as it
reduces the real value of nominal liabilities at fixed interest rates.

Thus, the recent problems faced by Greece are only the tip of a sovereign-debt iceberg in
many advanced economies (and a smaller number of emerging markets). Bond-market
vigilantes already have taken aim at Greece, Spain, Portugal, UK, Ireland, and Iceland,
pushing government bond yields higher. Eventually they may take aim at other countries
– even Japan and the United States – where fiscal policy is on an unsustainable path.

In most advanced economies, aging populations – a serious problem in Europe and Japan
–exacerbate the problem of fiscal sustainability, as falling population levels increase the
burden of unfunded public-sector liabilities, particularly social-security and health-care
systems. Low or negative population growth also implies lower potential economic growth
and therefore worse debt-to-GDP dynamics and increasingly grave doubts about the
sustainability of public-sector debt.

The dilemma is that, whereas fiscal consolidation is necessary to prevent an unsustainable
increase in the spread on sovereign bonds, the short-run effects of raising taxes and
cutting government spending tend to be contractionary. This, too, complicates the public-
debt dynamics and impedes the restoration of public-debt sustainability. Indeed, this was
the trap faced by Argentina in 1998-2001, when needed fiscal contraction exacerbated
recession and eventually led to default.

In countries like the euro-zone members, a loss of external competitiveness, caused by
tight monetary policy and a strong currency, erosion of long-term comparative advantage
relative to emerging markets, and wage growth in excess of productivity growth, impose
further constraints on the resumption of growth. If growth does not recover, the fiscal
problems will worsen while making it more politically difficult to enact the painful reforms
needed to restore competitiveness.

A vicious circle of public-finance deficits, current-account gaps, worsening external-debt
dynamics, and stagnating growth can then set in. Eventually, this can lead to default on
euro-zone members’ public and foreign debt, as well as exit from the monetary union by
fragile economies unable to adjust and reform fast enough.

Provision of liquidity by an international lender of last resort – the European Central Bank,
the International Monetary Fund, or even a new European Monetary Fund – could prevent
an illiquidity problem from turning into an insolvency problem. But if a country is
effectively insolvent rather than just illiquid, such ―bailouts‖ cannot prevent eventual
default and devaluation (or exit from a monetary union) because the international lender
of last resort eventually will stop financing an unsustainable debt dynamic, as occurred
Argentina (and in Russia in 1998).

Cleaning up high private-sector debt and lowering public-debt ratios by growth alone is
particularly hard if a balance-sheet crisis leads to an anemic recovery. And reducing debt
ratios by saving more leads to the paradox of thrift: too fast an increase in savings
deepens the recession and makes debt ratios even worse.

At the end of the day, resolving private-sector leverage problems by fully socializing
private losses and re-leveraging the public sector is risky. At best, taxes will eventually be
raised and spending cut, with a negative effect on growth; at worst, the outcome may be
direct capital levies (default) or indirect ones (inflation).

Unsustainable private-debt problems must be resolved by defaults, debt reductions, and
conversion of debt into equity. If, instead, private debts are excessively socialized, the
advanced economies will face a grim future: serious sustainability problems with their
public, private, and foreign debt, together with crippled prospects for economic growth.

The Euro Zone’s Default Position
Simon Johnson and Peter Boone


WASHINGTON, DC – Kazakhstan may be far removed from the euro zone, but its recent economic experiences
are highly relevant to the euro’s current travails. As the euro zone struggles with debt crises and austerity in
its weaker members, Kazakhstan is emerging from a massive banking-system collapse with a strong economic
For most of the last decade, Kazakhstan gorged on profligate lending, courtesy of global banks – just like
much of southern Europe. The foreign borrowing of Kazakh banks amounted to around 50% of GDP, with
many of these funds used for construction projects. As the money rolled in, wages rose, real-estate prices
reached to near-Parisian levels, and people fooled themselves into thinking that Kazakhstan had become
Asia’s latest tiger.
The party came to a crashing halt in 2009, when two sharp-elbowed global investment banks accelerated loan
repayments – hoping to get their money back. The Kazakh government, which had been scrambling to
support its overextended private banks with capital injections and nationalizations, gave up and decided to
pull the plug. The banks defaulted on their loans, and creditors took large ―haircuts‖ (reductions in principal
But – and here’s the point – with its debts written off, the banking system is now recapitalized and able to
support economic growth. Despite a messy default, this fresh start has generated a remarkable turnaround.
The West European approach to dealing with crazed banks is quite different. Ireland, Europe’s (Celtic) tiger
over the last decade, grew in part due to large credit inflows into its ―Banking Real Estate Complex.‖ The Irish
banking system’s external borrowing reached roughly 100% of GDP – two Kazakhstans. When the world
economy dove in 2008-2009, Ireland’s party was also over.
But here’s where the stories diverge, at least so far. Instead of making the creditors of private banks take
haircuts, the Irish government chose to transfer the entire debt burden onto taxpayers. The government is
running budget deficits of 10% of GDP, despite having cut public-sector wages, and now plans further cuts to
service failed banks’ debt.
Greece is now at a crossroads similar to that of Kazakhstan and Ireland: the government borrowed heavily for
the last decade and squandered the money on a bloated (and unionized) public sector (rather than modern –
and vacant – real estate), with government debt approaching 150% of GDP.
The arithmetic is simply horrible. If Greece is to start paying just the interest on its debt – rather than rolling
it into new loans – by 2011 the government would need to run a primary budget surplus (i.e., excluding
interest payments) of nearly 10% of GDP. This would require roughly another 14% of GDP in spending cuts
and revenue measures, ranking it among the largest fiscal adjustments ever attempted.
Worse still, these large interest payments will mostly be going to Germany and France, thus further removing
income from the Greek economy. If Greece is ever to repay some of this debt, it will need a drastic austerity
program lasting decades. Such a program would cause Greek GDP to fall far more than Ireland’s sharp decline
to date. Moreover, Greek public workers should expect massive pay cuts, which, in Greece’s poisonous
political climate is a sure route to dangerous levels of civil strife and violence.
European leaders are wrong if they believe that Greece can achieve a solution through a resumption of normal
market lending. Greece simply cannot afford to repay its debt at interest rates that reflect the inherent risk.
The only means to refinance Greece’s debt at an affordable level would be to grant long-term, subsidized
loans that ultimately would cover a large part of the liabilities coming due in the next 3-5 years. And, even on
such generous terms, Greece would probably need a daunting 10%-of-GDP fiscal adjustment just to return to
a more stable debt path.
The alternative for Greece is to manage its default in an orderly manner. Reckless lending to the Greek state
was based on European creditors’ terrible decision-making. Default teaches creditors – and their governments
– a lesson, just as it does the debtors: mistakes cost money, and your mistakes are your own.
With each passing day, it becomes more apparent that a restructuring of Greek debt is unavoidable. Some
form of default will almost surely be forced upon Greece, and this may be the most preferable alternative. A
default would be painful – but so would any other solution. And default with an ―orderly‖ restructuring would
instantly set Greece’s finances on a sustainable path.
After tough negotiations, the government and its creditors would probably eventually slash Greece’s debt in
half. Greek banks would need to be recapitalized, but then they could make new loans again.
A default would also appropriately place part of the costs of Greece’s borrowing spree on creditors. The
Germans and French would need to inject new capital into their banks (perhaps finally becoming open to
tighter regulation to prevent this from happening again), and the whole world would become more wary about
lending to profligate sovereigns.
Ultimately, by teaching creditors a necessary lesson, a default within the euro zone might actually turn out to
be a key step toward creating a healthier European – and global – financial system.
Copyright:                             Project                            Syndicate,                        2010.
For        a      podcast       of      this     commentary           in      English,   please      use       this

The Greek Conundrum
George Soros
The euro is a unique and unusual construction whose viability is now being tested. Otmar
Issing, one of the fathers of the common currency, correctly stated the principle on which
it was founded: the euro was meant to be a monetary union, but not a political one. The
participating states established a common central bank, but they explicitly refused to
surrender the right to tax their citizens to a common authority. This principle was
enshrined in Article 125 of the Maastricht Treaty, which has since been rigorously
interpreted by the German constitutional court.
The principle, however, is patently flawed. A fully-fledged currency requires both a central
bank and a treasury. The treasury need not be used to tax citizens on an everyday basis,
but it needs to be available in times of crisis. When the financial system is in danger of
collapsing, the central bank can provide liquidity, but only a treasury can deal with
problems of solvency. This is a well-known fact that should have been clear to everyone
involved in the euro’s creation. Issing admits that he was among those who believed that
―starting monetary union without having established a political union was putting the cart
before the horse.‖
The European Union was brought into existence step-by-step by putting the cart before
the horse: setting limited but politically attainable targets and timetables, knowing full
well that they would not be sufficient, and thus that further steps would be required in
due course. But, for various reasons, the process gradually ground to a halt. The EU is
now largely frozen in its current shape.
The same applies to the euro. The crash of 2008 revealed the flaw in the euro’s
construction, as each member country had to rescue its own banking system instead of
doing it jointly. The Greek debt crisis brought matters to a climax. If member countries
cannot take the next steps forward, the euro may fall apart, with adverse consequences
for the EU.
The original construction of the euro postulated that each member would abide by the
limits set by the Maastricht Treaty. But previous Greek governments egregiously violated
those limits. The Papandreou government, elected in October 2009 with a mandate to
clean house, revealed that the budget deficit reached 12.7% of GDP in 2009, shocking
both the European authorities and the markets.
The European authorities accepted a plan that would reduce the deficit gradually, but the
markets were not reassured. The risk premium on Greek government bonds continues to
hover around three percentage points, depriving Greece of much of the benefit of euro
membership – namely, being able to refinance government bonds at the official discount
With the risk premium at current levels, there is a real danger that Greece may not be
able to extricate itself from its predicament, regardless of what it does, because further
budget cuts would further depress economic activity, reducing tax revenues and
worsening the debt-to-GDP ratio. Given that danger, the risk premium will not revert to
its previous level in the absence of outside assistance.
The situation is aggravated by the market in credit default swaps, which is biased in favor
of those who speculate on failure. Being long CDS, the risk automatically declines if they
are wrong. This is the exact opposite of short-selling in equity markets, where being
wrong means that the risk automatically increases.
Recognizing the need, the last Ecofin meeting has, for the first time, committed itself ―to
safeguard financial stability in the euro area as a whole.‖ But Ecofin has not yet found the
mechanism for doing so, because the current institutional arrangements do not provide
one – although the Lisbon Treaty establishes a legal basis for it.
The most effective solution would be to issue jointly and separately guaranteed eurobonds
to refinance, say, 75% of the maturing debt, as long as Greece meets its agreed-upon
targets, leaving Greece to finance the rest of its needs as best it can. This would
significantly reduce the cost of financing, and it would be the equivalent of the IMF
disbursing its loans in tranches as long as conditions are met.
But this is politically impossible at present, because Germany is adamantly opposed to
serving as the deep pocket for its profligate partners. Therefore, makeshift arrangements
will have to be found.
The Papandreou government is determined to do whatever is necessary to correct the
abuses of the past, and it enjoys a remarkable degree of public support. There have been
mass protests and resistance from the old guard of the governing party, but the general
public seems ready to accept austerity as long as it sees progress in correcting budgetary
abuses – and there are plenty of abuses to allow progress.
So makeshift assistance will be sufficient to allow Greece to succeed, but that leaves
Spain, Italy, Portugal, and Ireland. Together they constitute too large a portion of the
euro zone to be helped out by makeshift arrangements. The survival of Greece still leaves
the future of the euro in question. Even if the EU handles the current crisis, what about
the next one?
It is clear what is needed: more intrusive monitoring and institutional arrangements for
conditional assistance. Moreover, a well-organized eurobond market would be desirable.
The question is whether the political will to take these steps can be generated.

How to Save the Euro
Daniel Gros

BRUSSELS – The European Union is facing a constitutional moment. The founders of Economic and Monetary
Union (EMU) warned even before the euro’s birth that fiscal profligacy would constitute a danger to the
common currency’s stability. Nevertheless, the euro-zone’s member countries insisted on maintaining their full
sovereignty in this area.
The solution to this conundrum was supposed to have been the Stability and Growth Pact, working in tandem
with the so-called ―no bailout‖ clause in the Maastricht Treaty. The latter was intended to impose market
discipline, and the former, to preserve the stability of public finances by fixing a strict limit on the size of
national budget deficits.
Both proved futile. The Stability and Growth Pact clearly did not prevent ―excessive‖ deficits, and the no-
bailout clause failed its first test when European leaders, facing the Greek crisis, solemnly declared on
February 11 that euro-zone members would ―take determined and coordinated action, if needed, to safeguard
financial stability in the euro area as a whole.‖
The failure to impose market discipline via the no-bailout clause was predictable: in a systemic crisis, the
immediate concern to preserve the stability of markets almost always trumps the desire to prevent the moral
hazard that arises when imprudent debtors are saved. But in September 2008, the United States
government thought otherwise, and allowed Lehman Brothers to fail in order to impose market discipline. The
disaster that followed illustrated the damage that an uncontrolled failure can produce.
Yet the lesson should not be that failure has to be avoided at all costs: applied to the case of Greece, this
would mean that the pressure on the Greek government to adjust would evaporate. The alternative, instead,
is to think ahead and prepare for failure!
A debtor’s strongest negotiating asset is always that creditors cannot contemplate default, because default
would bring down the entire financial system. But market discipline can be established only if default is a true
possibility. This is why it is crucial to create a mechanism to contain the cost – and thus minimize the
unavoidable disruptions – resulting from a default.
This is the key aim of the Euro(pean) Monetary Fund (EMF), which Thomas Mayer and I have proposed, and
which has been put on the Union table for discussion by German Finance Minister Wolfgang Schauble, among
others. The EMF (or rather ESF, as some have dubbed it, for European Stability Fund) could manage an
orderly default of an EMU member country that fails to comply with the conditions attached to an adjustment
We imagine a simple mechanism, modeled on the successful experience with Brady bonds. These were bonds
issued by distressed Latin American countries in the early 1990’s as part of an arrangement to reschedule
their international debts. US government securities provided collateral for them.
To safeguard against the systemic effects of a default, the EMF could offer holders of the defaulting country’s
debt an exchange of this debt against claims on the EMF. Of course, debt-holders would be obliged to accept a
uniform discount (or ―haircut‖) on what they are owed.
This would be a key measure to limit the disruption from a default. A default creates ripple effects throughout
the financial system, because all debt instruments of a defaulting country become, at least upon impact,
worthless and illiquid. But, with an exchange à la Brady bonds, the losses to financial institutions would be
limited (and could be controlled by the choice of the haircut given to creditors).
In return for offering the exchange against a haircut, the EMF would acquire the claims against the defaulting
country, which would then receive any additional funds from the EMF only for specific purposes that the EMF
Other EU transfer payments would also be disbursed by the EMF under strict scrutiny, or they could be used to
pay down the defaulting country’s debt to the EMF. Thus, the EMF would provide a framework for sovereign
bankruptcy comparable to the procedures that exist in the US for bankrupt companies that qualify for
How would the EMF finance its interventions? We propose to establish a common insurance fund with
contributions proportional to the risk that each member country represents. Ideally, one should base the
contributions on market indicators of default risk. But the very existence of the EMF would distort credit-
default swap spreads and yield differentials among EMF members.
We therefore propose that contributions to the EMF should be based on member countries’ fiscal deficits and
public debt levels, because both represent warning signs of impending liquidity or insolvency risk. The EMF
could receive a levy that would be proportional to any fiscal deficit in excess of 3% of GDP and public debt in
excess of 60% of GDP – the caps imposed by the Stability and Growth Pact. This levy would represent a sort
of automatic fine, thus making the elaborate structure of the Pact redundant.
These two simple elements – orderly default and a financing mechanism – could resolve the current crisis
within the euro zone: by creating a European Monetary Fund along these lines, the euro area would acquire an
institution that could support member countries in difficulties, but that would also ensure that market
discipline really worked.
Copyright: Project Syndicate, 2010.

The Next Global Problem: Portugal
Gonçalo Santos for The New York TimesPrime Minister José Sócrates is trying to reassure world markets that he can bring down
Portugal’s deficit.

10:17 a.m. | Updated

Peter Boone is chairman of the charity Effective Intervention and a research associate at the Center for
Economic Performance at the London School of Economics. He is also a principal in Salute Capital
Management Ltd. Simon Johnson, the former chief economist at the International Monetary Fund, is the
co-author of 13 Bankers.

The bailout of Greece, while still not fully consummated, has brought an eerie calm in European financial

It is, for sure, a huge bailout by historical standards. With the planned addition of International Monetary
Fund money, the Greeks will receive 18 percent of their gross domestic product in one year at preferential
interest rates. This equals 4,000 euros per person, and will be spent in roughly 11 months.

Despite this eye-popping sum, the bailout does nothing to resolve the many problems that persist. Indeed, it
probably makes the euro zone a much more dangerous place for the next few years.

Next on the radar will be Portugal. This nation has largely missed the spotlight, if only because Greece
spiraled downward. But both are economically on the verge of bankruptcy, and they each look far riskier
than Argentina did back in 2001 when it succumbed to default.
Portugal spent too much over the last several years, building its debt up to 78 percent of G.D.P. at the end of
2009 (compared with Greece’s 114 percent of G.D.P. and Argentina’s 62 percent of G.D.P. at default). The
debt has been largely financed by foreigners, and as with Greece, the country has not paid interest outright,
but instead refinances its interest payments each year by issuing new debt. By 2012 Portugal’s debt-to-
G.D.P. ratio should reach 108 percent of G.D.P. if the country meets its planned budget deficit targets. At
some point financial markets will simply refuse to finance this Ponzi game.

The main problem that Portugal faces, like Greece, Ireland and Spain, is that it is stuck with a highly
overvalued exchange rate when it is in need of far-reaching fiscal adjustment.

For example, just to keep its debt stock constant and pay annual interest on debt at an optimistic 5 percent
interest rate, the country would need to run a primary surplus of 5.4 percent of G.D.P. by 2012. With a
planned primary deficit of 5.2 percent of G.D.P. this year (i.e., a budget surplus, excluding interest
payments), it needs roughly 10 percent of G.D.P. in fiscal tightening.

It is nearly impossible to do this in a fixed exchange-rate regime — i.e., the euro zone — without vast
unemployment. The government can expect several years of high unemployment and tough politics, even if
it is to extract itself from this mess.

Neither Greek nor Portuguese political leaders are prepared to make the needed cuts. The Greeks have
announced minor budget changes, and are now holding out for their 45 billion euro package while implicitly
threatening a messy default on the rest of Europe if they do not get what they want — and when they want it.

The Portuguese are not even discussing serious cuts. In their 2010 budget, they plan a budget deficit of 8.3
percent of G.D.P., roughly equal to the 2009 budget deficit (9.4 percent). They are waiting and hoping that
they may grow out of this mess — but such growth could come only from an amazing global economic boom.

While these nations delay, the European Union with its bailout programs — assisted by Jean-Claude
Trichet’s European Central Bank — provides financing. The governments issue bonds; European
commercial banks buy them and then deposit these at the European Central Bank as collateral for freshly
printed money. The bank has become the silent facilitator of profligate spending in the euro zone.

Last week the European Central Bank had a chance to dismantle this doom machine when the board of
governors announced new rules for determining what debts could be used as collateral at the central bank.

Some anticipated the central bank might plan to tighten the rules gradually, thereby preventing the Greek
government from issuing too many new bonds that could be financed at the bank. But the bank did not do
that. In fact, the bank’s governors did the opposite: they made it even easier for Greece, Portugal and any
other nation to borrow in 2011 and beyond. Indeed, under the new lax rules you need only to convince one
rating agency (and we all know how easy that is) that your debt is not junk in order to get financing from the
European Central Bank.

Today, despite the clear dangers and huge debts, all three rating agencies are surely scared to take the
politically charged step of declaring that Greek debt is junk. They are similarly afraid to touch Portugal.

So what next for Portugal?

Pity the serious Portuguese politician who argues that fiscal probity calls for early belt-tightening. The
European Union, the European Central Bank and the Greeks have all proven that the euro zone nations have
no threshold for pain, and European Union money will be there for anyone who wants it. The Portuguese
politicians can do nothing but wait for the situation to get worse, and then demand their bailout package,
too. No doubt Greece will be back next year for more. And the nations that “foolishly” already started their
austerity, such as Ireland and Italy, must surely be wondering whether they too should take the less austere

There seems to be no logic in the system, but perhaps there is a logical outcome.

Europe will eventually grow tired of bailing out its weaker countries. The Germans will probably pull that
plug first. The longer we wait to see fiscal probity established, at the European Central Bank and the
European Union, and within each nation, the more debt will be built up, and the more dangerous the
situation will get.

When the plug is finally pulled, at least one nation will end up in a painful default; unfortunately, the way we
are heading, the problems could be even more widespread.

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