Containing the Eurozone Crisis

As Greece inches closer to defaulting on its pile of sovereign debt, European leaders must move quickly to recapitalize the continent’s exposed banking sector, says EU economics expert Jacob Funk Kirkegaard.

October 06, 2011

To help readers better understand the nuances of foreign policy, CFR staff writers and Consulting Editor Bernard Gwertzman conduct in-depth interviews with a wide range of international experts, as well as newsmakers.

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Economic Crises

European policymakers moved to shore up (NYT) the continent’s financial sector in a new effort to limit sovereign debt contagion. The action came a day after it became clear a bailout would be needed for French-Belgian bank Dexia (Bloomberg), which passed a stress test in July, but remains heavily exposed to Greek debt. Jacob Funk Kirkegaard, a research fellow at the Peterson Institute for International Economics, says the so-called eurozone sovereign debt crisis is actually comprised of multiple crises, which have hampered the ability of EU officials to act decisively. Kirkegaard says policy inaction combined with a general crisis of confidence in the eurozone is contributing to volatility in global financial markets. It is a "big step forward" that eurozone leaders are finally acknowledging the need to recapitalize their banking systems. "That is something that is absolutely necessary for this crisis to be contained," Kirkegaard argues.

Why is the eurozone sovereign debt crisis fueling such extreme global market volatility?

The fundamental issue is that we call it the "European sovereign debt crisis," but the reality is that it’s actually multiple crises. It’s a competitiveness crisis in some euro-area countries, it’s a fiscal crisis, it’s a banking crisis, and then it is also insufficient institutionalization of the euro. You actually have three or four different crises at the same time, which is why we are seeing the inability of the European authorities to act. It’s really that inability combined with the generalized crisis of confidence in Europe that is creating this incredible volatility that we are seeing in the global markets. It also has to do with the fact that the U.S. economy is very weak, for reasons that are mostly domestic.

What is the direct impact of the eurozone crisis on the United States? What do investors need to be concerned about, and what do average observers need to understand about the crisis and its implications?

The inability of the European authorities to act and the generalized crisis of confidence in Europe are creating this incredible volatility that we are seeing in the global markets.

There are two things. One is that the direct implications for the United States and its financial sector from the crises in Greece, Ireland, and Portugal [were] quite small. Its only when the crises in Europe started spreading to Spain and Italy that the vast exposure and the risk to the U.S. economy and the U.S. banking system became far more urgent. [U.S. financial institutions lend to French and German banks, for example, which are highly exposed to the economies of Spain and Italy.] There is another aspect of this, which is the indirect exposure of the U.S. economy to Europe. You cannot have a situation where the European economic situation is potentially catastrophic, [because] certainty and confidence isn’t going to return to the U.S. domestic economy. We are not going to see economic growth and job creation in the United States until that happens.

How is the eurozone situation affecting other regions of the world, specifically the developing economies of Asia and Latin America?

The euro crisis is manifesting itself in the emerging markets through this incredible uncertainty about the outlook. At the end of the day, if you were to have a collapse of a large European bank or a sovereign like Greece, then you would have a situation that was not dissimilar to what you saw after Lehman Brothers. And even if the growth fundamentals in the emerging markets are fairly strong, that kind of shock in the global economy would clearly manifest itself there. So it’s a catastrophic potential risk coming out of Europe, and the related broader uncertainty is [indicative of] the direct impact that Europe now poses for those parts of the world.

Can the eurozone crisis be contained?

Certainly the European crisis can be contained. The last couple of days we have taken a fairly big step forward because we’ve started to see [European policymakers] accept the news that European countries need to recapitalize their banking system. That is something that is absolutely necessary for this crisis to be contained, which is one pillar. The second pillar is that you need more fire power, which means you need to use a leveraged version of the European Financial Stability Facility (EFSF), which is something that is now officially being discussed among European policymakers. Once you have that, you should be able to go quite a long way to contain any contagion from Greece so that a default in Greece or a restructuring doesn’t spill over to Italy or through the European banking system.

There are certainly a number of things that other countries could do, such as the United States. The Obama administration has handled the crisis in Europe fairly well. They have essentially worked through the IMF and then through backdoor channels, such as when [U.S. Treasury Secretary Timothy] Geithner went to Poland a couple of weeks ago to basically offer the Europeans constructive policy advice about what had worked in crisis prevention [in the United States during the peak of the global financial crisis]. There is quite a lot that you can do indirectly to push the Europeans in the right direction, but it doesn’t change the fact that fundamentally this is a domestic European dispute.

Are European policymakers moving fast enough, particularly vis-à-vis financial markets?

You are faced with the fundamental problem that what is financially required or necessary to stabilize the markets is not politically feasible or legitimate in the short term.

You are faced with the fundamental problem that what is financially required or necessary to stabilize the markets is not politically feasible or legitimate in the short term. We’ve seen this over the last couple of months. The deal that was struck on July 21[to expand the EFSF], which is now finally [close to being] ratified by seventeen parliaments in the euro area. That was a deal that maybe made some sense in July, but is clearly not efficient to address the problems as they look today. In that sense, the Europeans have not acted fast enough.

But at the same time, you have to do it in a politically legitimate way. It took more time than it needed to and, as a result, the crises are becoming somewhat worse, but not catastrophically much worse. The slowness of the political response has forced the ECB to step up and avoid catastrophic outcomes. You can say it has been sufficiently rapid to prevent a catastrophic meltdown in Europe but not sufficiently rapid to avoid a negative macroeconomic impact.

And does that negative macroeconomic impact and the politics of this all necessitate greater fiscal integration?

Yes, there is no doubt about that, that you need to have more fiscal integration coming out of this--and you have considerably more fiscal integration already. When you think about what the EFSF is, it is essentially the first entity that can act as a fiscal agent for the entire euro area. That is a huge step forward from what Europe had before the crisis. Increased economic integration is already happening at a very rapid pace as a result of this crisis, and it quite clearly will need to continue. In the long run, you could have things like euro bonds, but only at the end of, say, an eight- to ten-year time period.

But European policymakers have continued to drag their feet on Greece, the epicenter of the sovereign debt crisis. What do they need to do there?

Greece is an insolvent country: It needs to have some sort of debt relief or it needs to restructure its debt. Currently, there is a deal with the private creditors that [could potentially give Greece] up to 20 percent of debt relief in net present value terms. That’s too little. You would need to have bigger haircuts off private creditors. But you are in a situation where European governments are also [preparing to] recapitalize their banks.

The real thing European governments have to ask themselves is, "Who would you rather bail out--Greece or your banks?" It’s a question of the government saying, "Are we going to give Greece some money and take it back from the banks with our other hand, or are we going to give banks some recapitalization money so that they are actually able to much better sustain a more thorough restructuring in Greece?"

I think the latter is going to be the case because governments have realized that the costs of having an undercapitalized banking system are too big. More and more small and medium-size businesses can’t get a loan from their bank, and in this situation--where you have stagnating growth in the euro area--that becomes an enormously important issue. The best way to address that issue is to recapitalize their bank. When you do that, it makes it much less risky to restructure Greek debt.

What role can international institutions like the IMF play in stemming the tide of the eurozone crisis?

The IMF in this crisis has been enormously constructive because it has been able to provide the Europeans an important know-how and technical capacity in how to design a reform program--like the one that Greece and Portugal and Ireland are now going through. More importantly, the IMF has provided financial market credibility to what is going on in these crises. Private-market people have a fairly good understating of what it means to be on an IMF program. It is providing constructive advice [and financing] from the outside, which is necessary. [The eurozone sovereign debt crisis] is fundamentally a domestic European dispute, but a dispute that has very significant spillover potential, if it blows up, to the entire global economy.