German student Caroline Duong has won the 2011 Threadneedle Investment Award for an essay on the debt crisis in Europe and the investment implications of a Eurozone break-up.
Lessons from Latin America also show that a cut on debt is the most feasible solution, at least in economic terms.
Here, the initial rescheduling bought time for American banks to recover, but Latin America was still unable to repay its debt. Eventually, it was relieved of some of its debt burden via ‘Brady-Bonds’, which replaced original bonds under new conditions (Economist, 2011a).
Similar bonds, guaranteed by the EU would be possible in Greece, especially since around 80%-90% of Greek debt is issued under Greek law and therefore a cut of up to 50% is considered legally feasible (Wiesmann, 2011; Economist, 2011b).
Cutting Greece’s debt and guaranteeing Portugal’s and Ireland’s debt via the EFSF could avoid contagion (Unmack, 2011). European banks would suffer some losses and will need some recapitalisation by governments and in addition, the Greek government would also need EFSF funding to keep its banks afloat and so avoid a Greek banking crisis (ibid). This solution has so far been politically rejected, but in the long run it is the most realistic.
The bail-out of Portugal is quite different, though its debt levels are lower than that of Greece its economy is in even worse shape.
Portugal has severe underlying structural problems and urgently needs to reform to bring its economy back in shape (Boland, 2011). Unless it does so, high interest rates will prevail as Portuguese low productivity will prevent a real reduction of its debt-to-GDP ratio. Bailing out Portugal is necessary, but should come with strings attached to force reform and prudent fiscal policy. It, too, is challenged by low growth prospects which will continue to challenge its debt sustainability.
To regain stability of the EMU in the long run, the fundamental issues of the EMU framework must be rectified. Conditional rescue packages will bring some structural reform in individual countries, but the EU must address the inherent issue of growth convergence and consistent (Keynesian) fiscal policy. This will involve creating measures to unite European countries and overcome political resistance for the sake of economic stability.
The ultimate goal of the EMU has been to advance to an American style fiscal union with pooled debt and a central government in charge of fiscal policy. Such structural reform would establish control and stability among EMU members, providing equal cost of borrowing and would promote fiscal prudence.
Economic differences between countries would be balanced by central government spending and the surplus in booming countries used to stimulate weaker ones (Llevyllin, 2010). Fiscal union would rescue peripheral countries from years of deflation and austerity measures, and be a painful, though quick and long-lasting, solution to the EMU shortcomings. Politically, however, such a scenario is unthinkable and therefore unlikely to be put in place.
More realistically, the EU could implement an in-between step towards complete fiscal union, by establishing a central institution with governing responsibilities and authority to punish non compliance with EU targets encompassed in the Maastricht treaty and Growth and
Previously, credibility and time consistency was the greatest issue of policies dealing with fiscal prudency.
The stability Growth Pact was principally right, however practically often ignored and ultimately neither enforceable nor credible (Belke, 2010). The lack of a mechanism to override national sovereignty makes any policy a guideline rather than a rule.
In the end, any country can choose to ignore EU benchmarks and, as seen in the case of Greece, because of core economy exposure to periphery debt still be rescued.
Therefore, individual countries would not only have to embrace the fundamental rules of the EU membership, but be willing to hand over fiscal autonomy should they be unable to comply, so giving the central authority the means to enforce EU policies (ibid).
A credible and time consistent framework would also provide for equal debt quality and broadly similar cost of borrowing. A stronger fiscal union and a European Monetary Fund – essentially a permanent EFSF – equipped with credible threats and real authority would provide greater control over individual countries. Political independence would underline credibility of the EFM, reduce moral hazard and so ensure future sustainability of the EMU (Belke, 2011).