How to save the euro Dr Andrew Lilico PX Eurozone crisis debate 27 October 2011

Outline Yesterday’s deal Who’s in and who’s not Why any form of debt pooling should be rejected Different issues in different countries Solution for “banking crisis” countries Solution for “competitiveness crisis” countries

Yesterday’s “Deal” Recapitalise EU banks (~€100bn) 50% haircut for private bondholders (~€200bn / 2 = ~€100bn) –No credit event Leveraged EFSF four to five times (perhaps €1tr-€1.4tr) Governance stuff

Strengths and weaknesses Strengths –It could have been even more stupid Weaknesses –Recapitalising banks => shrink balance sheets => money stock drop => slump –50% Haircut Why only private sector? Why did EU rank ahead? Target debt/GDP = 120%. No buffer Failing to trigger sov CDS a bad mistake => Italian bond yields up –Leverage EFSF – just more debt pooling

Who’s in and who’s not? “Saving the euro” = EEC6 in currency union –No Italy = no euro = no EU “Saving the euro” ≠ EMU17 in currency union –euro can survive exit of Greece and Cyprus –euro could even survive exit of Greece, Cyprus, Portugal, Finland, and Slovakia Who’s in and who’s not is fundamentally a political decision –Proceed on assumption Greece and Cyprus are out

Reject any form of debt pooling! “Debt pooling” = any arrangement under which Germany, France, Finland, etc. become responsible for current Italian, Spanish etc. debts –“Eurobonds”; “leveraged EFSF”; “ECB purchases of €trs of PIIGS bonds” are all debt pooling Fiscal union ≠ debt pooling –Collective debt issuance ≠ responsibility for legacy debt

Debt pooling Without conditionality: –In academic studies (Gneezy, Haruvy and Yafe, Economic Journal 2004), splitting the bill => 36% higher bill With conditionality:

Different crises in different countries 2010 figures (Eurostat) Govt debt to GDP Govt deficitBank assets to GDP Avg Growth “Unsalvageable” Greece143%11%173%2.4% Cyprus61%5%586%2.8% “Banking crisis” Belgium97%4%182%1.4% Spain60%9%335%2.1% Ireland96%32%328%2.4% “Competitiveness Crisis” Italy119%5%163%0.2% Portugal93%9%240%0.7%

Solution for “banking crisis” countries Disentangle state from banking sector Banks distressed => impose debt-equity swaps –Bring forward EC “bail-in” proposals to now from 2013 Part of more general special resolution regime for banks Do not cast good money after bad (“recapitalisation”) –Not an irrational market error a “speculator attack” simply insolvency from past losses –Banking bailouts Immoral (tax the poor to spare rich the consequences of their errors) Economically destructive (moral hazard; financial instability) Failed strategy, even in own misguided terms

Solution for “competitiveness crisis” countries Raise growth rate enough for countries to service own debts How? Eurozone-only structural funds (“Eurozone competitiveness funds”) –Monies spent by Brussels (so no lobster problem) –Monies spent by Brussels (so no vassal problem)

Amounts required –Ireland in 1990s: 0.5% of GDP on structural funds –Italian + Portuguese GDP = €1.8tr => 0.5% = €9bn Might need twice this level in early years to be credible cf structural & cohesion funds budget = ~€58bn per year –Key: spend on investments => GDP growth effect, not just levels Might need to rise over time, even with some growth effect cf cost of debt pooling –Effectively taking German and French debt exposures to current Italian levels –add ~ 100bps to funding costs => ~€36bn per year

Curlicues Real money, not “guarantees” Initiative principle would be different –Structural funds match funding to govt projects Match funding abandoned –Brussels initiative to spend => spending sovereignty centralised Accompanied by tighter fiscal policy constraints –Probably any budget running a deficit above 2% of GDP to be approved by Brussels –=> fiscal sovereignty centralised

Longer term Funding for Eurozone competitiveness funds: –Initially fund with Eurozone member contributions –Later impose special Eurozone taxes –With a funding stream in place, could issue own debt Call these “Eurobonds” if you like, but they aren’t debt pooling (no legacy debt) Eurozone taxes + spending sovereignty, and curtailed Eurozone Member fiscal sovereignty => need for democratic mechs –Eurozone finance minister, perhaps directly elected?