Financial Times
October 4, 2011
The eurozone was launched on a wing and a prayer. The wing has fallen off and the deities are not listening to prayers. Everyone focuses on averting a crash. But it is as vital to ask how to fly securely.
How, then, did the eurozone fall into its plight? A part of the answer is that it lacked mechanisms for handling crises, that its members have diverged hugely and that it was blighted by its early successes.
The easy credit conditions and low interest rates of the first decade delivered property bubbles and explosions of private borrowing in Ireland and Spain, incontinent public borrowing in Greece, declines in external competitiveness in Greece, Italy and Spain and huge external deficits in Greece, Portugal and Spain. When financial markets panicked, borrowers suffered “a sudden stop”, which caused cascading crises of illiquidity and insolvency for sovereigns and banks. The eurozone has been running to catch up. But the crisis runs faster. Almost half of the sovereign debt shows heightened credit risk.
The eurozone had no mechanisms for cross-border financing of borrowers who had lost access to funds. In theory, adjustment should have occurred via the classical mechanisms: a spiral of sovereign defaults, banking collapses, slumps, unemployment, falling wages, fiscal retrenchment and all round misery. Nobody forewarned the public that such brutality lay in wait. Politicians did not understand this either. When the time came, they all flinched.
So what has to be done? The answer comes in two pairs: the first is “stocks and flows”; the second is “financing and adjustment”. Stocks refers to cleaning up the legacy of the past. Flows refer to the need to return to sustainable economic growth. Financing and adjustment refer to the how and the when of efforts to clean up stocks and restore sustainability to flows.
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