The way out of Europe's volatile debt crisis is likely to involve painful belt-tightening, increased emergency aid, and eventually a restructuring of debt in the most troubled countries, according to finance experts at the W. P. Carey School of Business.
"It is becoming obvious that the peripheral, high-indebted countries in Europe are not going to be able to work themselves out of this mess," Clinical Associate Professor of Finance Werner Bonadurer says. "Their growth prospects are very low given the necessary domestic austerity measures and their lack of competitiveness, as well as subpar global economic expansion."
For more than a year, the European Union has been in crisis over the huge debts faced by its weakest economies. Cutbacks in social programs and benefits have stirred unrest in those countries, as well as in better-off nations in the Eurozone. The specter of sovereign default looms across the continent.
The European Union and the International Monetary Fund have orchestrated rescues of Greece and Ireland, but concerns about those two countries, as well as others, remain high.
"The worry is that Portugal might join them and also Spain," says Associate Professor of Finance Sreedhar T. Bharath. "And the big worry is that Italy might also go in."
Europe faces difficult choices as it tries to navigate a crisis that shows no signs of easing, faculty experts agree. "In the long run, the only way out is very deep and maybe painful reform in their markets, as well as a weaker euro" Bonadurer says.
Roots of a crisis
The current woes of the 16-nation monetary and economic union can be traced to the terms of the agreement that established the common currency in 1999, according to scholars at the W. P. Carey School. Under the agreement, the countries have a common monetary policy carried out by the European Central Bank, but each follows its own fiscal path. Problems arise when a monetary policy that benefits one country harms another.
"When the euro was created life was good," Finance Professor of Practice Anand Bhattacharya says. "No one was worried that things could go bad. This was one happy family."
But in the past decade, sharp differences in the growth rates and fiscal policies among countries in the Eurozone have emerged. The common currency has prevented the less competitive members of the monetary union from taking the course typically used by countries faced with a debt crisis: currency devaluation.
"If they had their own currency, they could devaluate and make themselves competitive again," Bonadurer says. "This is not an option they have at this stage."
The euro abolished market-based nominal exchange rates but it has led to divergences in real exchange rates. Consumer prices and wages in weaker countries have risen at a faster rate than in Germany since the start of the euro in 1999. Firms in these countries cannot compete with Germany in foreign markets and with low-cost imports from Asia in their home markets. Leaving the euro would allow Italy, Spain and the rest to devalue and bring their wage costs into line with workers' productivity.
"If they could devalue their currency, their exports could again become competitive, and they could eventually prune wages to make them compatible with the productivity of their workers," Bharath says. "Now they cannot do that."
Many observers have cited the lack of fiscal budget discipline, and the generous wage and retirement policies in Greece and other countries as the cause of the fiscal crises that led, in turn, to the debt crisis. But these countries had limited options, according to Bhattacharya.
"One has to wonder if these countries followed fiscal policies to accomplish their national objectives because they did not have a monetary policy available to them," Bhattacharya says.
According to Bharath, the weaker members of the Eurozone are jealously eyeing Poland, a member of the European Union that did not adopt the euro. Poland's currency, which floats against the euro, has fallen 20 percent since 1999.
"It is not a coincidence that Poland is the one member of the European Union that has not been in recession," Bharath says. "Poland has a pressure release valve that Greece and other countries don't have."
As the debt crisis unfolded over the past year, the European Union responded with a series of emergency rescues. In the spring of 2010, the International Monetary Fund and the European Union engineered a bailout of Greece and also established a $750 billion contingency fund for future emergencies in the Eurozone. In November, Ireland was offered a $112 billion aid package.
This approach may not be sufficient to resolve the financial difficulties facing countries in the monetary union, according to experts.
Bharath believes that interest rates attached to the bailouts are punitive and so high that recipients will be unable to repay the loans. He foresees Greece and Ireland possibly returning for second bailouts at even higher interest rates.
"In some sense, they have set in motion a chain of events that will make sovereign default a foregone conclusion," Bharath says.
Bonadurer believes that the emergency fund needs to be bolstered if the debt problems that have engulfed Greece and Ireland are to be kept from spreading to other countries.
"Markets have a tendency to be one step ahead," he says. "As soon as you start talking about Portugal and Spain, the markets are already looking at Italy, Belgium, and even the UK. The markets need to see shock and awe action. They need to be impressed. They need to understand that the European Union will do whatever it takes."
Saving countries from default
Experts at the W. P. Carey School believe that despite the emergency aid, the poorer members of the monetary union will be hard-pressed to meet their obligations. That raises the possibility of sovereign default.
"In my view it is inevitable that there will be debt restructuring. The current liquidity crisis will likely become a solvency crisis," Bonadurer says.
Bonadurer believes that restructuring will not be attempted for at least two years, and in the meantime, countries will be kept afloat with emergency aid. Restructuring of debt will be a delicate and dangerous process, he says. It inevitably means that investors will take losses.
"As soon as banks are faced with taking haircuts, we are back to square one -- a reinvigoration of the banking crisis," Bonadurer says.
Bhattacharya believes that while sovereign default is a looming possibility, the big players in the world economy will step in to prevent it from happening.
"The way the world is interconnected, I would be very surprised if we wound up with an actual sovereign default," he says. "I would be hard-pressed to believe that the Germans would let Greece or Spain or Portugal actually go into default."
Bhattacharya compares the situation to Lehman Brothers' collapse in the fall of 2008. The U.S. government stepped in then to prevent a domino effect involving other big banks. "When Lehman began to default, everyone said, 'Who's next?'" Bhattacharya notes. "If that happened in Europe, you can imagine what it would do to the value of the currency."
Will the euro survive?
For the troubled economies of the Eurozone, the road ahead appears difficult. In return for international aid, they are being forced to make deep cuts in government spending.
"In some areas, wages, social benefits, and entitlements have been absolutely out of control," Bonadurer says.
The sacrifices required of the population in these countries are highly unpopular, and the bailouts are not particularly popular in the better-off countries either.
Bharath says the German public is resisting rescuing countries that may have brought problems onto themselves. "Taxpayers in Germany are not going to be happy about any of this," he says.
But while all parties may be tempted to abandon the euro, they also recognize the perils that would accompany such a course of action.
"The problem is that it's not so easy to leave," Bharath says. "The chaos it could create would be of an order of magnitude that is hard to comprehend."
The immediate effect would be a run on the banks in many countries, Bharath says. Deposits, mortgages, other loans would all have to be converted to new currencies -- a complex process, which would be fraught with the potential for conflict.
"You also have to distribute all of the new currency," Bharath says. "When they moved to the euro, they planned for it for five or six years. This would be a confused situation, and you have to do it quickly."
Bonadurer does not believe that Europe will abandon the euro. "Don't underestimate the strong political will to keep the euro alive. But at this stage, nobody has a Plan B. Everybody is absolutely scared. The consequences would be catastrophic."
Abandoning the euro would mean freezing deposits in some countries, according to Bharath. And because countries lose foreign exchange when their citizens go abroad, there would have to be curbs on foreign travel, he notes.
"In a place like Europe, these things are impractical. For all practical purposes now, the countries are integrated," Bharath says.
- The debt crisis in Europe has its roots in the initial Eurozone agreement, which establishes one monetary policy for countries with differing levels of international competitiveness and very different approaches to fiscal policy.
- The European Union and International Monetary Fund engineered bailouts for Greece and Ireland and also established a contingency fund for future emergencies. The fund may need to grow considerably if European countries are to regain financial stability.
- Some countries are in such difficult financial straits that restructuring of their debt may be inevitable, although they may not be labeled sovereign defaults.