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The Euro Crisis and Its Implications July 2012

Prof. Bodo Herzog

2 AUTHOR

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PROF. BODO HERZOG Professor of Economics ESB Business School Reutlingen University

Email: [email protected] Web Page: Click here

Bodo Herzog is professor of economics at ESB Busi-

State University and Zeppelin University. Since 2008,

ness School, Reutlingen University. Moreover, he is

He is member of several political advisory councils in

Director of the Institute of Finance and Economics and

Germany.

a research professor at Reutlingen Research Institute (RRI).

Professor Herzog’s research focuses mainly on macroeconomics, monetary economics, financial econom-

He has worked as a senior economist for the German

ics, and neuro-economics. He has published many

Council of Economic Experts and as Chief Economist

articles in professional journals and several academic

and Head of the Economics Department at Konrad

books. He is a frequent columnist for “The European”

Adenauer Foundation in Berlin. Professor Herzog

magazine.

studied mathematics and economics at the University Konstanz. He holds a PhD in economics with a dissertation on fiscal-monetary interaction in the European Monetary Union. He was a research fellow at Massachusetts Institute of Technology. In addition, Professor Herzog is a regular visiting professor at Portland

3 TABLE OF CONTENTS

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TABLE OF CONTENTS

Abstract........................................................... 04

1.

Euro Crisis: What Are the Hidden Issues?....... 05

1.1.

Current Account Imbalance: A Divergence



Appendix..................................................... 28



Endnotes..................................................... 31

5.

Investor´s Corner......................................... 32

of Competitiveness?.......................................... 05 1.2.

EMU’s Unique Institutional Rules: Friend or Foe?............................................................... 08

1.3.

Re-Financing of Sovereign Debt: Merely Challenging in the EMU?................................... 09

2.

Current Challenge in EMU: Contagious Sovereign Debt................................................ 12

2.1.

Size of Government Debt................................... 12

2.2.

Composition of Government Debt..................... 16

3.

Impact on the Real and Financial Economy.... 18

3.1.

Economic Effects of Debt Crises....................... 18

3.2.

Economic Effects of Sovereign Spreads............ 20

3.2.

Economic Effects of Austerity Measures........... 23

3.3.

Public Debt Sustainability: Evaluation of Investors’ Decision-Making............................... 24

4.

Policy Conclusions & Outlook......................... 25



References...................................................... 27

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4 THE EURO CRISIS AND ITS IMPLICATIONS

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The Euro Crisis and Its Implications Prof. Bodo Herzog 1 July 2012 White Paper in Cooperation with DWS Investments

ABSTRACT In this white paper, we explain the key forces behind

In addition, we argue that it is almost unmanageable

the euro crisis and analyse its impact on government

for Greece to regain competitiveness by more than

and investor decision-making. We argue that as long

20% within the straitjacket of the European Monetary

as existing macro dynamics, especially current account

Union. Our empirical analysis of debt crises demon-

imbalances and high levels of debt, are not reversed,

strates a long-lasting negative impact on economic

the euro area will remain in crisis mode. Furthermore,

output and loan policies. Thus, the economic outlook

contagion has the potential to create an immediate

for the indebted countries is gloomy. Tackling the roots

crisis of confidence and amplify existing challenges.

of the euro crisis should therefore be the top priority

We find that, with a few exceptions, euro area govern-

on the policy agenda. We provide a novel toolbox for

ment debt is similar in size and composition to pub-

investors’ assessment of sustainable public finances

lic debt of countries outside the euro. However, the

that will enhance their decision-making in sovereign

market reaction has been exaggerated in Europe due

bond markets.

to the continent’s unique institutional framework. The



United States, United Kingdom, and Japan are by no

Key words: EMU, Sovereign Debt, Sustainability,

means in a better position in the long run. We con-

Macroeconomic Implications

firm the hypothesis that Greece is an exceptional case.

1 Dr. Herzog is Professor of Economics at ESB Business School. He is also research professor at RRI Reutlingen Research Institute and Director of the Institute of Finance and Economics at ESB Business School and KFRU Reutlingen University. Contact address: Alteburgstr. 150, 72762 Reutlingen, Germany. Email: [email protected] Acknowledgement: I am grateful for very helpful comments from Henning Stein, Johannes Müller, and Jun Shiomitsu. Moreover, special thanks to both Katja Hengstermann and Cristina Debora Manea for outstanding editing. I am responsible for all remaining errors.

5 THE EURO CRISIS AND ITS IMPLICATIONS

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EURO CRISIS: WHAT ARE THE HIDDEN ISSUES? The European Monetary Union (EMU) is in crisis. With-

the economic outlook. The typical self-reinforcing and

out a doubt, the rescue packages of the past several

contagious processes now threaten the very existence

years were necessary to stabilize the euro area and the

of the monetary union. Given that regulators continue

financial markets in the short term. However, it is ques-

to classify bonds as absolutely secure assets, it is cru-

tionable whether this rescue path will lead to a sustain-

cial to ensure that current liquidity problems do not

able framework of economic governance. There is a

culminate in an overall solvency crisis.

danger that policymakers will follow the wrong path, leading to a future break-up of the euro area. The cur-

Investors’ distrust in the solvency of the euro area

rent rescue philosophy of helping the indebted coun-

can be inferred from the development of default risk

tries with guarantees on the one hand and demand-

premiums on European sovereign bonds and CDS

ing austerity on the other hand is appropriate only as

spreads. Remarkably, the current state of financial

a short-run stabilization tool and does not solve the

turmoil has impaired the creditworthiness of mainly

structural problems in the medium and long term (Her-

euro area banks. Figure 1 shows that CDS spreads of

zog 2011, 2012). An effective solution requires a pro-

euro area banks are now higher than they were fol-

found analysis of the structural and hidden issues of

lowing the collapse of Lehman Brothers in September

the so-called euro crisis. In addition, we address the

2008, while CDS spreads for U.S. banks remain below

question: What will be the impact on investors?

that level (Figure 1). Hence, this chart demonstrates the effect of “contagion” in the euro area. The next

The euro faces a crisis with multi-dimensional roots.

subsections provide a rigorous diagnosis of the root

One facet is the sovereign debt crisis, which started in

causes and hidden issues of the euro crisis.

the spring of 2010 and has now turned into a crisis of confidence that continues to spread and has already

1.1 Current Account Imbalance: A Divergence of

affected five euro member states – Greece, Portugal,

Competitiveness?

Ireland, Spain, and Italy – that together account for one-third of the EMU’s economic output. The pres-

For more than two decades, economists have dis-

ent uncertainty has triggered an additional decrease in

cussed the threat posed by uncontrolled reversals

consumer and investor confidence, further weakening

Figure 1: CDS Spreads For Monetary Financial Institutions in the Euro Area and United States

Source: Thomson Financial Datastream (2011,2012).

6 THE EURO CRISIS AND ITS IMPLICATIONS

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Figure 2: Current Account in Billions of USD of Selected Euro Area Countries in 2010

Source: IMF (2011,2012).

of global imbalances to individual countries and the

euro area countries, but also in the U.S. and Iceland

global economy. Not surprisingly, global imbalances

(not reported).

expanded massively leading up to the financial crisis of 2007 and thereafter declined significantly (Figure

The current account imbalances and high private defi-

1A-Appendix; IMF 2010). A similar pattern, though to

cit and debt levels are closely linked to the euro cri-

a smaller degree, is observable within the euro area

sis. Financial institutions relocated the high savings of

(Figure 2).

surplus countries – Germany, for instance – to deficit countries in order to finance household and corporate

A closer look at Figure 2 reveals that Spain, Italy,

loans. Due to the typical home bias in investment, the

Greece, and Portugal were the biggest deficit coun-

lion’s share of savings simply moved from core Euro-

tries, while Germany and the Netherlands were the

pean surplus countries to periphery deficit countries.

major surplus countries. The current accounts of the other deficit or surplus countries are negligible. If we

The irrationality of this process is reflected in the fact

calculate the current account relative to GDP, however,

that mortgage interest rates in Spain and Ireland were

we immediately identify Greece, Portugal, Spain, and

lower than in Germany even though Spain and Ireland

Ireland as the biggest deficit countries. Ireland and

had higher private debt levels and, consequently, car-

Spain are two particularly special cases because both

ried higher default risks. In addition to private debt

featured sound public finances before the onset of the

accumulation, countries such as Greece, Portugal, and

financial crisis. The problem in Spain and Ireland was

Italy accumulated huge public debt in the run-up to the

the relatively high level of private debt, i.e. household

financial crisis. There is evidence that the major deficit

and corporate debt. The debt accumulation was trig-

countries avoided sufficient budget consolidation dur-

gered by historically low (real) interest rates since the

ing the economically good years. Furthermore, with

beginning of the EMU in 1999. Consequently, both

the onset of the financial crisis, governments around

economies experienced an unsustainable investment

the globe implemented substantial stimulus measures

and housing boom. Figure 3 shows that high private

and financial guarantees in order to stabilize the finan-

deficit-to-GDP is not just prevalent in the troubling

cial sector and real economy. These policy measures

7 THE EURO CRISIS AND ITS IMPLICATIONS

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Figure 3: Private Sector Deficit-to-GDP1 for Selected Countries in 2007

Source: IMF and own calculations (2011,2012).

increased public debt even further in a relatively short

levels, while Ireland’s problems were caused by high

period of time. As a result, markets questioned the

private debt levels and extensive public support for the

sustainability of public finances in the heavily indebted

banking sector during the financial crisis. Euro area

countries, leading to a widening of sovereign bond

contagion in turn affected the other countries, like

spreads and CDS spreads since 2010.

Spain and Italy, soon thereafter. Thus, the overlap of both trends – massive private and public debt accu-

Ireland slipped into sovereign debt problems for differ-

mulation as well as public support to the financial sys-

ent reasons from those of Greece and Portugal. Greece

tem – is the major force behind the euro crisis.

and Portugal are victims of inherently high public debt

Figure 4: Unit Labour Costs of Selected Euro Area Countries (Index 2000 = 100)

Source: Eurostat (2011,2012).

8 THE EURO CRISIS AND ITS IMPLICATIONS

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Figure 5: Productivity and Labour Costs (annual average between 2000 and 2010 in %)

Source: Eurostat and own calculations (2011,2012).

In addition to these problems, the five troubled coun-

so-called wage-indexation rules. The nominal wage is

tries – Greece, Portugal, Spain, Italy, and Ireland –

thus not linked to productivity growth but to inflation.

declined substantially in competitiveness over the past decade. Wages rose faster than productivity for

In short, the key macroeconomic forces behind the

years, meaning that their unit labour costs, relative to

euro crisis are the current account imbalances and

their major rivals, were about 20% higher than in 2000

declining competitiveness of countries in the euro

(Figure 4 on previous page). Given that none of the

area. Historically low interest rates also triggered pri-

countries is able to make adjustments via a nominal

vate and public debt accumulation before the onset of

devaluation, the only way out is via painful nominal

the financial crisis. These reckless market conditions

wage cuts. This does improve competitiveness, but it

caused an artificial economic and wage boom that

also exacerbates the debt problems of private house-

eroded the competitiveness of some countries during

holds. While the current unit labour costs for the five

the period from 2000 to 2008. Finally, fiscal measures

countries is insufficient to regain an average level,

to stabilize the financial sector and real economy raised

there have been some positive signs. Since 2008, Ire-

concerns about the sustainability of public finances in

land has been making significant corrections to regain

these euro area countries.

competitiveness. The picture for Italy is a bit more controversial. The trend in unit labour costs is still

1.2 EMU’s Unique Institutional Rules: Friend or

upwards despite some positive political reform steps

Foe?

since 2011. Nevertheless, there remains a divergence between these countries’ unit labour costs and those

Another special characteristic of the euro crisis is the

of the surplus countries.

institutional straitjacket of the monetary union. A comparison with highly indebted G-7 member states, such

It turns out that the divergence of the unit labour costs

as Japan, the United Kingdom, and the United States,

is not caused by insufficient productivity growth in

shows that the euro area has less flexibility with cen-

the five troubling countries, but rather by the wrong

tral bank bond-buying programs and state support (cf.

adjustment of nominal wages according to productiv-

section 2). In addition, the U.S. is in a unique position

ity (Figure 5). There is empirical evidence that deficit

due to the safe-haven status of the dollar.

countries increased wages more than surplus countries. Almost all Southern European states still have

The EMU fundamentally changed the framework of

9 THE EURO CRISIS AND ITS IMPLICATIONS

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European governance and monetary policy. Member

financial investors or the lack of credibility and disci-

states issue debt denominated in euros, but lack their

plinary incentives in the institutional setup of the EMU.

own central banks to create the means to repay their debts. European member states assumed that the

Fortunately, since 2010, financial markets have

spill-over risk of default was eliminated by institutional

responded with a differentiated assessment of the

rules, such as the no-bailout clause and the Stability

creditworthiness of sovereign bonds. However, the

and Growth Pact implemented in 1997. These rules

relatively abrupt reversal of sovereign yields has pro-

were meant to guarantee that unsound fiscal policy

duced a situation similar to a bank run in the euro

and thus default were solely national, rather than Euro-

area. These self-reinforcing and systemic effects have

pean, issues. However, as early as the 1990s, many

been highly “contagious” – that is, they have cre-

experts realized that the no-bailout clause lacked cred-

ated temporary liquidity problems that have evolved

ibility. When faced with severe turmoil it was expected

into enduring solvency crises in some countries. This

that the rules would be abandoned. This was the case

can be attributed to the fact that a country’s solvency

in 2005, when the Stability and Growth Pact was

depends firstly on the interest rate it has to pay for

revised, as well as in 2010, when the no-bailout clause

its debt and secondly on its expected economic out-

was abolished at the onset of the sovereign debt crisis

look, both of which have deteriorated in the problem

in Greece.

countries.

The existing shortcomings of economic governance

The unique institutional setup of the EMU, combined

within the EMU have been discussed since 2003.

with ongoing uncertainty and self-reinforcing pro-

From the beginning, the enforcement mechanism of

cesses, has the euro area facing a crisis of confidence.

the stability pact was identified as too weak and the

This is nicely illustrated by Standard & Poor’s justifi-

sanction scheme as too inconsistent. Accordingly, the

cation for downgrading Italy in September 2011, in

institutional framework established little discipline.

which the agency noted that Italy is expected to pay

Although Greece consistently ran deficits in excess

higher interest and that the country’s austerity pro-

of 3% of GDP and maintained debt levels above 60%

gram has weakened output. Both factors – lower GDP

of GDP, European policymakers failed to demand the

and higher interest rates – increase debt levels. This

obligatory austerity measures. Now, more than 10

leads to a vicious cycle in which higher debt leads to

years later and in the heat of crisis, policymakers are

even higher interest payments and slower growth.

demanding such austerity. There is no doubt that these

Simply put, this assessment is always true and justifies

measures are necessary, but the implementation came

a downgrade at all times. Surprisingly, this argument

far too late. EMU’s institutions and policymakers failed

was not applied to, and the market reactions were

to create strong disciplinary incentives.

subdued for, countries with similar debt levels such as the U.K., U.S., and Japan. Consequently, the unique

Furthermore, during normal times financial markets –

institutional framework of the European Monetary

banks, insurance companies, and rating agencies, in

Union triggered substantial downgrades and snowball

particular – failed to sufficiently differentiate the cred-

effects that led to a surge in bond yields in the heavily

itworthiness of euro area countries. This is astonish-

indebted countries. In summary, specific institutional

ing since the legal and institutional framework of the

issues explain why the EMU faces unusually tough

EMU, including the assigning of responsibility for the

challenges compared to other countries with similar

soundness of fiscal policy to national governments,

debt levels.

has been clear since the beginning of the monetary union. The reasons for this partly “irrational” market

1.3 Re-Financing of Sovereign Debt: Merely Chal-

opinion on creditworthiness, aside from the clear lack

lenging in the EMU?

of credibility of the no-bailout clause, are still unclear. It could be due to misunderstandings on the part of

Finally, we discuss the sovereign debt dimension

10 THE EURO CRISIS AND ITS IMPLICATIONS

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Figure 6: 10-Year Bond Rates in Selected Countries, in %

Source: Thomson Financial Datastream (2011,2012).

and the currency perspective of the euro crisis. High

monetary policy and the lack of exchange-rate depre-

sovereign debt levels triggered an extraordinary yield

ciation for euro area countries are both major prob-

dynamic, signalling a crisis of confidence in the euro

lems helping to fuel the crisis.

area. Judging the solvency and sustainability of a country’s public finances, however, requires a general

The markets are by no means impressed by the tough

equilibrium assessment of the debt-to-GDP ratio over

austerity programs of EMU countries. Financial mar-

time. This issue is studied in subsection 3.4 based on

kets even perceived higher default risks for the five

new estimates.

euro area countries, which triggered contagious effects. Markets are strongly disappointed with struc-

Despite considerable efforts to consolidate budgets

tural debt problems in the euro area. One aspect is that

in Greece, Portugal, Ireland, and Spain, the impact on

the government’s accumulation of debt was not fully

bond rates was negligible in 2011 (Figure 6). These

offset during economic good times in past decades.

countries reduced their primary balance – public

Moreover, the government’s indebtedness will soon

deficits excluding interest payments on government

become even more difficult to manage due to Europe’s

liabilities – in the years 2009 to 2011 by 7.6 percent-

ageing population. 2

age points. Highly indebted G-7 countries, such as Japan, the United States, and the United Kingdom,

Given the risk of self-reinforcing spirals, and the fact

are far behind this. Nevertheless, bond rates in these

that the European Central Bank (ECB) is the only

countries dropped 1 percent, while rates for the five

institution capable of acting in the short run, the

indebted euro area countries climbed even further.

unique institutional problems in the euro area are still unsolved. Only with a time delay did policymakers

This dynamic is a bit surprising. For instance, Japan

agree to implement the European Financial Stability

has a very high debt-to-GDP ratio of 213% and has

Facility (EFSF), with about €440 billion. The EFSF will

a quickly ageing population. Nevertheless, Japan, as

be converted to the European Stability Mechanism

well as the U.S. and the U.K., is still able to finance itself

(ESM) after a transitory overlap of both rescue facili-

in the capital market at interest rates similar to the low

ties. The ESM is another step forward; however, there

rates paid by Germany, which features much sounder

are several flawed incentives within the ESM proce-

public finances. This market paradox can be explained

dure. This rescue umbrella might be too low compared

by the EMU straitjacket. The EMU’s one-size-fits-all

to the Italian and Spanish refinancing requirements of

11 THE EURO CRISIS AND ITS IMPLICATIONS

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Table 1: Refinancing Requirements of Selected Euro Area Countries in 2012 and 2013

Source: IMF and own calculations (2011,2012).

approximately €1.1 trillion in the years 2012 and 2013

still the second-largest reserve currency according

(Table 1). Table 1 shows the refinancing requirements

to recently published data by the IMF. From 1999 to

of selected euro area countries. These amounts indi-

2011, the share of U.S. dollar reserves has declined

cate an urgent need to tackle the roots of the euro

from 71.0% to 61.7%, while euro reserves increased

crisis. Nonetheless, the crisis with respect to Greece,

from 17.9% to 25.7%. This trend demonstartes the

Portugal, and Ireland is manageable. As markets calm

increasing demand for the euro currency. In fact,

down and eventually return to normal, refinancing via

according to interest-rate parity, the recent drop of the

capital markets might be achievable.

euro can easily be explained as a temporary phenomenon. Moreover, since December 2010, there has been

Indeed, the period of the so-called “Great Modera-

explicit political willingness and action to tackle the

tion” – which was characterized by relatively low inter-

roots of the European sovereign debt crisis. It is not

est rates and low volatility – contributed to today’s

just talking, as it was in the previous years; now there

problem. First, it triggered excessive risk taking and

is bold and decisive action. Policymakers agreed to

maturity transformations. Second, there is empirical

implement constitutionallly alike national debt rules in

evidence that the more integrated and liberalized the

25 euro area countries (though not in the United King-

financial system, the higher the co-dependence of

dom or Czech Republic). In March 2012, they ratified

the default risk of publicly traded banks (Anginer and

the fiscal compact, which is all in all another positive

Demirguc-Kunt 2011). Consequently, the generous

sign.4 In addition, European policymakers reformed the

global liquidity conditions and lack of global supervi-

existing economic governance of the euro area by the

sion created a hidden instability in the financial and

so-called six-pack reform. Altogether, this is certainly a

macroeconomic environment. Research provides sig-

step in the right direction, but it is not a quantum leap.

nificant evidence that both factors are key drivers of

There are two options in the long-run:

booms in credit markets (Elekdag and Wu, 2011). • Option A (centralization): This is a fundamental In summary, the so-called euro crisis is definitely not

change in the existing policy framework toward a

a crisis of the euro currency. Despite the weaker euro-

transfer union with Eurobonds and a European finance

dollar exchange rate in recent months3, the euro is

minister, budget, and taxes. This option would insist

12 THE EURO CRISIS AND ITS IMPLICATIONS

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that EMU member states abandon a substantial part of

for sound finances in the long run and enhance the

their national sovereignty over fiscal policy. This would

consistency of the institutional setup. Thus, Option B

require immediate and fundamental legal changes at

requires a return to and enhancement of the funda-

both the European and national level. The recent judg-

mental principles of the existing monetary union.

ment by the constitutional court in Germany has partly eliminated this option for the near future.

Either option would be effective as a solution from an economic point of view. However, a combination of

• Option B (decentralization): This is an effective,

options A and B – that is, sharing the costs of unsound

de-politicized, rules-based framework aligned with

fiscal policy while retaining national sovereignty over

market forces and consistent institutional incentives.

fiscal policy – is likely to fail.

This would strengthen the fiscal and market incentives

2. CURRENT CHALLENGE IN EMU: CONTAGIOUS SOVEREIGN DEBT

This section explains the challenges of public debt

government debt must be monitored carefully and

accumulation in Europe and its policy implications.

taken into account for a more comprehensive analy-

We argue that the total amount of government debt

sis of sustainable public finances; and (iii) deficit and

consists of explicit and implicit debt. Market partici-

gross debt should remain the basis for the “Excessive

pants and rating agencies often overlook the “hidden

Deficit Procedure” within the Stability and Growth

debt” in the form of implicit and contingent liabilities.

Pact. However, these should be analysed with the ulti-

In addition, the composition of public debt provides

mate goal of a balanced budget in the medium term.

valuable information about the maturity and holder of sovereign debt. Consequently, the debt’s composi-

2.1 Size of Government Debt5

tion plays a key role when evaluating the solvency and vulnerability of public finances. Policy conclusions are

The financial, economic, and sovereign debt crises

that: (i) Debt ratios must be stabilised to re-establish

of the past few years have imposed a substantial fis-

market confidence; (ii) implicit or off-balance-sheet

cal burden on governments. In all countries, stimulus

Table 2: Government Debt-to-GDP in the Euro Area (2007-2012) Percentage of GDP



2007

2008

2009

2010

2011

2012

1

Gross Debt

66.2

69.9

79.3

85.2

87.7

88.5

2

Change in Debt Ratio (2 = -3+4+5)

-2.3

3.6

9.5

6.0

2.4

0.8

3

Nominal GDP growth

4

Deficit

-3.5

-1.6

2.3

-2.0

-2.5

-2.9



0.7

2.0

6.3

6.0

4.3

3.5



Automatic stabilisers

-1.0

-0.5

2.0

1.6

1.3

1.0



Other expenditures

1.7

2.5

4.3

4.4

3.0

2.5

Deficit-debt adjustment

0.5

3.2

0.9

1.9

0.6

0.2



Support of financial sector

0.0

1.9

0.5

2.5

-

-

Ohter expenditures

0.5

1.3

0.4

-0.6

-

-

5





Source: ECB and European Commission (2011,2012).

13 THE EURO CRISIS AND ITS IMPLICATIONS

Table 3: Debt-to-GDP for Euro Area Countries

DWS | GLOBAL FINANCIAL INSTITUTE

66.2% to 88.5%. The level of government debt in 2012 is expected to increase by almost €2.7 trillion from a stock of about €6 trillion in 2007. The volume of gov-

Year

1999

2007

2010

Austria

58

58

70

eign debt holders are the monetary financial institutes

Belgium

110

84

96

(MFIs) with 35% or €2.746 trillion, insurance compa-

Cyprus

43

45

61

nies and pension funds with 16% or €1.215 trillion,

Germany

61

65

82

and investment funds with 9% or €692 billion. The

Estonia

2

1

1

remaining 40%, or €3.17 trillion, is held by others,

Spain

61

36

61

including foreign investors and hedge funds. Auto-

Finland

37

34

47

matic stabilisers, expansionary counter-cyclical fiscal

France

59

64

82

policies, and government support to the financial sec-

Greece

70

107

142

tor during the financial crisis of 2007 to 2009 drove the

Italy

109

103

118

recent public debt accumulation (Table 2). However,

6

7

19

stabilization expenditures have been somewhat erratic

Malta

45

59

69

across countries, particularly in Germany, the Nether-

Netherlands

61

45

60

lands, Portugal, and Ireland.

Slovenia

11

23

39

Slovakia

31

21

41

In 2009, the severe recession and resulting negative

Portugal

50

68

93

output gap added to debt accumulation by 2.3 per-

Ireland

48

25

96

centage points. In all other years, GDP growth has

ernment bonds in the euro area is estimated to be as high as €7.822 trillion euro in 2010. The major sover-

Luxembourg

slightly reduced future debt levels (cf. row 3), even if Source: ECB and European Commission (2011,2012).

the net contribution to debt was mostly positive, as shown in row 2 in Table 2. Line 5 in Table 2 justifies the

spending during recession years has led to sharp

hypothesis that the recent debt accumulation in the

increases in debt-to-GDP and deficit-to-GDP ratios.

euro area is also caused by deficit deterioration due

This has had adverse consequences on sovereign

to public stimulus and support to the financial sector.

bond yields, private investments due to crowding out, and potential output. Moreover, these increases

Consequently, debt-to-GDP ratios increased in almost

affected markets’ confidence in government liquidity

all countries. Let us compare the debt levels of 2007

and solvency.

and 2010: Ireland’s debt increased by roughly 71 percentage points, Greece’s by about 35 percentage

A government is called solvent in a given period if the

points, and Portugal’s and Spain’s by around 25 per-

discounted value of its current and future budget bal-

centage points (Table 3). In addition, Table 3 illustrates

ance surpluses is higher than the sum of the initial

that more countries breached the 60% debt-to-GDP

stock of debt. In the European context, we define the

threshold in 2010. The variety of deficit-to-GDP levels –

60% debt-to-GDP limit as a threshold. A government

not explicitly reported here – is also remarkable, rang-

is called liquid if the available government’s liquid

ing from double-digit deficits in Ireland and Greece to

assets in a given currency are in line with its maturing

deficits below 3% of GDP in Luxembourg and Finland,

liabilities. Hence, the maturity profile of government

and even a small surplus in Estonia.

debt, including the refinancing needs of outstanding short-term debt, is relevant for analysing liquidity.

By the end of 2011, debt ratios in most euro area countries exceeded the 60% threshold with only a few

The euro area’s gross public debt-to-GDP ratio

exceptions. Interestingly, there is also a split in short-

increased over the period of 2007 to 2012, from

term and long-term outsanding debt in the euro area.

14 THE EURO CRISIS AND ITS IMPLICATIONS

DWS | GLOBAL FINANCIAL INSTITUTE

Figure 7: Debt-to-GDP from 1997 to 2010 (left) and Deficit-to-GDP in 2010 (right)

Source: ECB (2011,2012).

For almost all countries, with the exception of Estonia

growth. According to our calculations, U.S. net debt7

and Luxembourg, long-term debt securities are well

has a similar magnitude to that of the euro area. Even

above 60% of GDP. Nevertheless, those dynamics and

more striking is a comparison of government deficits.

high debt levels are not hopeless. The Netherlands,

In 2010, the euro area deficit situation was relatively

for example, was able to reduce its debt by around

modest compared to those of Japan, the United King-

138% of GDP in just ten years from 1946 to 1956. This

dom, and the United States (Figure 7).

gigantic consolidation effort was mainly accomplished with sustained economic growth and double-digit sur-

Next, we give a detailed analysis of the indirect debt

pluses during this time period.

burden and contingent liabilities, such as guarantee schemes provided to secure the financial sector and

A comprehensive evaluation of the euro area’s situ-

special-purpose vehicles, also known as “bad banks.”

ation requires a comparison with its competitors,

Table 4 shows the cumulative amount of contingent

including the U.S., the U.K., and Japan. A trivial direct

liabilities as a result of the stabilisation operations car-

comparison of public finances is not possible with-

ried out in the financial sector during the years from

out some careful adjustments due to methodological

2008 to 2010. The first column in Table 4 depicts the

and statistical differences across countries. In Japan,

total impact on government debt in percentage of

for instance, debt and deficit statistics are compiled

GDP due to financial sector stabilization (i.e. acquisi-

according to System of National Accounts 2008, while

tion of shares, loans, asset purchases, and other mea-

in the U.S. it is based on the National Income and

sures). The second column represents the total impact

Product Accounts (NIPA) methodology. All account-

on government-contingent liabilities. On top of these

ing frameworks are slightly different and comparison

implicit state guarantees we have to add explicit state

requires careful adjustment and interpretation.

guarantees of the EFSF today or the ESM in the future (columns 4 and 5).

We apply the European definition of government debt and calculate the debt levels for the U.S., Japan, and

The average grant guarantee of the euro area is 6.5% of

Europe in Figure 7. The graph shows an increasing

GDP (bottom line in column 2). Most notably, the Irish

debt-to-GDP ratio between 2007 and 2010 of approxi-

government has provided vast guarantees of 125%

mately 19 and 29 percentage points in the euro area

of GDP. The fiscal risks of these guarantees depend

and U.S., respectively. In Japan, the debt ratio was at

on the probability of default, so there is no immediate

180.4% in 2009 and rose about 60 percentage points

impact on public deficit and debt. The financial trans-

in the last 10 years, due to high deficits and low GDP

actions tax currently being discussed as a means to

6

15 THE EURO CRISIS AND ITS IMPLICATIONS

DWS | GLOBAL FINANCIAL INSTITUTE

Table 4: Cumulative Financial and Public Sector Stabilisation

Financial Stabilization 2008-2010

ESM (European Stability Mechansim)



Total Impact

Total impact on

ESM Subscribed

Paid-in Capital



on Debt

contingent liabilites

Capital in bn €

in bn €



in % of GDP

in % of GDP

Belgium

5.8

15.8

24.3

2.8

Germany

13.5

2.8

190.0

21.7

Estonia

0.0

0.0

1.3

0.1

Ireland

23.2

125.2

11.1

1.3

Greece

2.3

25.1

19.7

2.3

Spain

2.4

5.6

83.3

9.5

France

0.2

4.7

142.7

16.3

Italy

0.3

0.0

125.4

14.3

Cyprus



0.0

17.2

1.4

0.2

Luxembourg

6.1

3.2

1.7

0.2

Malta

0.0

0.0

0.5

0.1

Netherlands

9.0

6.8

40.0

4.6

Austria

2.6

7.8

19.5

2.2

Portugal

3.6

3.1

17.6

2.0

Slovenia

4.0

6.1

3.0

0.3

Slovakia

0.0

0.0

5.8

0.7

Finland

0.0

0.0

12.6

1.4

Euro Area

5.5

6.5

700.0

80.0



Source: ECB and EU Commission (2011,2012).

finance future default costs is therefore questionable

accounting standards, this does not affect the explicit

if not implemented globally or in Europe at all. Unfor-

debt-to-GDP ratio; however, it will raise implicit debt

tunately, this tax unencumbers mainly public but not

levels.

private debt. In the end, the transaction tax is paid by consumers, not by the financial sector. Moreover, as

This issue of implicit debt leads to a very important

long as this tax is not introduced internationally, it may

point: Explicit public debt levels are often biased sig-

just slow market processes or reduce volatility trig-

nificantly and do not give valid information about the

gered by traders in the euro area.

sustainability of fiscal policy. Thus, the evaluation of the size of government debt requires the measurement

For the current discussion about the sovereign debt

of explicit and more importantly implicit government

crisis and high debt levels, the fact that the current

debt, namely, future debt from current government-

EFSF guarantees have not yet had an impact on debt

managed pension schemes unrecorded in official sta-

is of great importance. Even the paid-in capital of

tistics. Table 5 provides a rough overview of implicit

€80 billion to the ESM will not increase government

government liabilities for selected euro area countries.

debt because the paid-in capital will be treated as direct loans from an international organisation, such

The total (explicit and implicit) debt stock in the euro

as the IMF. According to the definition of the public

area is estimated to be 330% of GDP (Mink et al. 2008).

16 THE EURO CRISIS AND ITS IMPLICATIONS

Table 5: Implicit and Explicit Debt (2008)

DWS | GLOBAL FINANCIAL INSTITUTE

4.8% of GDP, close to the euro area average. The main message from these projections is that future primary budget deficits, and therefore debt-to-GDP ratios, will

( % of GDP)







Social

Defined-Benefit

solidations are neglected. Achieving public and private



Security

schemes

sustainability requires a more progressive attitude in

rise even further if reforms and credible budget con-

Germany

275

47

public policy and business. These are the real future

France

292

60

challenges of high sovereign debt in Europe and the

Italy

322

1

Euro Area

278

52

G-20 member states. 2.2 Composition of Government Debt

Source: Eurostat and ECB (2011,2012).

The composition of government debt in terms of Germany stands out with the lowest ratio, due to past reforms in the social security and pension systems. Nevertheless, accurate interpretation is tricky because these numbers are based on estimations and rely on long-term assumptions about future economic performance. In addition, we must take into consideration increasing government costs due to an ageing population. The increase of ageing-related government expenditure relative to GDP over the period of 2007 to 2060 is estimated to be 5.2 percentage points for the euro area. The highest demographic cost share in the euro area is expected in countries such as Greece, Cyprus, Luxembourg, Malta, and Slovenia, ranging from 10% to 18%. The lowest share is expected in Estonia, 0.4%. Germany’s expenditures related to demographic challenges are expected to be around

maturity and currency influences both governments’ and investors’ costs and risks related to the rollover of outstanding government debt. Private and public debt management seeks to minimize costs and focuses on certain targets with respect to the sovereign bond market. There are several macroeconomic implications related to the composition of government debt: a) The government bond yield curve commonly serves as a benchmark for pricing private sector bonds. Higher sovereign yields distort the information signal and crowd out private sector borrowing; b) A high share of short-term debt increases the government’s dependence on short-term monetary policy rates and thus creates an incentive to increase

Figure 8: Euro Area Debt by Holders and Maturity in 2010

Source: ECB (2011,2012).

17 THE EURO CRISIS AND ITS IMPLICATIONS

DWS | GLOBAL FINANCIAL INSTITUTE

Table 6: Holder and Currency Denomination of Government Debt, 2010

Non-

Currency



Central

Resident Creditors Other

Resident

Denomination



Bank

MFIs

Residents

Creditors

Euro

Other

Belgium

1.4

23.5

14.7

4.1

56.3

100.0

0.0

Germany

0.2

31.5

9.2

10.1

49.0

98.9

1.1

Estonia

0.0

57.0

1.1

4.4

37.9

100.0

0.0

Ireland

-

-

-

-

-

Greece

3.2

23.9

0.3

3.1

69.6

Spain

3.4

28.4

7.9

18.8

41.5

99.4

0.6

France

-

-

-

-

-

99.9

0.1

Corporations

-

-

98.2

1.8

Italy

3.6

27.0

15.6

9.1

44.6

99.8

0.2

Cyprus

14.2

22.3

6.6

7.2

49.7

99.7

0.3

Luxembourg

0.0

47.5

-

-

30.1

100.0

0.0

Malta

5.9

40.2

19.6

28.7

5.6

100.0

0.0

Netherlands

0.3

18.2

10.6

2.6

68.3

92.4

7.6

Austria

0.4

12.0

6.9

4.2

76.4

97.3

2.7

Portugal

0.8

22.4

5.8

7.8

63.3

98.5

1.5

Slovenia

1.0

27.7

10.1

3.5

57.7

99.8

0.2

Slovakia

0.0

62.4

0.0

0.6

37.0

99.7

0.3

Finland

0.0

12.5

1.2

15.2

71.1

100.0

0.0

Euro Area

1.7

26.5

11.9

7.8

52.1

99.1

0.9

Source: ECB (2011,2012).

pressure on the central bank;

The most visible changes were recorded in Cyprus, Greece, and Spain, where the share of short-term debt

c) A high share of debt denominated in domestic declined massively between 1995 and 2010. This sigcurrency protects the debt level and currency against nals a reduction in rollover risk. In the first years of exchange rate risks.

the EMU, by contrast, these countries used short-term debt due to easy access to the capital markets to sat-

Figure 8 depicts the composition of euro area debt isfy their refinancing needs (BIS 2011). by debt holders and residual maturity. In 2010, nonresidents held 52% of debt in the euro area, while resi- Finally, we discuss the holders and residual maturity of dents held the remaining 48%, out of which 38% was government debt as well as the currency denominaheld by monetary and financial institutions and the rest tion by euro area countries. Table 6 summarizes the by central banks, non-financial corporations, and indi- holders and currency denomination of government viduals. The majority of euro area government debt, debt. The table with the maturities of government debt 73.9%, has a maturity over one year.

is relegated to the appendix (Table A1).

The average maturity of euro area government debt The analysis of the numbers in Table 6 reveals intersecurities has been around six to seven years since esting patterns for certain euro area countries and 2007, showing a slightly declining trend. The financial provides valuable conclusions for investors. A comcrisis shifted the debt maturity structure in some euro parison of the five highly indebted countries reveals area countries due to governments’ liquidity risks. that Greece and Portugal are far more exposed to

18 THE EURO CRISIS AND ITS IMPLICATIONS

DWS | GLOBAL FINANCIAL INSTITUTE

non-resident creditors than Spain and Italy are. Greece

countries. On top of this, Greece possesses one of the

has a foreign debt exposure of 69.6% and Portugal of

highest shares of short-term and variable interest rate

63.3%. Both countries are in the top group of non-res-

debt with maturity over one year (Table A1), which

ident creditor holders in the euro area.

greatly exposes the Greek economy to future interest rate decisions. Altogether, the risk exposure for Greece

Additionally, Greece and Portugal have relatively

is dramatic. These patterns explain the extraordinary

high shares of foreign currency debt in comparison

role of Greece, and illustrate that its economy is a spe-

to the euro area average. Admittedly, the level is not

cial case and an exception in Europe. This statement

as high as in some other G-20 countries. However,

does not mean that the euro crisis, including the Greek

both Greece and Portugal are more exposed to mar-

tragedy, is unmanageable. Instead, it means that all

ket dynamics and financial risks than other euro area

options have to be considered – and soon.

3. IMPACT ON THE REAL AND FINANCIAL ECONOMY This section provides a policy-oriented analysis of the

triggers capital outflows and, in some occasions, a

impact of the euro crisis on the economy. First, we anal-

banking or exchange-rate crisis.

yse the economic impact of debt crises in subsection 3.1. In subsection 3.2, we study the effect of sovereign

Recently, several studies have offered evidence that

yield spreads on the financial and real economy. The

debt-to-GDP levels above 80-90% impair economic

analysis is based on our own estimates and is related

growth (Reinhart and Rogoff, 2010; Cecchetti et al.,

to recent research studies. Subsection 3.3 provides

2011). An analysis of Italy illustrates this for a debt-to-

a brief discussion of tough austerity programs and

GDP level of 100%. The combination of these studies

their impact on the economy. Finally, subsection 3.4 is

has led to the conclusion that, at low levels, debt is

devoted to a new approach for the assessment of the

good. But when does debt go from good to bad? Is

sustainability of public finances. We demonstrate the

there an optimal level of government debt?

usefulness of this approach for investors who consider investments in sovereign bond markets. This relatively

First, it is important to note that debt is not inherently

simple but scientifically rigorous approach provides an

evil. Borrowing allows for the smoothing of consump-

overall evaluation of the sustainability of a country’s

tion and income over the course of the business cycle,

public finances.

which is welfare enhancing. This improves the efficiency of capital allocation across the economy and

3.1 Economic Effects of Debt Crises

across generations. Theoretically, there is the potential in normal times for a society’s welfare to rise with

There is a great deal of empirical evidence that high

modest debt levels. Nevertheless, the literature pro-

government debt hampers economic growth and dis-

vides three main channels through which sovereign

courages capital accumulation. The theoretical argu-

debt affects output negatively: (1) exclusion from inter-

ment is that high debt levels erode public finances and

national capital markets; (2) an increase in borrowing

lead to expected future increases in distortionary taxa-

costs; and (3) international trade. The balance between

tion. In addition, high and still growing public debt may

positive and negative effects is merely an empirical

increase nominal and real interest rates. Higher inter-

question.

est rates crowd out private investment, generating a snowball effect in which slower growth leads to even

The following part is an empirical investigation of this

higher debt and higher interest expenditures, which

problem. A data sample of 24 OECD countries over the

are then financed by additional debt. The end result

period of 2000 to 2010 is used. The novelty of the data-

is a vicious cycle detrimental to economic growth and

set is the inclusion and distinction of domestic and for-

the sustainability of public finances. Accordingly, this

eign debt. With this approach we are able to analyse

19 THE EURO CRISIS AND ITS IMPLICATIONS

DWS | GLOBAL FINANCIAL INSTITUTE

Figure 9: Bivariate Panel Regressions of GDP Growth and Debt Holders (in %)

the impact of foreign and domestic debt holders on

debt is associated with the largest reduction in output

the economy. We begin by looking at the relationship

growth. This supports the hypothesis that a country

between debt and economic growth. Calculation of

with a high share of foreign debt holders faces more

time-series correlation coefficients shows a statisti-

challenges than a country with high domestic debt

cally significant negative relationship. Our first model

holders. Consequently, the Greek and Portuguese debt

shows that total debt-to-GDP reduces output growth

problem is far more difficult to solve than the situation

by -0.25. The disaggregated approach allows us to

in Spain or Italy, where a relatively high proportion of

disentagle the overall impact: Residential debt-to-GDP

the debt is held by residents.

reduces output growth by -0.26, and foreign debt-toGDP reduces output growth by -0.27. It is striking to

Recent evidence from the ECB’s bank-lending survey

see that a one percentage-point increase in foreign

suggests that credit rationing increased in 2011, especially towards non-financial corporations and households. There are several reasons for this, including the

Table 7: Panel Regression of GDP Growth and Debt Holding Variable

Coefficient

Constant

4.126255***



(1.058854)

FOREIGN_DEBT

-0.046944***



(0.015499)

RESIDENT_DEBT



-0.043454*



(0.025079)

TOTAL_DEBT

-0.003886



(0.019561)



Dependent: GDP growth. Panel regression. Std. errors in

higher risk of an economic downturn in the euro area, higher capital requirements, and further deleveraging needs. Interestingly, there has also been a decline in the demand for credit, which has been partly offset with more market-based financing via issuing corporate bonds. Therefore, to evaluate the impact of this dynamic we estimate a regression of annual output growth on foreign debt-to-GDP, residential debt-toGDP, and total debt-to-GDP. Figure 9 displays the graphical result. Statistically, all three regression models show a significant negative relation between output growth and debt holding. This suggests that high debt levels are linked to lower output growth. It turns out that foreign debt holding has the largest negative impact on domestic growth (left panel).

parentheses and * / ** / *** indicate statistical significants at 10% / 5% / 1% level.

The second step of this empirical approach is the estiSource: Own estimation.

mation of a multivariate time-series regression model.

20 THE EURO CRISIS AND ITS IMPLICATIONS

DWS | GLOBAL FINANCIAL INSTITUTE

The dependent variable is output growth and the inde-

There are other studies that confirm that debt crises

pendent variables are, once again, foreign debt-to-

may lead to significant contractions in output. For

GDP, residential debt-to-GDP, and total debt-to-GDP,

instance, Furceri and Zdzienicka (2011) conducted a

plus several control variables. By specifying time and

study based on 154 countries from 1970 to 2008. They

cross-section fixed effects, an applicable equation was

find that debt crises produce significant and long-last-

estimated. The results are reported in Table 7. Statis-

ing output losses. On average, a debt crisis reduces

tically, all coefficients display a significant negative

output by about 10% after eight years. Moreover, it

effect.

turns out that debt crises tend to be more detrimental than banking and currency crises. This result is similar

The multivariate regression confirms that foreign debt

to Reinhart and Rogoff (2010), who find that output is

holding is a major obstacle to future growth. The neg-

reduced by 1.8 percentage points when the debt-to-

ative coefficient for foreign debt holding is the only

GDP ratio exceeds 70% and by more than 2.0 percent-

one statistically significant at the 1% level. The other

age points when the debt-to-GDP ratio exceeds 90%.

coefficients are significant at the 10% level or, in the

In summary, debt crises have a long-lasting and sig-

case of total debt-to-GDP, statistically insignificant. We

nificant negative impact on output. Our analysis illus-

interpret the result as follows: A one percentage-point

trates that this impact is even more significant when

increase in foreign debt holding is associated with a

foreign debt holding is high relative to residential debt

reduction in subsequent output growth of 4-5% (Table

holding.

7). Although this is quite high, we have not controlled for all growth factors in our regression model. There-

3.2 Economic Effects of Sovereign Spreads

fore, a suggestion for further research is an estimation of this effect within a comprehensive growth model

The financial and economic crisis, as well as the fail-

according to Barro and Sala-i-Martin (2004). A sec-

ure to reverse global imbalances in a controlled way,

ond suggestion is to perform a threshold regression

have put significant pressure on public finances. On

in order to identify the optimal debt level – the point at

average, OECD countries’ deficits increased from 1%

which debt turns from good to bad.

of GDP to 8% of GDP, while debt rose from 73% of GDP to 97% of GDP, between 2007 and 2010. The

It is important to note that our results are in line with

sovereign debt turmoil has been particularly severe in

preliminary literature in this field. Cecchetti et al.

Greece, Portugal, Ireland, Spain, and Italy. In this sub-

(2011) find that private, corporate, and household debt

section we explore the major channels through which

are negatively correlated with growth. Surprisingly,

increasing sovereign spreads impact future output.

they first discover that government debt is positively

A characteristic crisis of confidence in sovereigns is

related to growth. Admittedly, after testing all growth

triggered by investors’ concerns about the sustain-

factors and crises they conclude that government debt

ability of public finances. If the concerns are justified,

is always negatively related to growth. The threshold

the result is a decrease in sovereign creditworthiness

for government debt is estimated to be around 85% of

and increase in sovereign spreads. Both effects drive

GDP, for corporate debt around 90% of GDP, and for

up banks’ funding costs and impair funding and loan

household debt roughly 85% of GDP. Given the future

policies. Consequently, what are the triggering pro-

challenges of demographic ageing and already-high

cesses investors must look at to understand this tricky

tax levels in Europe, it will be difficult to stabilize or

relationship?

reduce current debt limits. Trabandt and Uhlig (2010) find that some European countries are already on the

In theory, there are four channels through which sov-

wrong side of the Laffer curve. This implies that they

ereign risk affects bank funding conditions and the

cannot generate additional revenue by further increas-

economy as a whole:

ing capital income taxes. Consequently, fiscal policy will be more constrained in the future.

1) Losses on sovereign holdings: Higher sovereign

21 THE EURO CRISIS AND ITS IMPLICATIONS

DWS | GLOBAL FINANCIAL INSTITUTE

Figure 10: Difference Between Short-Term and Taylor Interest Rate (in %)

Source: own calculation with EU and ECB Data (2011,2012).

yields mean losses on banks’ government bond hold-

5) Lower collateral values and higher needs for

ings. This weakens the balance sheet, decreases cred-

central bank funding: The significant downgrades of

itworthiness, and affects over-the-counter derivative

government bonds exclude papers from the pool of

positions, the effects of which, according to anecdotal

eligible collaterals. This affects the operations of the

evidence, are sizeable (Davies 2011).

central bank, which uses sovereign debt as collateral, and impairs funding costs of private banks. The ECB

2) Downgrading of banks: Sovereign downgrades

has increased liquidity provisions – recently by two

often affect domestic bank ratings, raising their fund-

tenders of about €500 billion over three years – and

ing costs and weakening their international market

collateralised this funding with the help of government

position. Only 2% of the domestic banks across seven

bonds. This policy measure, which was meant to avoid

euro area countries had a credit rating higher than that

a credit crunch, has reduced the funding pressure on

of their respective sovereign in 2010.

private banks, but has transferred higher credit risks and exit costs to the ECB.

3) Rescission of explicit and implicit state guarantees: The deterioration of sovereign debt reduces the

Next, we study – using our own estimates – the impact

funding benefits that banks derive from investments

of the liquidity provisions by the European Central Bank

in public debt. Moreover, the political willingness of

on sovereign debt and loan policies. The ECB plays a

explicit and implicit support for banks has slightly

special role in the euro area because it faces a one-

changed this view. Nevertheless, more and more

size-fits-all problem. Figure 10 shows that monetary

countries would like to have the banking system pay

policy was too accommodative from 2004 to 2008.

a fair contribution of stabilization costs via a (transaction) tax. Others demand stricter financial regula-

Moreover, Figure 10 shows a sizeable heterogene-

tion and supervision – higher core capital buffers, for

ity in the stance of monetary policy across countries

instance – especially for systemic banks.

in the euro area. This heterogeneity is a result of the fact that the interest rate differential – the difference

4) Straitjacket of the euro area versus domestic mar-

between the key ECB interest rate and the theoreti-

ket forces: There is evidence for the hypothesis that

cally appropriate Taylor interest rate for each country

short-term government bond yields are related to the

– is dependent on the domestic market environment.

domestic deposit rates even if the ECB sets the mini-

A negative gap in Figure 10 illustrates that monetary

mum bid rate for all euro area countries. This relation-

policy is too expansive given economic conditions.

ship could have an impact on bank funding in certain

Simply put, European monetary policy was too expan-

countries and therefore affect the overall economy.

sive – especially for the five problem countries of

22 THE EURO CRISIS AND ITS IMPLICATIONS

DWS | GLOBAL FINANCIAL INSTITUTE

Table 8: Comparison of Size of Quantitative Easing/Bond Purchasing Programs)

Japan

United States

United Kingdom

Euro Area



2000 - 2004

2008 - 2010

2009 - 2010

2010

4.0

10.8

13.5

0.7

2.3

11.6

17.7

0.8

In Relation to GDP (%) In Relation to Debt (%)

Source: BoE, BoJ, EU, ECB, Fed, IMF (2011,2012).

Greece, Portugal, Ireland, Italy, and Spain – during the

has been the most aggressive in the sheer expansion

last decade.

of its balance sheet.

Since 2008, the situation – with the exception of

By contrast, the unconventional policy measures of

Greece – has calmed down. However, macroeconomic

the ECB have been less significant (Table 8). In May

stabilization has required ultra-low interest rates since

2010, during the initial stages of the sovereign debt

2008. This has led to the so-called “zero lower bound”

crisis, the ECB initiated a bond-purchasing program in

problem, in which interest rates fall nearly to zero and

which it purchased about €63.5 billion of assets and

conventional monetary policy measures are rendered

extended long-term refinancing operations directly to

largely ineffective. Only unconventional measures,

banks. Both unconventional measures constitute a

such as quantitative easing or other bond-purchasing

de facto euro zone version of quantitative easing. In

programs, are effective in stimulating the economy

addition, the ECB primarily bought risky government

and stabilizing the financial system. In theory, both

bonds of the troubled countries. The total volume is

conventional and unconventional policy measures

now estimated at €220 billion. Table 8 demonstrates

increase the money supply and provide additional

that the size of liquidity provisions by the ECB was

liquidity to markets. However, there is still a contro-

modest by international comparison until 2010. Thus,

versial debate in economics about the effectiveness of

the ECB’s exit strategy – that is, the unwinding of its

unconventional policy measures.

unconventional measures and shrinking of its balance sheet back to more normal levels – is less costly than

The tactics vary. The Bank of Japan (BOJ) applied these

for other central banks.

extraordinary measures first in March 2001 because of the banking crisis of the 1990s. The BOJ purchased

Critics contend that these unconventional actions

about ¥63 trillion of government and corporate bonds

could fuel higher inflation and weaken the respective

in 2005 to overcome deflation. Analysis of this policy

domestic currency. Whether these policy measures

has largely been negative because of its failure to

really do accelerate inflation remains unresolved.

accelerate recovery or significantly stimulate growth.

More dangerous in terms of inflation is the announce-

After the collapse of Lehman Brothers in 2008, the

ment by the Fed of its intention to keep its benchmark

Federal Reserve System in the United States adopted

interest rate near zero until late 2014. This approach is

the same policy, causing its balance sheet to swell to

linked to discussion of “financial repression” and con-

$2.2 trillion. The Fed’s quantitative easing programs

stitutes an artificial manipulation of the yield curve by

have mostly involved long-term government bonds

pulling down long-term bond yields. But what if the

and mortgage-backed securities. In March 2009, the

Fed gets it wrong? It would certainly not be the first

Bank of England followed a similar policy and pur-

time a central bank got it wrong (Barnett 2012).

chased about £198 billion of safe government bonds – one-sixth of the debt of the United Kingdom. The BOE

Next, we estimate the impact of sovereign yields on

23 THE EURO CRISIS AND ITS IMPLICATIONS

Figure 11: Sovereign Risk Prima (in basis points) Versus Debt-to-GDP (in %) in Selected Euro Area Countries (2008 to 2010)

DWS | GLOBAL FINANCIAL INSTITUTE

inclusion of more control variables, such as open market operations by the ECB, changes in the minimum bid rate, or downgrades, might improve the robustness of the results. 3.3 Economic Effects of Austerity Measures The austerity hypothesis that slashing budget deficits will stimulate economic growth is currently in vogue in Europe. As a result, the last several years have seen considerable research in this field. Alesina and Perotti (1996) argue that fiscal consolidation is expansionary if implemented through spending cuts. This sounds contrary to conventional wisdom but is based on rigorous empirical research. The following subsection briefly summarizes some stylized facts of austerity programs and their impact on the economy. There are three conclusions:

loan policy while controlling for monetary policy. Con-

* Fiscal adjustments on the spending side are more

sistent with the literature, we find nonlinearities in

likely to lead to a permanent stabilisation of the budget

the relationship between sovereign risk and govern-

than revenue increases;

ment debt (Figure 11). In addition, our result confirms the hypothesis that loan policy is more constrained towards both non-financial and financial corporations.

* Adjustments on the spending side have lower costs in terms of lost output;

The impact on households is similar, but insignificant (Figure 2A – Appendix).

* Fiscal adjustments on the spending side are not followed by an economic downturn due to the so-called

Moreover, a comprehensive time-series regression

confidence effect on consumers and investors. Cred-

confirms the negative impact on output of high sov-

ible spending-side consolidation does work.

ereign spreads. By estimating a VAR model with innovatively gathered flow-of-funds statistics for the euro

The quantitative impact of fiscal consolidation via

area, we find evidence that an unexpected policy tight-

higher revenues (i.e. higher taxes) is estimated by

ening significantly cuts firm and household demand

Romer and Romer (2007). They find that a 1% higher

for bank loans. However, firms partially replace a

tax rate reduces output by about 3% in the follow-

monetary contraction with inter-company loans, while

ing three years. On the other side of the ledger, the

households increase precautionary savings. In the end,

seminal paper by Blanchard and Perotti (2002) finds

both effects slow economic activity and credit dynam-

that spending-side consolidation increases output and

ics while worsening budget deficits. We find that loan

consumption. For OECD countries, the authors also

policy matters most to the corporate sector due to the

show that the effect of revenue-side consolidation is

pivotal role of business firms in the economy.

to reduce output in the first three quarters by an average of 0.6 percentage points.

There are numerous avenues for further research. We suggest a panel data set for all euro area countries in

It is important to understand that raising taxes has neg-

order to identify existing differences in loan policies

ative supply-side effects on labour costs and invest-

across euro area member states. Furthermore, the

ments. On the contrary, these supply side-effects do

24 THE EURO CRISIS AND ITS IMPLICATIONS

Table 9: Sustainability Regulation for Germany and United States (US)

A simple starting point for the assessment of sustainability is the evolution of the government debt-to-GDP ratio. More in-depth studies also consider implicit government debt and liquidity dimensions, i.e. whether the

Variable

Germany

Constant

-3.7505*

0.0509***

tions in an orderly manner. This subsection exemplifies



(1.9409)

(0.0151)

the assessment of sustainability for the United States

0.0610**

-0.0017***

and Germany. We argue that this approach is helpful in



(0.0265)

(0.0002)

evaluating the sustainability of sovereign debt. More-

GVAR

-1.3354***

-0.01433**

over, it is easily applicable to investors’ decision-mak-



(0.0793)

(0.0049)

ing. The scientific underpinning and technical detail of

YVAR

-22.4822***

-0.0530

this method is based on a paper by Herzog (2010).8 In



(4.2545)

(0.2181)

this case we use data from 1980 to 2010 for govern-

Adj. R-squared

0.8921

0.9298

ment expenditures, deficits, primary deficits, debt, and

F-statistic

42.3587

71.6486

output.

Debt-to-GDP

US

DWS | GLOBAL FINANCIAL INSTITUTE

government is able to rollover its maturing debt obliga-

The most effective test of sustainability of public Dependent: GDP growth. Primary deficit. Regression, Newy-

finances is a positive response of primary surpluses

West t-values controlled for autocorrelation and heteroskedasty.

to the debt-to-GDP ratio while controlling for govern-

Std. errors in parentheses and * / ** / *** indicate statistical

ment spending (GVAR) and the business cycle (YVAR).

significants at 10% / 5% / 1% level.

The regression results are reported in Table 9. Our Source: Own estimation.

estimates are robust for all regressions.9 We find that German public finances are sustainable with a posi-

not apply to spending cuts, which imply lower future taxes. Almost all successful supply-side consolidation episodes led to lower interest rates and were supported by wage moderation, which played a key role in ensuring competitiveness. There is also evidence that countries that depreciate their currencies to regain competitiveness are unable to do so without wage restraints. In conclusion, whether a country is inside or outside a monetary union, wage moderation is always needed in order to regain competitiveness and to consolidate the public budget. The combination of currency depreciation and wage restraint is the most efficient and fastest way to get back on track. 3.4 Public Debt Sustainability: Evaluation of Investors’ Decision-Making Both liquidity and solvency aspects are linked to the analysis of the sustainability of public finances. Debt sustainability generally refers to the ability of the government to manage its public finances by servicing its debt obligations while meeting the provisions of goods and services for society, both now and in the future.

tive debt-to-GDP coefficient of 0.061. This coefficient is statistically significant at the 5% level. In contrast, U.S. public finances are currently unsustainable with a negative debt-to-GDP coefficient of -0.001. This number is statistically significant at the 1% level. Why is a positive response of primary surpluses to the debt-to-GDP ratio an indicator of sustainability? The positive relationship can be derived from a rigorous general equilibrium model, beyond the scope of this white paper. Here we explain this issue by a more intuitive approach. A necessary and sufficient condition for unsustainable finances is the following empirical relationship: Increasing primary deficits (negative number) triggers higher debt accumulation (positive number). In other words, this is a negative relation because the deficit becomes more negative and the debt becomes more positive. Thus, a negative relation indicates unsustainable finances. On the contrary, sustainable finances require a positive relationship, i.e. the higher the debt, the higher the primary surpluses or the lower the primary deficits.

25 THE EURO CRISIS AND ITS IMPLICATIONS

DWS | GLOBAL FINANCIAL INSTITUTE

For Germany we see this positive relationship in the

and an ageing population, the debt problem could

debt-to-GDP coefficient in our regression. For the

exacerbate in the future. By comparison, Germany is

United States we find a significant negative relation-

in a sound position. At the moment, the U.S. has the

ship. This finding points to an unsound fiscal policy

advantage that the dollar is still the world’s reserve

in the U.S. Our calculation has immediate and very

currency, which allows it to borrow at reduces rates,

valuable implications, because it provides a simple but

and the demographic changes it faces are slower than

useful assessment of the soundness of public finances

in Europe.

across countries. Investors now have a relatively fast and applicable procedure for evaluating the sustain-

An interesting question for further research is the

ability of sovereign debt.

assessment of sustainability in all European countries or the G-20. A second research hypothesis for

The unsustainable situation in the United States is a

the future is the question of nonlinear effects of the

huge policy challenge going forward. This challenge

debt-to-GDP ratio and the impact of the 60% thresh-

is amplified by the widening deficit and massive debt

old. Resolution of these issues would offer important

accumulation of the last several years, the weak eco-

insights for investors. We recommend – as a lesson of

nomic outlook, accelerating health-care spending,

the sovereign debt crisis – more research in this field

and persistently elevated unemployment rates. Given

to support the decision-making process of long-run

that the U.S. also faces a large current account deficit

financial investments in sovereign bond markets.

4. POLICY CONCLUSIONS & OUTLOOK This white paper addresses the question of whether

been based on a decentralized market approach, but

we face a pure euro crisis or a sovereign debt crisis

with a no-bailout clause that lacked credibility and a

and what the implications for the macroeconomy are.

weak enforcement mechanism within the Stability and

Fortunately, the euro has not lost confidence despite

Growth Pact. Interestingly, the treaty also contains

the challenging structural problems in the EMU. But

an implicit “no exit clause,” which creates the wrong

how can a currency gain or lose confidence? Keep in

incentives in such an environment. This arrangement

mind that a currency is a confidence trick: Its value

led market participants to believe that all countries in

depends entirely on the belief that it has value. This

the EMU are indistinguishable and that the project is

belief, in turn, strongly depends on the monetary and

irrevocable. However, this claim is wrong in an effec-

fiscal fundamentals of a country or a group of countries

tive decentralized approach. EMU fiscal policy was and

in a monetary union. Since the European Central Bank

still is made at the national level and therefore exposed

is entirely independent, the euro crisis was mainly trig-

to different domestic shocks and risks. Investors might

gered by European and national policies. Thus, the

learn that, despite a common currency, sovereign risks

euro crisis was caused by unsound fiscal policies and

vary from country to country. There exist two options

an unsuitable institutional setup within the EMU. The

for circumventing this perception in the long run. The

resulting crisis of confidence can be attributed to this

centralization approach establishes a transfer union via

unique setup.

a permanent transfer of sovereignty from the national to the European level and a joint financing of public

The re-design of this institutional framework requires

debt. The decentralized approach, on the other hand,

both the strengthening of rules and increased eco-

is based on effective rules, market forces, and either a

nomic integration. As discussed above, there are two

systematic exit clause or a temporary transfer of sov-

long-run options: either more centralization or more

ereignty in the case of unsound policy. Political com-

decentralization. To date, the monetary union has

mitment to one of the long-run options is needed to

26 THE EURO CRISIS AND ITS IMPLICATIONS

stabilize the monetary union now and in the future.

DWS | GLOBAL FINANCIAL INSTITUTE

of the fiscal compact. Tackling the root causes is of particular interest in case of a crisis of confidence.

There is no doubt that the new fiscal compact is a step

A simple treatment with Keynesian stimulus policy,

in the right direction, though past experience casts a

which is reasonable and appropriate in the face of

skeptical eye on this approach. Nonetheless, it might

demand shocks, will trigger the wrong incentives dur-

be sufficient to buy time and bring back investors’ con-

ing such crises. Certainly there is no simple solution to

fidence in the euro area. Yet the long run remains chal-

the euro crisis, but muddling through without a clear

lenging, especially when reform pressures decline as

direction is fraught with growing dangers – and ulti-

market conditions improve. The litmus test will be the

mately doomed to fail.

ongoing enhancement and rigorous implementation

27 THE EURO CRISIS AND ITS IMPLICATIONS

DWS | GLOBAL FINANCIAL INSTITUTE

References Alesina, A. and R. Perotti (1996), “Fiscal Discipline and

Herzog, B. (2010), “Anwendung des Nachhaltigkeit-

the Budget Process”, American Economic Review,

sansatzes von Bohn zur Etablierung eines Frühindika-

Vol. 86, No. 2, pp. 401-407.

tors in den öffentlichen Haushalten“, Kredit und Kapital, Vol. 43, No. 2, pp. 183-206.

Anginer, D. and A. Demirguc-Kunt (2011), Has the Global Banking System Become More Fragile over

Herzog, B. (2011), “Wohin steuert die europäische

Time?, Policy Research Working Paper, No. 5849,

Wirtschafts-

World Bank.

Positionen,

und Vol.

Währungsunion?“, 19,

pp.

7-24,

Zeitschrift

Berlin,

ISBN

978-3-942775-40-3. Attinasi, M.G. et al. (2009), What Explains the Surge in Euro Area Sovereign Spreads during the Financial

Herzog, B. (2012), “EMU at Crossroads”, Quarterly

Crisis of 2007-08?, ECB Working Paper, No. 1131,

Journal on European Issues, CESifo Forum, No.

Frankfurt.

4/2011, pp. 23–29.

Barnett, W.A. (2012), Getting It Wrong – How Faulty

Mink, R. et al. (2008), Reflecting Pensions in National

Monetary Statistics Undermine the Fed, the Financial

Accounts Work of the Eurostat/ECB Task Force, NBER

System, and the Economy, MIT Press.

Working Paper, No. 15815.

Barro, R. and X. Sala-i-Martin (2004), Economic

Reinhart, C.M. and K. Rogoff (2010), “Growth in time

Growth, MIT Press.

of debt”, American Economic Review, No. 100, pp. 573-578.

BIS (2011), Interactions of sovereign debt management with monetary conditions and financial stability,

Romer, C. and D. Romer (2010), “The Macroeco-

Report, No. 42.

nomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks”, American Economic

Blanchard, O. and R. Perotti (2002), “An Empirical

Review, Vol. 100, No. 3, pp. 763-801.

Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output”, Quar-

Trabandt. M. and H. Uhlig (2010), How far are we from

terly Journal of Economics, Vol. 11, pp. 1329-1368.

the slippery slope?, The Laffer curve revisited, ECB Working Paper Series, No. 1174.

Cecchetti, S. et al. (2011), The Future of Public Debt, in S. Gokarn (ed.), Challenges to central banking in the context of the financial crisis, pp. 183-217. Davies, M. (2011), “The rise of sovereign credit risk: implications for financial stability”, BIS Quarterly Review, No. 09, pp. 59-70. Elekdag, S. and Y. Wu (2011), Rapid Credit Growth: Boon or Boom-Bust?, IMF Working Paper, No. 241, Washington. Furceri, D. and A. Zdzienicka, (2011), How Costly Are Debt Crises?, IMF Working Paper, No. 280, Washington.

DWS | GLOBAL FINANCIAL INSTITUTE

28 THE EURO CRISIS AND ITS IMPLICATIONS

Appendix

Figure 1A: Current Account in Billions of USD of Major Countries in 2010 (Positive numbers for surplus countries and negative for deficit countries)

Source: IMF (2011,2012).

29 THE EURO CRISIS AND ITS IMPLICATIONS

DWS | GLOBAL FINANCIAL INSTITUTE

Figure 2A: Spreads on Sector-Specific Loan Policies, in log (y-axes)

30 THE EURO CRISIS AND ITS IMPLICATIONS

DWS | GLOBAL FINANCIAL INSTITUTE

Table A1: Residual Maturity of Government Debt, 2010 Up to 1 year

Over 1 and up to 5 years

Over 5 years



variable



interest rates

Belgium

24.0

35.5

0.0

40.5

0.0

Germany

28.1

35.5

-

36.5

-

Estonia

8.3

32.9

0.0

58.8

0.0

Ireland

-

-

-

-

-

Greece

10.2

41.5

13.8

48.3

15.3

Spain

21.5

35.9

0.0

42.6

0.0

France

33.3

31.7

0.2

35.0

0.1

Italy

25.2

30.4

5.4

44.5

4.2

Cyprus

10.6

44.9

0.0

44.5

10.2

9.0

-

-

-

-

Malta

13.7

45.1

1.6

41.2

0.0

Netherlands

29.6

31.7

0.0

38.7

0.0

Austria

8.8

34.2

0.7

57.0

0.6

Portugal

29.5

28.5

1.3

41.9

0.2

Slovenia

8.8

34.1

3.8

57.1

0.8

Slovakia

13.8

43.0

7.8

43.3

0.1

Finland

24.0

34.9

12.8

41.1

13.7

Euro Area

26.1

33.6

2.9

40.3

2.9

Luxembourg



variable interest rates

Source: ECB (2011,2012).

31 THE EURO CRISIS AND ITS IMPLICATIONS

DWS | GLOBAL FINANCIAL INSTITUTE

Endnotes 1. Private deficits are calculated as the current account

of current to long-run trends. The long-run trends are

minus the public balance. Thus, the number reports

estimated with a Hodrick-Prescott (HP) filter.

the private deficit holdings of the selected countries. 9. We also estimated time-series regressions from 2. I am preparing another DWS white paper about

1919 to 2011 and 1960 to 2011 for the U.S. We

demographic challenges and their impact on the real

find a robust negative relationship between primary

and financial economy. This study contains a more

deficit and debt-to-GDP while controlling for govern-

detailed analysis of those implications and will be

ment spending and the business cycle according to

forthcoming in the second half of 2012.

the Bohn approach. All results point to unsustainable public finances in the U.S. For Germany we have data

3. Cf Beise (2012). He is arguing that the crisis of con-

restrictions until 1995 due to the re-unification process

fidence diffuses slowly towards the heart of Europe –

in 1990 and the new public finance budget rules in

the euro currency. Source: Süddeutsche Zeitung, 10

1995.

January 2012. 4. Cf Szalay (2012). She is arguing that the euro currency is more prepared for the future challenges than the U.S. Europe is tackling the structural problems now, while the U.S. is shifting its problems into the future. 5. Definition of government debt is always based on ESA debt (ESA stands for European System of Accounts 2010). ESA defines government debt as a stock variable which covers all explicit liabilities at market value, excluding equity. Therefore, the level of ESA debt is affected by changes in market yields. 6. For our debt comparison we apply the “EDP debt” definition used in Europe. EDP stands for Excessive Debt Procedure. This definition covers government liabilities such as currency and deposits, securities other than shares (excluding financial derivatives), and loans. 7. Net debt takes into account prices and marketability of government assets. However, this leads to potential biases in periods of market turbulences and complicates the compilation, whereas gross debt remains a more robust indicator and is better used for simple comparisons without the necessary adjustment we have to do under the net debt definition. 8. Our data displays severe heteroskedasticity which is why we use Newy-West adjusted standard errors and tackle the stationarity problem by calculating the gaps

32 DISCLAIMER

DWS | GLOBAL FINANCIAL INSTITUTE

DWS Investments is the global mutual fund business of the Asset Management division of Deutsche Bank Group, collectively referred to as “Deutsche Bank”. In the US, DWS Investments is the brand name for the US retail asset management and financial institutions group, a division of Deutsche Asset Management. This material was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. It is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for Deutsche Bank AG and its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein. Neither Deutsche Bank AG nor any of its ­affiliates, gives any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of the Deutsche Bank Group, the Issuer or any officer, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person. The opinions and views presented in this document are solely the views of the author and may differ from those of DWS ­Investments and the other business units of Deutsche Bank. The views expressed in this document constitute Deutsche Bank AG or its affiliates’ judgment at the time of issue and are subject to change. The value of shares/units and their derived income may fall as well as rise. Past performance or any prediction or forecast is not indicative of future results. Any forecasts provided herein are based upon our opinion of the market as at this date and are subject to change, dependent on future changes in the market. Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance. Investments are subject to risks, including possible loss of principal amount invested. Publication and distribution of this document may be subject to restrictions in certain jurisdictions. © DWS Investments · July 2012

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