The European Central Bank has given the euro a boost with its moves to lower interest rates and get credit flowing throughout the monetary union. We hope Europe’s leaders won’t let the sugar high distort their view of the monumental changes still required to ensure the currency’s longer-term survival.
The ECB’s increasingly accommodative stance represents a much-needed recognition of the deepening economic strife that austerity policies have visited upon the currency union’s weakest members. More than five years after the start of the 2007 recession, unemployment rates are still rising throughout much of the euro area. At the same time, government debt as a share of economic output is growing, thanks in large part to shrinking economies.
Whatever optimism investors can muster rests largely on the ECB’s pledge to do “whatever it takes” to hold the euro together, by which it means buying the bonds of governments that are taking steps to return to fiscal health. Problem is, if you accept the EU’s definition of fiscal health — government debt of less than 60 percent of gross domestic product — then the goal is probably unattainable for a large portion of the euro area.
If governments can’t reach the 60 percent target in the foreseeable future, that strongly suggests they can’t manage their finances and will eventually have to renege on some portion of their obligations. The resulting losses to creditors could be much larger than in last year’s Greek debt restructuring, and could render some large euro-area banks insolvent. If Europe isn’t ready to handle such a scenario in an orderly manner, the question of the common currency’s survival will again come to the fore.
How big, then, is the problem? To get a sense, we made some very long-term projections for selected euro-area countries, going out to the year 2030. We assumed, generously, that economic growth and interest rates would gradually reach a stable and relatively benign level. In Spain, for example, borrowing costs and the nominal growth rate converge at 4.2 percent. We then calculated the amount by which each government’s revenue would have to exceed expenditures (excluding interest payments) — or what primary budget balance it would have to achieve and sustain — to bring debt down to 60 percent of GDP by 2030.
The result isn’t pretty (see chart). Greece would have to run an average primary surplus of more than 8 percent of GDP from 2021 through 2030. That’s about a sixth of Greece’s current government expenditures, and almost six percentage points more than the largest 10-year average surplus the country has been able to sustain in its postwar history. The situation isn’t much better for Italy, Portugal and Spain, all of which would have to run primary surpluses much larger than any they’ve achieved during any extended period in the past 60 years.
In other words, at least four euro-area governments, with combined debts of almost 3 trillion euros, have little to no hope of ever getting their obligations down to the level the EU has defined as prudent. Even if they make it through their current economic difficulties, they’ll still have debts large enough to make them extremely vulnerable to any future financial crisis. Unless they want to spend the rest of their days on the brink of disaster, they’ll have to make a deal with their creditors to reduce the burden.
The mechanisms needed to manage such a large debt restructuring are plain. The first is euro bonds, collectively backed by all the nations of the euro area. Such bonds would give strapped governments something of value to offer investors in return for accepting losses on existing debt, and could ultimately lower euro-area borrowing costs by creating a market large and liquid enough to rival U.S. Treasuries. A central finance ministry would manage the issuance of the bonds, ensuring that individual governments’ euro-bond debt never exceeded 60 percent of GDP.
The second is a banking authority with enough resources to handle the financial carnage a major debt restructuring would entail. This means giving it not only the power to take over insolvent banks and make creditors share the cost of recapitalizations, but also the money to inject its own funds if other options aren’t feasible.
The third is a system of fiscal transfers, in which high- growth countries would send stimulus money to those suffering slumps. This would help prevent recessions from turning into debt emergencies, and smooth out the stark differences in economic cycles that make sharing a currency perilous for the countries of the euro area. In the U.S., for example, federal transfers such as income-tax credits cushion as much as 40 percent of the blow of recessions in individual states. In Europe, the same end might be better achieved through a mutual unemployment-insurance fund.
All the mechanisms require a level of risk-sharing and a loss of sovereignty that Europe’s leaders, particularly Germany’s, have so far shunned. If they don’t come around, there’s a good chance that the ECB’s assurances eventually won’t be enough to keep the euro intact.