The European Sovereign Debt Crisis

1. The European Sovereign Debt Crisis Philip R. Lane

2. Overview • Pre-Crisis Risk Factors • The Financial Crisis and the Sovereign Debt Crisis • Prospects for Post-Crisis Reduction in Sovereign Debt

3. Pre-Crisis Risk Factors • Capacity of Euro-member countries to withstand financial shocks known to be a challenge • Through 90’s and mid 2000’s public debt didn’t appear to be a looming problem. • With the creation of the Euro, 60% ceiling on debt/GDP ratio established, along with maximum of a 3% deficit/GDP ratio

5. Pre-Crisis Factors • Some countries that would get into fiscal crisis looked healthy around 2007 • Low spread on sovereign debt showed markets didn’t expect default risk • Good growth performance masked the vulnerabilities

7. Pre-Crisis Factors • Financial imbalances and external imbalances posed risks • Credit boom during the 2003-2007 period • Ultimately, national governments failed to tighten fiscal policy during the period of growth from 2003-2007

8. The Financial Crisis and the Sovereign Debt Crisis • Global financial crisis of late 2008 had asymmetric effects across the euro zone. • Even with financial crisis, euro area sovereign debt markets remained calm through most of 2009 • In late 2009, sovereign debt crisis emerges • Ireland and Spain had larger-than-expected increases in deficit/GDP ratios • Most shocking new came from Greece, with 2009 budget deficit of 12.7 percent of GDP

10. The Financial Crisis and the Sovereign Debt Crisis • Bailouts established under which three-year funding would be provided if certain conditions met • Scale of funding far exceeded IMF lending levels, so EU was the major provider • Several issues arose in the funding: • Plausible time scale was longer than three-year term • Fiscal targets not conditional on state of Euro zone • Original bailouts included standard IMF penalty • Increased volatility in debt markets leads to self-fulfilling speculative attacks

11. Prospects for Post-Crisis Reduction in Sovereign Debt • Many European countries will have elevated public debt ratios • Even if current austerity measure are sufficient to stabilize debt ratios, the challenge will be reduction to safer levels • Growth in nominal GDP will likely be slow • Maintaining political environment will be difficult

12. Prospects for Post-Crisis Reduction in Sovereign Debt • New Fiscal Compact Treaty set to go in effect in 2013 with two primary principles • High public debt levels pose a threat to stability • Fiscal balance should be close to zero “over the cycle” • Reformed system allows for cyclical effects and stronger enforcement of the 60% ceiling • Primary source of fiscal discipline will be at the national level • More extensive reforms possible in the future

13. Conclusion • Origin and propagation of the European sovereign debt crisis can be attributed to the flawed design of the euro • Positive perspective is that the debt crisis will implement reforms to save the monetary union • Alternative scenario could result in the “mother of all financial crises”

14. Questions?