The Eurozone is at the crossroads of two possible futures, depending on policies that are set today.
Along one path, the divergence continues, debtor countries face extremely tough conditions in financial markets and their economies slide into a vicous cycle of increasing debt and decreasing growth while creditor countries enjoy cheap capital. Along the other path, financial conditions in the Eurozone normalise, the southern countries go onto a recovery path and cohesion in the Eurozone is restored.
The first is the ‘bad equilibrium’ the second it the ‘good equilibrium’ – both are plausible futures for the Eurozone (see also DeLong and Eichengreen 2012 on possible equilibriums in Europe).
How do we move away from the bad equilibrium and towards the good one?
The answer is not difficult intellectually and if we were allowed magic, it would be easy to implement – we could convert the Eurozone into a mature monetary union like the US overnight. The next day the bulk of public debt would be federal, backed up by federal taxing power, and the member states would have balanced budget rules enshrined in their constitutions knowing that bail-out is not an option. Some of them would surely face harsh conditions, but this would never become systemic.
Alas, we do not have the magic formula, nor does anyone else. Second-best action is called for, and very quickly, as time is running out.
The debt blackhole: Event horizon at 106% debt-to-GDP ratio
In a recent paper (Padoan et al. 2012), we examine a possible set of policy actions in the pursuit of the ‘good equilibrium’, where debt is relatively low and stable and growth is sustained . We find that historically, on average for the OECD as a whole, the public debt ratio tends to 75% of GDP in a ‘good equilibrium’ whereas once a country breaches a 106% threshold it can no longer, on its own, escape from a ‘bad equilibrium’. The policy messages emerging from our exercise are clear.
First, countries in a ‘bad equilibrium’ need to be offered a way to backstop some if not most of their sovereign default risk (which may be the result of contagion). This may imply an open-ended guarantee for sovereigns (solvency risk) and banks (liquidity risk). Conversely like in any insurance scheme, conditions must be clear and strongly enforced to limit moral hazard. In such a case spreads would normalise and financial conditions in countries in distress ease.
Second, without a backstop even severe structural and fiscal adjustment is useless – contagion-driven rising spreads cancel the benefits of and undermine the support for reforms. The financial backstop would buy time and allow structural reforms to bear their fruits in terms of higher and stronger growth. Countries in distress would switch to a higher potential growth path, while easier financial conditions and stronger confidence ensure that demand is crowded in. The sovereign debt burden would be more manageable as output would grow faster than debt, in turn supporting the fall in yield spreads and making this less dependent on the financial backstops.
Third, as the above actions increase the available fiscal space, the required fiscal consolidation will be smaller, and more palatable and effective, thus reinforcing a virtuous circle that is likely to set in. Fiscal consolidation is clearly necessary, but there are ways to ensure it is both growth friendly and equitable. For instance, spending items like active labour market policy or education could be ringfenced and tax loopholes closed.
What a good equilibrium would look like
Figure 1 below illustrates numerically how a ‘typical’ Eurozone country in distress would recover. In a baseline without policy action, adverse developments in growth, interest rates and debt mutually reinforce each other, trapping the economy in a perpetuous downturn. Unlimited (but conditional) financial backstops that achieve a cut in market bond yields of the order of 500 basis points would sunstantially slow down the economic contraction and contain the rise in the debt burden.
Next, structural reform that manages to close the gap from the OECD average economic performance within 20 years would boost growth by 0.75% per year and bring support for fiscal sustainability (OECD 2012). A once-and-for-all cut in the primary fiscal deficit of the order of 6% of GDP would then suffice to stabilise the debt ratio and secure sustainable growth and low interest rates.
Importantly, in a medium-term timeframe the trade-off between ‘austerity’ and growth vanishes. However, as depicted in Figure 1, in the very short-run it does exist (growth is initially lower with than without fiscal consolidation), and this is complicating the political economy of fiscal consolidation. This is why it is necessary for countries attempting to escape from a bad equilibrium to be able to benefit from a ‘confidence bridge’ through financial backstops while implementing credible structural adjustment.
Figure 1. How a ‘typical’ Eurozone country can recover
The views expressed in this article are those of the authors and do not necessarily reflect those of the OECD or the governments of its member countries
DeLong, J Bradford and Barry Eichengreen (2012), “New preface to Charles Kindleberger, The World in Depression 1929-1939”, VoxEU.org, 12 June.
OECD (2012), OECD Economic Surveys: Eurozone, March 2012, OECD Publishing.
Padoan, PM, U Sila, and P van den Noord (2012), "Avoiding debt traps: financial backstops and structural reforms", paper presented at the 9th EUROFRAME Conference on Economic Policy Issues in the European Union: “The Eurozone in crisis: challenges for monetary and fiscal policies, and prospects for monetary union”, 8 June, Kiel, Germany,