End of game? Don’t bet on it

Charles Wyplosz 25 July 2012



Here we go again:

  • Once again, pressure is mounting on the Eurozone’s public debts.
  • Once again, markets and the media expect some dramatic flare-up followed by 'determined and comprehensive' policy measures.
  • Once again, policymakers are bewildered by 'irrational' market reactions.
  • Once again, technocrats – including many academics – are pushing for a deeper union that public opinion loathes.

But once again, we will see limited policy decisions that will temporarily loosen the pressure while leaving the crisis untreated.

This time it is Spain, soon to be followed by Italy. For more than one year, it was a foregone conclusion that both countries would follow the same path as Greece. The only question was which shoe would be the first to drop and when.

The reasons behind the crisis’s spread have been described ad nauseam. The story starts with some vulnerability.

  • In Spain, it is banks exposed to credit risk stemming from the housing price bubble.
  • In Italy, it is a large public debt that has remained roughly unchanged for more than a decade while growth has been miserable – even during the period of the Great Moderation characterised by fast growth and low inflation.

Then, one day, the financial markets take a hard look at the country and grow worried. In Spain they ask: “What if things go sour?” and “What if banks need to be bailed out?” Although public debt has been moderate, it will suddenly jump. In Italy: “What if interest rate spreads rise and the long-stable public debt becomes unstable?”

  • In both cases – as in Greece before – the policy response has been to impress markets with austerity measures.
  • In both cases, market analysts work the numbers and conclude that a recession will follow which will worsen the budget and make the public debt unstable.
  • Interest rates rise, tax revenues fall and the government loses market access.

This is where Spain and Italy now stand, or are close to stand. At this stage, governments claim that “we are not Greece”, pretty much as the Greek government in early 2010 claimed “we are not Latin Americans”. This is all true, but when market access is lost, external help becomes unavoidable.

What’s next?

What will happen next is all too familiar. Tough austerity measures will be imposed by the Troika and this will make matters worse. Targets will be missed, recession will deepen, banks will shake and new conditions will be imposed. Markets and media will theorize exit from the Eurozone by more and more countries.

There is no reason to believe that solutions that failed repeatedly will succeed this time. The silver lining is that these solutions are becoming increasingly more difficult so that policymakers will have to do what they hate most – acknowledge failure.

The math is simple.

  • The first proposed bailout, for Greece in early 2010, involved €10 billion.

In the end, Greece was lent €110 billion, and two years later another €130 billion is under negotiation. The EFSF had a lending capacity of €250 billion and the ESM could add €500 billion, but this project is now hijacked by the German Constitutional Court that will not rule until next September.

  • Quantitatively, Spain and Italy are in a completely different league.

Going beyond these numbers is simply technically impossible because fewer and fewer countries are left to credibly pledge increasingly larger support. Moody’s decision to put the German public debt (already above 80% of GDP) on a negative watch is a healthy reminder that the EFSF/ESM route is leading nowhere good.

Simple truth: Crisis rolls on until the ECB acts decisively

The simple truth has been known all along (Delbecque, 2011; Wyplosz; 2011). The crisis will not end until the ECB acts as lender in last resort. It can do it on the cheap by either partially guaranteeing all Eurozone public debts or by setting a cap on their interest rates (Baldwin and Gross 2010). This will bring the speculative phase of the crisis to a temporary end, leaving room for the other required steps.

The ECB has started to move in that direction at the end of 2011 with its LTROs, but it did so via banks, in effect deepening the vicious loop between governments and banks (Wyplosz, 2012). This is why the effect was short-lived.

  • The first next step is already on the official agenda.

Once debts are partially protected, their prices will settle and banks should acknowledge losses on their holdings. This will push a number of banks into bankruptcy. Inevitably, they will have to be restructured, and this will involve hundreds of billions of euros.

Smart bank restructuring does not involve losses to be borne by the taxpayers but it requires liquidity injections.

  • The ECB will have to act as lender to last resort for banks.

The ECB has open that door too when it has called for a banking union. Its reasoning is absolutely correct on this.

  • Injecting cash into banks amounts to throwing good money after bad unless the banks are properly restructured.

That in turn calls for a single European supervisor with full bank resolution authority.

  • National governments still balk at the prospect of giving up national authority.

Authority which was used to protect their national champions with disastrous consequences (Ireland and Spain are two now-obvious cases in point and many national closets hide large skeletons).

  • The second next step is to acknowledge that many public debts must be restructured.

As noted above, commercial banks will have to take losses but more losses will have to be borne by the ECB and the EFSF, which have absorbed hundreds of billion worth of public debts.

Private bondholders too will be hurt for having purchased what they saw as safe assets. This is a step that all governments want to avoid, which is understandable but futile. The more they wait, the deeper will be the haircuts and the larger the eventual losses. Prompt corrective action is a basic way to deal with this kind of situation.

When all else fails, policymakers will do the right thing

Over the last few months, these ideas have started to be taken on board, but partially and hesitantly. Coherence, however, is of the essence, as has been illustrated by the LTROs. At this juncture, the risk is that the banking union – a strong but ambiguous terminology – will not be carried to its logical conclusion. More money will be provided to Spain and Italy, but not enough and with counterproductive conditions.

The result is that the ECB will sit on the fence, acting whenever a climax is reached because its ultimate mission is to preserve the euro’s existence, but still short of acting as a full-fledged lender in last resort for both banks and governments. After all, the ECB can rescue the Eurozone, but it cannot repair it – only governments can do that.

To make things worse, governments will not accept to envisage public debt restructuring, leaving the root cause of the crisis untreated. There will be many more small steps in the right direction but certainly not the grand strategic plan that is sorely needed.

The really good news is that, at long last, the euro has started to depreciate. Since there is no room left for an expansionary monetary policy and since most governments cannot use fiscal policy in a countercyclical way – just letting the automatic multipliers act remains a dream – the only possible boost to stop economic recession from spreading is a rise in exports. A weak euro is in Europe’s interest.


Baldwin, Richard and Daniel Gros (eds.) 2010, "Completing the Eurozone Rescue: What More Needs to Be Done?", VoxEU.org, 12 June.

Belbecque, Bernard. 2011. “Capping interest rates to stop EZ contagion”, VoxEU.org, 17 October.

Wyplosz, Charles. 2011. “A failsafe way to end the Eurozone crisis”, VoxEU.org, 26 September.

Wyplosz, Charles. 2012. “The ECB’s trillion euro bet”, VoxEU.org, 13 February.



Topics:  EU policies

Tags:  EZ crisis

Emeritus Professor of International Economics, Graduate Institute, Geneva; CEPR Research Fellow


CEPR Policy Research