1. The Euro’s Three Crises (Shambaugh)
A banking crisis
A sovereign debt crisis
A growth crisis
Interdependence!

2. The banking crisis Initial problems
The size of euro zone banks
300% of GDP vs. 100% in the US, ING
Corporate reliance on banks
Cross-border banking
No supervision at euro zone level
No statutory lender of last resort
No euro zone bank rescue facility

3. The banking crisis US subprime contagion

4. The banking crisis Hesitant ECB reaction (39% vs. 210%)

5. The banking crisis How the two other euro zone crises worsen it:
The growth crisis
Weak economy and falling asset prices damage banks’ balance sheets
The sovereign debt crisis
Sovereign defaults bankrupt banks with sizable sovereign debt holdings

6. The sovereign debt crisis Mixed initial conditions

7. The sovereign debt crisis Loss of confidence in 2010

8. The sovereign debt crisis Markets punishing fiscal profligacy?

9. The sovereign debt crisis Markets fearing unsustainability?

10. The sovereign debt crisis Markets punishing public and private indebtedness

11. The sovereign debt crisis The problem of dual equlibria
”Good” equilibrium: A virtuous circle
Trust → Low interest rates → Small budget deficit → Sustainable public debt → Trust…
”Bad” equilibrium: A vicious circle
Lack of trust → High interest rates → Large budget deficit → Unsustainable public debt → Lack of trust…

12. The sovereign debt crisis
How the two other euro zone crises worsen it
The banking crisis
Risk of bank failures leads to higher expected public debt as a result of bank support
The growth crisis
Weak growth raises debt/GDP ratios via higher budget deficits and lower GDP

13. The growth and competitiveness crisis

14. The competitiveness crisis Hard to compete on foreign markets

15. The competitiveness crisis Hard to compete on domestic markets

16. The growth crisis Fiscal austerity leads to lower growth

17. The growth crisis Weak banks are reluctant to lend

18. The growth and competitiveness crisis
How the two other euro zone crises worsen it
The banking crisis
Weak banks with higher capital requirements slow growth through reduced lending
The sovereign debt crisis
Austerity measures imposed to reduce budget deficits weaken aggregate demand via lower public spending and lower disposable income

19. The euro zone’s three crises: Many vicious circles

20. Solving the euro crisis Shambaugh’s suggestions
Fiscal devaluation plus fiscal revaluation
Monetary policy: Quantitative easing
Recapitalization of banks
Fiscal expansion in solid countries
Banking union
Supervisory agency
Deposit insurance
Bank resolution agency

21. Solving the euro crisis Other suggestions
The dream solution: Economic growth The Baltic solution: All at once The dissolution solution: Back to square 1 The Soros (1) solution: Germany leaves The default solution: Sovereign default The Soros (2) solution: Eurobonds The realistic ”solution”: Muddling through

22. The dream solution: Growth
Higher GDP growth leads to:
Less need for public spending + higher tax revenues = Lower budget deficits
Lower debt/GDP ratios
Less private defaults = stronger banks
But unachievable because:
Low competitiveness = low foreign demand
Austerity measures = low domestic demand

23. The Baltic solution: All at once
Nominal wage cuts
Public spending cuts
Migration
Political consensus
Too late for euro zone

24. The Baltic solution 25% public wage cuts

25. The Baltic solution: Rapid gain in competitiveness

26. The Baltic solution: Migration

27. The Baltic solution: Steady growth from a lower level

28. The dissolution solution How it works
Exchange rate depreciation leads to rapid gain in competitiveness
Increased competitiveness leads to export led growth
Export led growth leads to higher employment
Higher employment leads to reduced deficits
Lower interest rates lead to stabilized asset prices
Stable asset prices lead to financial stability
This was Sweden’s and Finland’s way out of the crisis

29. The dissolution solution Is it so unrealistic?

30. The Soros (1) solution How it works
Germany leaves the euro
The D-mark appreciates
The euro depreciates
Remaining euro zone rapidly gains competitiveness and goes for the growth solution via export led growth
Economically interesting - politically unrealistic

31. The sovereign default solution
Countries with unsustainable public debt enter orderly default proceedings
Partial debt cancellation, debt restructuring, moratorium
Defaulted creditors (too big to fail) saved via nationalization
End of austerity measures – resumed economic growth
Economically interesting - politically possible?

32. The sovereign default solution Which countries?

33. The Soros (2) solution: Eurobonds How it works
Pooling of all existing euro zone public debt
= Pooling of all national sovereign risk
= Lower borrowing costs
= Lower budget deficits
= Existing debt sustainable
Conditions on further Eurobond borrowing

34. The realistic solution Muddling through
Continued austerity measures to reduce budget deficits
Structural policies to raise aggregate supply
Reduced demand and increased supply lead to
Stagnating GDP
Rising debt/GDP ratios
Higher unemployment
Financial instability
Realistic – but politically dangerous

35. Thank you for your attention!