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SCRIPT Slide 1 We are performing a skit addressing the Eurozones problem with debts and deficits. And Now...

A member of the Irish government, European Commission, ECB, and IMF walk into a bar. Robby: I used to be a banker and now I bar tend at the Celtic Tiger Pub. It used to be overflowing with customers, and now its empty. In the past three years Irelands GDP has fallen by 14%. What happened? First a housing crisis, Ireland has 120,000 vacant houses. Thats a mid-sized city. Then a recession drove unemployment from 4.6% to 14.6%. Then because of a financial crisis the government guaranteed the bank debts because our banks were too big to fail. Turns out they were too big to save. That gave us a DEBT TO GDP ratio of 98.6% and a sovereign debt crisis. Now, we are told we have to accept an austerity plan that cuts the government budget by 15 billion. That is 9% of GDP. This will only make things worse. Basically, Austerity leads to high unemployment. Our high unemployment decreases GDP, which increases the DEBT TO GDP ratio. We have just elected a new government and hopefully theyll get a better deal from the European Commission, European Central Bank, and the International Monetary Fund. We need to fix our debt to get our Celtic Tiger growing again or else Ireland will again be a country of poor emigrants. (Micah Walks into the Bar) Slide 2 Robby: Here comes Patrick ODonahue from the negotiations with the ECB, IMF and EC. Patrick, are you fighting the good fight? Micah: Things are rough. Others are coming over for a drink. Hopefully we can talk honestly away from the negotiating table. Mind yourself, this is important. Robby: I know how important it is. Austerity is killing us. GDP is still shrinking at 1% and unemployment is at 14.6%. Cutting the budget by 15 billion euros by 2014 will make everything worse. We voted for you to do the right thing remember those campaign promises. Micah: Negotiations are tough; we need the rest of Europe to help us. Robby: Well, almost every Eurozone country is over its debt limits. Greece, Portugal and Spain are also facing sovereign debt crises. They can help us. Micah: Listen, any deal needs the support of Germany and France, but they think the crisis has passed and we are in recovery. The rest of the Eurozone is growing at 1.7% and unemployment is at 9.9% and going down Germany is growing at 3.6% and unemployment at 7.1%. The ECB recently raised rates by .25% because headline inflation has risen to 2.6%.

The housing bubble was fuelled by bank loans to buy houses which fuelled large amounts of real estate speculation. When housing and real estate began to lose value, many people defaulted on loans. This hurt banks because they lost money on loans and the collateral houses were worthless this made banks insolvent. In the fall of 2008, during a global banking crisis, the government guaranteed the bank debts. This meant that large bank loses were now covered by the government this and a simultaneous recession pushed the debt to GDP ratio from 25% to 98%. To limit the debt problem, the government enacted an austerity program of lower government spending (on social programs and education) and higher taxes. This contractionary fiscal policy has pushed up unemployment. Higher unemployment means lower GDP growth (Okuns law). There are only two ways for the Irish to get their Debt to GDP ratio under control. One is to shrink the size of the debt (more austerity). Second, is to grow the economy, so GDP is larger (making the ratio smaller). The austerity program, reduced government spending and higher taxes, has a negative multiplier effect on the economy every euro of reduced budget results in more than a euro decline in GDP.

Germany and France represent 48% of eurozone GDP. The ECB rate policy is more focused on these countries it is also correct for these countries, but bad for the PIIGS. In fact, ECB rate policy has generally

Robby: That will increase unemployment and blow up our debt problem. You made it our problem when you guaranteed the bank debt. Its about time something was done! Make sure those Europeans know that our bank debt is as much their problem as it is ours. Micah: We got the message in the election. Were coming up with a new plan. Robby: Is there even a plan? Stop mucking about and take a stance for the Irish people! I dont want to be left holding the bag on this. Micah: Well you wont. In case you havent been paying attention, Enda Kenny just passed on the opportunity for a reduction of the interest rate for our debt, because he wanted to make sure you keep a low corporate tax rate of 12.5%. (Pamela walks into the bar) Robby: Well good, Im glad you have some sense at least. Micah: Thanks, I guess....but taxes might have to go up eventually. Robby: But how are we going to get the economy going again if taxes go up? Pamela: Its your debt problem. You cant expect everyone else in Europe pay your debts you need to raise your taxes. Robby: You need to appreciate the pain that we are in. We still couldn't pay off the debt even if every worker in Ireland paid his full salary for a year. Pamela: Appreciate you? You need to appreciate that I am limited by the rules and treaties that everyone agreed to, including Ireland. Ireland agreed to the Maastricht Treaty and said theyd keep their deficits to 3% of GDP, but now their deficit is 32.3%--thats the biggest in the Eurozone. And Irelands debt is 98.6% of GDP. Robby: If it wasnt for the government bailing out the banks, the Irish debt to GDP ratio would be 80%. The Eurozone average is 84%. Pamela: How you got into it was your problem. We need to stop these violations and prevent Ireland from defaulting, before your problems become a contagion that spreads to other Eurozone countries. Im already stretched too thin because none of the periphery countries are doing well. Greece is in ruins, Italy has a history of big debt, Portugal just asked for a bailout, and if Spain goes, that could mean the end of the Euro.

been in appropriate for the PIIGS. ECB is expected to raise rates by another . 5% this year. Higher ECB rates will do three things to Ireland: 1. Raise the value of euro make Ireland less competitive. 2. Make it harder to pay back debts (not just government debt, but personal and company debt (this could worsen the condition of Irish banks). 3. Lower inflation will result in higher unemployment (Phillips Curve)

Ireland does need to reform its taxes but mostly personal and property taxes, not corporate taxes. Basically, Ireland needs to broaden its tax base so it is less affected by sudden economic changes. However, a recession is the worst time to introduce new taxes, the best time is after the economy has recovered. This is the issue of a transfer union where the strong pay for the weaker members. The 32% Irish deficit this year is a one-time jump because of the bank rescue. Without the bank rescue the deficit would be closer to 9%. Still high, but not too far out of line with other eurozone countries. Without the cost of the bank rescue, Irish debt would be affordable. Greek bailout is costing the EU 110billion, Ireland is 85 billion and Portugal is expected to be about 80 billion.

Robby: A year ago you held us up as a role model. Now you are throwing us in the same hole. You need to help us. Pamela: It would help if people would help themselves. Your policies need to be brought back in line so you arent a danger to the stability of the entire Eurozone. Robby: A housing bubble and financial crisis caused this mess, not fiscal irresponsibility. Now we are suffering austerity to get back into line. Isnt that enough? Pamela: Its not just about you. How I deal with you will affect how I deal with everyone else. I dont want to give you bail-out money indefinitely at a low interest rate, that will create a moral hazard. Robby: Moral what? Pamela: Moral Hazard. If we make an exception for Ireland, then Greece, Spain, and Portugal will not solve their problems and instead just want the same deal. We could be setting ourselves up for a transfer union where stable states fund debtor states. Why should the Germans and Finns pay for Ireland? (Ben walks into the bar) Robby: Maybe it would be the moral thing to do? Pamela: You have got to look at the big picture - it is not just Irelands debt. World markets have been testing the euro for weakness - interests rates for Greece, Ireland and Portugal are all at unsustainable levels. We need to prove to international markets that the euro is a stable currency. If the euro goes, nobody can help you. Robby: Lot of help you are now. (Pointing to Ben) And this guy here has increased our debt burden by raising interest rates a quarter of a percent. Ben: I have to do this. My mandate is to keep inflation low and protect the euro. Robby: Who needs the Euro? Ireland has a history of poverty, emigration and being dominated by other countries. We were hoping the Euro would change that! The single currency is just a trap. Ben: Listen, the price transparency and favorable interest rates of a single currency made the Celtic Tiger. More importantly, your banks wouldve failed without us. The liquidity funding we have given your banks keeps them afloat. If the banks failed, it would have taken down the government. We saved your country from insolvency. But, we cannot solve your problem. Robby: So, we have to follow your rules, but you cant help us?

Spain represents about 10% of eurozone GDP, its economy is not growing, has an unemployment rate of 20% and its banks could suffer massive loses if Portugal gets worse. During the Greek debt crisis, Ireland enacted its austerity package EU leaders praised it as a role model for the other PIIGS. Rescuing Ireland (or Greece or Portugal) means that other countries (now and in the future) will not be responsible in handling their debts since they can be rescued. While moral hazard is a problem, systemic banking collapse and fall of the euro would be worse. To a certain extent, moral hazard is inevitable it can only be reduced. Consider the simple existence of rescue systems. They do not encourage disaster lifeboats do not encourage ships to sink and fire departments do not encourage houses to be burned down. In fact, they encourage people to do things to make the world a more enriching place take the risk of sailing the ocean and building nice houses. Nobel Prize winner Paul Krugman says that Economics is not a Morality Play in other words, economic situations are about best using resources, not rewarding the good and punishing the bad. The Finns just elected the True Finn Party to 19% of its parliament the True Finns are opposed to bailouts like Portugal, which still needs to have its bailout approved. The ECB mandate is price stability. The original Irish Celtic Tiger growth was a result of the EU and Eurozone the later growth (and housing bubble) was the result of too low ECB rates.

Slide 3 Ben: The ECB has neither the power nor the mandate to fix an insolvent Ireland. Up in until now we have kept the Irish banks afloat with 50 billion in liquidity assistance. But, honestly, without a real solution, your banks are insolvent zombies. The results of last months stress test demonstrated this. Robby: Great. Who can make our banks solvent? Ben: Its really up to the EC and IMF to work that out. The IMF/EU rescue package has 35 billion to fund and recapitalize your banks. (Jackie walks into the bar) Robby: So, its pretty much wait and suffer? Ben: I cant do more for you. The EC ministers have to come up with a solution to this crisis. Until they change the ECB mandate, this isnt our job. Were here to protect the Euro and youre only one of seventeen countries we need to keep an eye on. Robby: Thats why we elected a new government... Maybe Democracy can trump Eurocracy. Jackie: Thats why were here. The International Monetary Fund may have a tough reputation but, without our backbone, Ireland will never return to the bond market. Robby: We need help. Jackie: And we are helping. Weve already contributed 22.5 billion to an 85 billion joined IMF/EU rescue package for Ireland to help restructure your banks, which is about 54% of Irelands 2010 GDP. Robby: How will this help us out of our hole? Jackie: In terms of composition, we are hoping that the 50 billion can provide funding to the Irish State to keep it out of bond markets for three years. This buys you the time to get your books in order before you go back onto bond markets. Robby: And in return? Slide 4 Jackie: You have to do your part. (Pointing to everyone else) And you and you and you! High debts and deficits have created an existential crisis for the eurozone and nothing else will improve until the debt crisis is resolved. The unrealized debt losses cripple your banks and austerity will limit growth. You have all been

Liquidity funding is the short-term lending that insures the banks have cash on hand to carry out daily business (bank money is tied up in loans or in the case of Ireland, lost). Without liquidity assistance, banks would not be able to do any business, which would cause the economy to seize up. Zombie banks are insolvent banks that are able to keep functioning because they have enough liquidity assistance (cash on hand) to carry out daily banking operations, but are technically bankrupt. The only way to be made solvent is to get new investors (doubtful for an bankrupt business) or get someone to take away the bad debt (this is the NAMA program - National Asset Management Agency (NAMA) which spent 37 billion buying 88 billion in bad bank loans (the banks acknowledged losing 51 billion). NAMA is selling these assets to get back the money spent this is not going well in a depressed real estate market.) The IMF/EU rescue package has two goals: fix the banks and protect Ireland from having to pay really high interest rates to carry its debt for the next three years. 35 billion will be spent shoring up the banks (this includes the 24 billion needed after the failed stress tests demanded by the rescue package). The other 50 is to fund the Irish government deficit over the next three years at a lower interest rate than market interest rates. IMF has the experience and determination for force countries to enact austerity packages. However, the IMF has recently said that harsh austerity may not be the best program for indebted countries. The goal is that in the next three years, Ireland will be able to resolve its banking problem, get is deficit and debt under control and start growing its economy so

passing the bag, hoping someone else will cover your losses. The only solution is to come together to figure out how you will all share the losses. Your plan for a large permanent rescue fund in 2013 is unrealistic. Based on my experience in Latin America and Asia, if you dont address this problem correctly, it will get a lot worse, and fast. I am the only independent voice here, so I am going to tell you how it is - bond markets have burned through all of your firewall solutions. If you want to save the single currency, you need to agree to a GRAND BARGAIN that ties a short-term solution that ends the current debt crisis with a long term solution to prevent a future debt crisis. Lower interest rates

that it does not have to pay such a high risk premium to borrow on international bond markets.

Micah: Finally, lets agree, the size of the debt is the problem. First off, we need to lower the rate and extend the length on the rescue package, which is at 5.8%, while the EU can get loans at a much lower rate of 2.9% Pamela: Weve been over this. We can definitely make a deal if you finally agree to increase your corporate tax rates to the European average. Robby: Hold on. The corporate tax rate is our competitive advantage. Besides, Frances effective tax rate is 8%. Micah: The Lisbon treaty said corporate tax rate was a national issue. If youre going to obey one of the treaties you had better obey all of them. Jackie: You guys are playing around while Rome is burning. If your debt is greater than your GDP and your interest rate is greater than your growth rate, changing those interest rates wont do anything. Even under the best forecast, your debt will be 125% of GDP by 2014. Raise inflation

The debt crisis is at the center of all euro area problems high unemployment, slow growth and weak banking system. A healthy economy needs to solve these problems however, this cannot be done without fixing the debt crisis. In debt crises in Asia (1997) and Argentina (2000), short term solutions did not solve major problems it only postponed the crisis. When the crises did hit they were very fast and much worse resulting in default and currency crashes.

Lowering the interest rate and lengthening the time for repayment would make the debt more affordable. However, there is still the problem that a rate of 3% would mean the debt would grow faster than the Irish economy making the debt to GDP ratio worse. Effective tax rate means the tax that is actually paid after accounting for government subsidies and tax breaks. The Irish originally rejected the Lisbon Treaty in referendum in 2008. It was passed in a second referendum. Basic point, the debt is on an unsustainable growth path. Not only in Ireland - Greek debt will reach 150% of GDP by 2014.

Robby: Well then why dont we just inflate the Euro and get rid of the debt that way. Ben: That is a ridiculous idea. Inflation is a hidden tax on everyone with Euros. It may fix your crisis, but it hurts everyone else. Inflation is a very slippery slope and is something that is very hard to control. It could threaten the stability of the Eurozone and the Euro. For now, target inflation must stay at 2%. Micah: Ireland needs more than 2% inflation. Raise it to 4%. This will decrease the debt and expand the economy. Thats not hyperinflation by any means... isnt that what the IMF plan is all about?

Jackie: You will be bankrupt before inflation destroys your debt. You need a faster solution. Unorganized Default Slide 5 Robby: Forget this! There is no solution. Lets just default and leave the Euro. Everyone Else: No! Robby: Well why does the single currency need to be part of our solution? Ben: Defaulting would kill the Euro and the ECB. We could lose the 150 billion Euro in assistance that we gave Ireland. The single currency is keeping you afloat. Jackie: If you unilaterally default or drop out of the Euro youre on your own and theres no way youll get back into the bond market. The single currency ensures Irelands survival. Pamela: You will take everyone else down with you. There will be massive contagion. Greece, Portugal, and God forbid Spain! There is no way the rest of the Eurozone could rescue Spain. Micah: We dont like this either, but lets face it, Irish taxpayers bailing out European banks for their poor investments is also moral hazard. We cant pay our debts, we need a realistic solution. What we need is an orderly restructuring. Slide 6 Pamela: If we give a haircut to you, then everyone will want one. Im really worried about this because Spain has the same bank problem, and it could result in a debt crisis too. Ben: I cant afford to give Spain the assistance I gave Ireland. Whatever solution works for Ireland needs to work for Spain. Pamela: Well, I am worried that banks across Europe are going to take a big hit, which would make them insolvent. European banks have around 560 billion Euro in exposure to Ireland, Greece and Portugal. Jackie: Listen, the banks made some bad investments and have to accept the losses. Look at the market value for these bonds - markets have already priced in a restructuring that they see as inevitable. Pamela: How can I give Ireland a deal and not include the others?
Inflation reduces the real value of the euro and reduces the cost of paying back debts. Inflation is hard to control because it affects peoples expectations of the future. Once people plan for higher inflation, it is hard to reduce inflation in the future (interest rates must go up which will hurt future investment and economic growth) At a 4% rate it would take 15 years to cut the real value of Irelands debt in half.

Leaving the Euro and going back to the old Irish currency (the punt) would be hugely expensive, complicated and take a long time (several years). The ECB has 150 billion loaned to Ireland (guaranteed by the Irish government). The sudden loss would cripple ECB programs to other countries. Without the IMF/EU loan, the Irish have nowhere to go for funding their government would be bankrupt. A unilateral Irish default would cause investors to panic and sell the bonds of the other PIIGS European interest rates would shoot up and the other PIIGS would be forced to default. Current situation is a form of transfer system from Irish tax payers to European bankers to rescue the bankers from poor

Jackie: You cant. Until you deal with the whole debt problem facing the Eurozone, markets will not believe anything you do. You need to solve all the problems at once. To have credibility, you need to hit the markets with all the bad news at once. Ben: Are you suggesting a Eurozone wide restructuring? That means Ireland, Greece, Portugal, and anyone else that wants to pile on? The losses could be massive - especially for the ECB. Jackie: The losses are not the whole debt, it will be part of the debt. The ECB losses could be covered by the rescue fund. Pamela: But the whole Eurozone will lose the faith of world markets. No one will invest in Europe for years. Ben: And the euro would crash! Micah: No it wouldnt, free of debt, we could grow our economies and investors will want to get in on that growth. Pamela: There is no good way out of this. No matter what we do were going to get burned. What we need is the least bad solution, and an organized default might be the way to go. But this is really going to hurt. Jackie: It will hurt, but if done right, it can fix the Euros debt and deficit crisis once and for all. Pamela: My only question is how do we figure out how much of a haircut is fair? How much should the investors be burned? Micah: Enough to give us an affordable debt. Without the bank debts, our debt to GDP ratio would be a manageable 80%. Jackie: Use market price for bonds as the guide for the amount for the haircut. This tells you what markets are expecting. Ben: I dont like this, but if anything this crisis has shown, nothing happens just once. How are we going to make sure its just one hit? Pamela: This can only be a one time deal. The moral hazard created by the haircut bailout could be setting the stage for more debt problems. Slide 7 Jackie: You need the second part of the GRAND BARGAIN. You need to have a credible long term solution. Lets brainstorm. What does a long term solution need to have to succeed?

investments in Ireland.

Spanish banks have large holdings of Portuguese bonds and large investments in Portugal.

German banks are very weak and a debt default could make them insolvent. In that case, German taxpayers would have to fund their own bank rescues to make their banks again solvent.

The reason interest rates on PIIGS bonds is high is because they have a high risk premium because investors fear they will not get their money back. The only way to deal with the risk of contagion is to treat the whole area at once. This is a bit like establishing a quarantine zone it has to be done to prevent the infection from escaping. Since the infection is the expectation of risk by world markets, the quarantine zone needs to cover all of the countries that markets consider to be risky. Both of these points are true the full effect of a debt default by large parts of the eurozone are unclear. It is clear that the euro would lose a lot of value (however, it is unclear how long it would stay down). In the case of the Asia countries that crashed in 1997, Russia (which defaulted in 1998) and Argentina, all three regions are currently growing and are able to attract investors in fact they have not been hurt

Robby: It needs to protect taxpayers from footing the bill to rescue banks that are too big to save. Pamela: It should support the capital mobility goal of the economic and monetary union - but prevent moral hazard on the part of both investors and borrowers. Micah: Honestly, politics in Ireland is so small, I should not have the power to regulate my banks - a government should only be responsible for its fiscal debts. Ben: Well, my mandate here needs to be more clear. The ECB liquidity assistance has not solved the problem - its just made a bunch of zombie banks. What I need is the power to liquidate and restructure insolvent banks in a orderly way. Micah: I agree, you need more power, but you also need more money. But who will pay? Pamela: No one will want to. After this haircut no tax payers in Europe will ever pay for another countrys bank problems. Robby: But, its not another countrys problem. Its a European banking problem. The banks need to pay to clean up their messes. Micah: Youre right. Why should taxpayers be responsible for the actions of bankers and borrowers? The best solution is for bankers to pay into a crisis resolution fund - it would be like insurance. Ben: And that could fund my mandate for resolving insolvent banks in an orderly way. Pamela: Wait, how would this work? Ben: Its pretty straight forward. When a bank becomes insolvent, the ECB would take it over and liquidate it in an orderly way - determining how much creditors are paid, and selling off assets - and protecting financial markets from collapse in the process. Pamela: If I have this right, this will create European bank insurance that will have enough power to stop a banking crisis like Irelands, or Spains, from spiraling out of control. Micah: Im sure that the Eurozone countries will agree to that. It protects the small countries from the risk of banks that are too big to save. Pamela: And it would save big countries from paying for their rescue. Ben: It would give the ECB the power to protect the euro during financial crises.

in the current global downturn (this is because the learned from the crisis to build up large cash reserves to serve as a rainy day fund). The goal of a haircut is to: 1. Share the pain between taxpayers and bond holders (make everyone pay for the mistake). 2. Give the country a debt it can afford to pay in the long run that does not cripple its growth. For this reason, a haircut needs to be set at an amount that is least disruptive to markets (to prevent larger problems in the financial system). A good analogy is how much to amputate from an infected limb enough to stop the infection, but not too so much that it would do more harm to the patients quality of life.

One of the big goals of the Economic and Monetary Union is the freedom of investment across the EU this promotes investment and economic growth.

This will give the ECB powers similar to the powers of the Federal Reserve. After the current crisis, the Federal Reserve was made a systemic regulator it can act to take over and shut down financial institutions whose failure might represent a danger to the whole economic system.

Micah: But protects national sovereignty in regards to national taxing and spending. Pamela: As the executive branch of the European Union, how do we make this Grand Bargain work? Slide 8 Jackie: You need to announce and act simultaneously on both plans. You will have an organized, one-timeonly debt restructuring to solve the short run sovereign debt crisis by reducing eurozone debts to 80%. To avoid moral hazard, you will establish an ECB led crisis resolution fund funded by banks. Hopefully, the bold plan will buy you credibility with the markets. Robby: So I guess we are all in agreement, this round is on the house }:^p
The big point if Europe is to have a common investment market (EMU) it needs to be seen as a one European financial system, not a collection of different national systems. In the United States, there is one American financial system, not the Florida or California financial system. If European banks are going to operate across the continent (like American banks), then they need to be supported by a continental system. The idea is that banks pay into a special fund of money that could be used to pay the debts of insolvent financial institutions. The ECB would take over a failing bank and unwind its business with other banks so as to prevent the financial chaos caused by the failure of a sudden bank failure. The best way to think of this is imagine the banking system as a series of circuits that carry electricity to power the motor of the economy. If one circuit fails (failed bank), the electricity stops flowing. The ECB will act as a buy-pass wire around the failed circuit to prevent a disruption of the flow of electricity.

Checklist for answering questions When answering a question it is important to address three points with the answer:

Address the economic concept explain and demonstrate knowledge about the concept that is at the heart of the question. Address the Eurozone Explain how the concept applies to the Eurozone and how the Eurozone operates. Address Ireland - Illustrate the concept with Ireland.

Key Point to make clear about restructuring proposal The recommendation to do a mass restructuring of Eurozone debt is not a good solution but it may be the best of many bad solutions. The limitations of a single monetary policy over such a diverse set of nations with no unifying fiscal policy and the slow growth prospects of the indebted nations means that the better more sensible options are not possible. The simple point is that a lot of money has been lost and the questions is who will suffer the losses. While other options seem nice, the reality of European politics stands in the way. The reality of a Greek restructuring does affect the solutions to the Irish problem. Nobel Prize winner Paul Krugman says that Economics is not a Morality Play in other words, economic situations are about best using resources, not rewarding the good and punishing the bad.

To make this plan work, under EU treaty procedure, the EC would have to introduce the plan to the Committee of Ministers or the European Parliament for approval. It would need unanimous approval to become law. The need for simultaneous action can be explained by the infection and quarantine analogy (mentioned before) works here as well. When there is an epidemic the goal is

to stop in now and prevent it from reoccurring. So, the establishment of a quarantine zone (organized default) stops the current infection. Then a mass inoculation against the infection prevents future infections (ECB resolution program). Both programs, to have maximum effect, must be done at the same time, or else there is the chance that the infection could escape, lay dormant and come back at a future date.