Dexia-AM economists on the European Debt Crisis

Q: First of all, please tell us about your definition of "sovereign debt crisis"? How can we say that country A is in a debt crisis and country B is not yet?

A: A country has entered a sovereign debt crisis if its public debt is no longer sustainable or no longer perceived as being sustainable by the markets: fiscal consolidation being no longer credible the government will stop being able to finance its debt on capital markets at reasonable interest rates… Barring an international help, the government will then be forced to default – partially or in totality – on its debt.

The crisis can be acute – as, recently, in the case, of Greece, Ireland, Portugal and before them Iceland – or just latent, as in the case of Japan today. In this latter case, the debt level is already very elevated, long-term growth prospects are modest and social budgets are set to remain in deficit as a result of population ageing: although market pressure is not (yet) being felt by Japan, the country cannot indefinitely maintain a substantial budget deficit without seeing, at some point, its creditworthiness called into question. This has been recently acknowledged by Japanese Prime Minister Yoshihiko Noda who said that the combination of the world’s most-rapidly aging society and a declining birthrate has put Japan in an “unprecedented situation” requiring increasing revenue and reining in welfare expenditures.

Q: Again, a definition. How can we say that a debt crisis is finally resolved? By saying a debt crisis is over, does that mean the country resumes positive growth rate, returns to capital market, pays back all the debt, bond spread falls below 5% or lower, or what else?

A: The crisis is solved when confidence in the government’s capacity to put his debt on a sustainable path has been restored: this should normally translate in the country being able to again access capital markets and finance its debt at a “reasonable” interest rate. This does not necessarily imply that growth will resume instantly in the country, although growth is a key ingredient of future debt sustainability…

To be more precise, there is no “magical” and universal level of interest rates under which debt will be sustainable: sustainability depends on the amount of accumulated debt, on nominal growth perspectives as well as on the level of interest rate at which the government borrows. If its growth potential is elevated, a country could borrow at a relatively high interest rate with its debt remaining sustainable.

Moreover, the nature of the euro sovereign debt crisis is peculiar. The problem is not only about restoring some governments solvency (this was the case for Greece for instance), but also about stemming market contagion and self-fulfilling expectations which could push other governments towards unsustainable debt dynamics.

Q: Based on your definition, can we say Ireland is almost out of the crisis?

A: Ireland is still under a Euro program and has not yet resumed issuing public debt on capital markets. Although its adjustment has been rather spectacular – Ireland notably succeeded in bringing its current account back to balance in just a couple of years starting from a deficit of more than 7% of GDP – Ireland is not out of the woods yet: while much lower than in November 2011 when its 10-year public financing cost reached 14%, interest rates are still above 7% while its debt to GDP ratio will be over 120% of its GDP by the end of 2012.

Q: In your view, why should the European debt crisis drag for so long?

A: In “periphery” Euro area countries, a double deleveraging process is now ongoing: the private sector – mainly households but also construction firms in some places – as well as governments are deleveraging at the same time. Debt reduction by both the private and the public sectors implies that the country, taken as a whole, will borrow less from the rest of the world. But for this to happen, its current account has to improve: domestic demand has to grow less than GDP. This can be achieved with different rates of GDP growth: strong export growth will leave some room for domestic demand to progress while the current account improves; weak export growth, on the other hand forces domestic demand to remain depressed. Obviously, in the first case, activity will increase more than in the second one!

This double deleveraging process is here to stay for a while and, in many countries, will constrain activity for another couple of years. Of course a weaker euro or stronger world growth would facilitate the ongoing euro area adjustment process.

Q: If Greece leaves the eurozone, what would be the consequence for this country and others in the EU?

A: For Greece, an exit would be dramatic. Greece has still a current account deficit of close to 10% of its GDP and an exit would imply a very rapid move back to balance. This would lead to a dramatic contraction of its domestic demand, as happened in Asian countries in 1998. Some commentators underline the favorable consequences of the currency depreciation on Greece’s exports. But Greece industrial basis is rather weak: a depreciation of the currency will barely boost its exports, while an exit from the area will surely disorganize the country and damage its tourism receipts.

For the euro area, a Greek exit is an experiment we should better avoid! Contagion would immediately spread to other vulnerable countries, Spain in particular but also Italy. And, barring a rapid and forceful response of Euro governments, contagion could easily intensify capital flights from the periphery and push towards a further disintegration of the euro. All in all, it is likely that the costs to core Europe of a Greek exit would be considerably higher than the costs of keeping Greece in the euro area.

Q: Some people say, back in 1997 when Korea was caught in a financial crisis, Korean women donated their gold jewelry to the state; but in Greece and Spain, etc., people go to the streets to protest against the austerity. Does that have something to do with culture? Why austerity is bad for a country with heavy debt burden and huge fiscal deficit?

A: The situation is different: in 1997 Korea was not confronted with a sovereign debt crisis but with a balance of payment crisis: its banks had borrowed short term in foreign currency and, facing a sudden stop of their foreign funding, had to pay back what they owed. This they could do only if the government could provide them with the needed foreign currency. Its reserves being insufficient the government had to borrow from the IMF. But this was just a bridge loan that the government paid back with the foreign currency the country quickly earned afterwards by accumulating current account surpluses. Austerity here played two roles: one marginal – the more gold the government received, the less dollars it had to borrow from the IMF –, the other central: budget tightening was the tool used to depress domestic demand until a sufficient trade surplus would appear. In Europe there is no need for a current account surplus to instantly appear and in some countries, more private sector spending could help the ongoing adjustment and not hinder it. What is true though is that in some countries paying taxes and refusing to collect undue benefits from the government is not viewed as a binding moral duty! Cultural differences do exist.

Q: In your view, what is the most effective way to tide over the crisis?

A: The only way to contain the crisis would be a radical reversal in euro governments’ strategy. Instead of “muddling through”, a new strategy has to be put in place: measures have to be taken to revive growth especially in the periphery, some form of Eurobonds – for example a debt redemption fund – has to be launched and banks, where needed, have to be recapitalized – preferably not by their own governments, but by a Euro fund. In the shorter term, some action by the ECB would also help calm markets’ tensions, especially if Greece were to exit the euro.

* Authors of "The sovereign debt crisis: placing a curb on growth". The book is freely downloadable at http://www.ceps.eu/book/sovereign-debt-crisis-placing-curb-growth