Philip R. Lane

The European Sovereign Debt Crisis

Pre-Crisis Risk FactorsThe Financial Crisis and the Sovereign Debt Crisis

Prospects for Post-Crisis Reduction in Sovereign Debt

Overview

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

Pre-Crisis Risk 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

Pre-Crisis Factors

Financial imbalances and external imbalances posed risks

Credit boom during the 2003-2007 periodUltimately, national governments failed to

tighten fiscal policy during the period of growth from 2003-2007

Pre-Crisis Factors

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 emergesIreland and Spain had larger-than-expected

increases in deficit/GDP ratiosMost shocking new came from Greece, with

2009 budget deficit of 12.7 percent of GDP

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

termFiscal targets not conditional on state of Euro zoneOriginal bailouts included standard IMF penalty

Increased volatility in debt markets leads to self-fulfilling speculative attacks

The Financial Crisis and the Sovereign Debt Crisis

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 slowMaintaining political environment will be

difficult

Prospects for Post-Crisis Reduction in Sovereign Debt

New Fiscal Compact Treaty set to go in effect in 2013 with two primary principlesHigh public debt levels pose a threat to

stabilityFiscal balance should be close to zero “over the

cycle”Reformed system allows for cyclical effects

and stronger enforcement of the 60% ceilingPrimary source of fiscal discipline will be at

the national levelMore extensive reforms possible in the future

Prospects for Post-Crisis Reduction in Sovereign Debt

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”

Conclusion

Questions?