Fiscal crisis, contagion, and the future of euro

Marco Pagano, 15 May 2010



Fiscal crisis, contagion, breakdown of the euro... Let’s try to understand what is going on. In the past few days, the scenarios discussed in the media have been changing so rapidly and dramatically that for many it may be hard to grasp the reason behind them. But in emergencies such as the one we are currently experiencing, the way to escape the worst-case scenarios and find an exit strategy is to stick to clear-headed thinking.

What happens when sovereign states accumulate large debts?

First, investors start worrying that this debt may not be sustainable: concerns rise over the ability of the state to pay back capital and interests by generating budget surpluses in the future (that is, fiscal revenues in excess of expenditures). In this case, investors require higher interest rates to subscribe new public debt as a compensation for the risk of insolvency. This in turn increases the risk of insolvency as it worsens public sector balance sheets. At some point, there may no longer be an interest rate able to compensate investors for the risk of insolvency; then they just stop subscribing the public debt. This is a situation of fiscal crisis and has only two possible (and not mutually exclusive) outcomes:

  1. government default followed by a renegotiation of the debt (as in Argentina’s case),
  2. monetisation of the debt, which is effectively bought by the central bank. This represents an injection of money in the economy and thus generates inflation and exchange-rate depreciation.

From Greece to Italy

Second, in the case of Greece, the second option – monetisation - was ruled out by Greece’s membership in the European monetary union: the Greek government could not force the ECB to buy its own bonds. For this reason, the only option was insolvency and renegotiation of the debt, unless other countries were willing to lend to Greece at an interest rate lower than the market rate. Why did euro-area countries choose to do so? In the past few days it has been clear that, following a substantial dose of indecision, they did it mainly for fear of “contagion”.

But what is contagion?

Here we come to the third and most interesting part of the story. As the Greek crisis unfolded, investors started to suspect that other countries with high levels of public debt, namely Portugal, Spain and Italy, would find themselves in a similar situation. But as governments of these countries rushed to point out, their fiscal position is not as dramatic as the Greek one.

So why are investors so concerned? Because, as economists say, in this game between sovereign states and investors there can be “multiple equilibria”. Even if the government is not highly indebted, investors might start questioning its willingness to raise taxes above a level considered “politically sustainable”. In the future, it might seek a renegotiation of the debt, its monetisation, or both. Fear that this will happen can push interest rates to a level so high that the investors’ prophecy will eventually come true. At the prevailing interest rates a country which would have otherwise been able to service its debt ends up needing a renegotiation or a monetisation of the debt to avoid full repayment (see for example Calvo 1988).

So the outcome depends on investors’ confidence. If there is confidence, the “good equilibrium” with moderate interest rates and stable markets prevails; when confidence disappears, the economy jumps to a “bad equilibrium”, where a fiscal crisis occurs. The contagion generated by Greek crisis has been exactly of this type. It has weakened investors’ confidence in countries which would have otherwise been in a safe situation. Moreover, the burden of Greek bail-out itself is affecting negatively the fiscal position of Portugal, Spain, and Italy. This too may have contributed to weaken confidence in their ability to service the debt.

Stock exchanges and speculation

The fourth element that has played a role in the crisis is “roll-over risk”. Countries involved are exposed to a fiscal crisis (the “bad equilibrium”) to the extent that they are forced to rely on the market to roll-over their debt. Thus, much depends on the amount of public debt coming to maturity in the next months. This in turn depends on the maturity structure of the public debt. If public debt mainly has a long-term maturity, then the amount of debt to be rolled-over in a certain time interval is small and the burden of a high interest rate might be sustainable. In these cases, the risk of a fiscal crisis is ruled out. If instead the debt has mainly a short-term maturity so that the amount to be rolled-over is large, then a fiscal crisis can occur, as illustrated in my paper with Francesco Giavazzi (Giavazzi and Pagano 1988). The argument is similar to the one used by banks to assess companies’ solvency. There, the roll-over risk arising from short-term maturity debt is one of the main factors in determining bankruptcy risk.

Why is the euro depreciating?

Fifth, in the last few days we have witnessed the sudden depreciation of the euro. Why is the euro depreciating? A possible answer is that as the crisis spreads to other large Eurozone countries, the risk of monetisation of the public debt becomes more concrete. Even if Greece can be bailed out by other countries in the Eurozone, this would not be feasible for the much larger public debts of Italy, Spain, and Portugal. In the scenario of a widespread crisis, the possibility that the ECB will monetise the debt of weak Eurozone countries exists, and fear of the implied inflation can explain the depreciation of the euro. However, a massive monetisation is an unlikely scenario, as it would eventually undermine price stability in the Eurozone and imply a substantial transfer of resources from strong to weak Eurozone countries.

A breakdown in the euro?

An alternative explanation for the depreciation of the euro is the fear of a breakdown of the single currency itself, a scenario that was unthinkable even a few months ago. In order to avoid having to bail-out weak Eurozone countries through debt monetisation, the strong countries might push the weak ones outside the Eurozone. Obviously, this would be a dramatic scenario, as redrawing the borders of the common currency could hardly happen without generating a financial earthquake. Meanwhile, such a crisis could degenerate into the insolvency on the public debt of several Eurozone countries, with devastating effects on the global economy. Given that the public debt of these countries is massively present in the balance sheets of banks and insurance companies all over the world, and in the Eurozone in particular, instability would spread throughout the financial system. Contagion would become really global. In comparison, the sub-prime crisis would almost pale into insignificance (see a similar discussion in Eichengreen 2007).

This explains why last week stock exchanges collapsed and why governments on both sides of the Atlantic are very concerned. However, governments’ invectives against speculators and markets are childish. The word “speculator” comes from the Latin word “specula” (watchtower) and indicates someone who tries to “look far away” and thus metaphorically “look ahead”, in other words to foresee future events. Whenever a saver decides whether to subscribe public debt bonds he also tries to “look ahead” and, in this sense, we are all speculators. And we all contribute to determine market outcomes, even when we decide to abstain from participating in them. Rather than blaming them, governments have to demonstrate that speculators and markets got their forecasts and bets wrong.

Restoring market confidence

Can the markets’ confidence be restored? As the origin of the problem lies in fiscal policy, confidence needs to be re-established there: strong and coordinated signals must be sent about the ability of the weak states in the Eurozone to put their fiscal situation in order, accepting the imposition of strong monitoring and discipline on fiscal policy by the Union’s institutions.

This implies a significant limitation on the fiscal sovereignty of member states, which comes on top of their delegation of monetary sovereignty to the ECB. But much more is needed than the fragile discipline imposed by the Maastricht treaty and by the stability pact, such as binding constraints on budget laws of member states and institutions able to enforce them.

It is not an easy task. Such a monitoring and enforcement system is difficult to put in place and politically painful to accept, as the riots and deaths in Athens demonstrate. Will governments and national parliaments be willing to do it? If the answer is “yes”, then Europe will re-emerge stronger from this crisis and will move toward completing its supranational structure with the gradual introduction of fiscal federal institutions, the natural counterpart of the ECB.

This may also offer the opportunity to finally fill the “democratic deficit” of the EU, since it is natural that binding fiscal decisions be taken by representative political bodies. In this way, the necessary limits to national fiscal sovereignty would not be seen as coming from the diktat of some technical and bureaucratic organism or ministers’ committee, as they have a supranational democratic legitimacy. If Eurozone countries have the courage to embrace this great challenge, not only will confidence be restored on security markets, but this crisis will become the occasion for a historical turning point in the development of Europe as political entity.


Francesco Giavazzi and Marco Pagano (1988), “The Management of Public Debt and Financial Markets,” in L Spaventa and F Giavazzi (eds.), High Public Debt: the Italian Experience, Cambridge University Press.


Topics: Europe's nations and regions
Tags: euro, Eurozone crisis, Fiscal crisis, Greece


Greek Restructuring or Bankruptcy

 Damaging as it might have been Greece should have been allowed to go bankrupt within the Eurozone.  The recent naive actions of the ECB and Euroepean 'leaders' have indicated panic and short-term thinking, rather than thoughtful, measured actions contributing to long-term stability.  The survival of Eurozone policitical and monetary Instituions are now threatrened by the implied open-ended committment to support and finance PIIGS's debts and junk government bonds.  The bankruptcy of the Greek government and subsequent restructuiring of Greek debts would only have directly affected some three percent of the Euro economy, True the contagion effects would have been considerable, but they could not in themselves threaten the financial viability of the ECB and Eurozone governments. European 'leaders' and the ECB have irresponsibly succeded in turning a Greek crisis into a Euro crisis by staking their credibility on the behaviousr of those they are providing incentives to behave badly... Few believe that Greece can avoid the need to  restructure its debts.  This implies continuing need for generous donors willing to overlook profligate incompetence. All this is an unacceptable incentive for others to follow Greece's appalling example.
Unfortunately the motives of some politicaians seeking to bail out Greek deficits are also suspect as their national banks are deeply involved in high-risk loans to the Greek government (for which they recieved high-interest rates) that are now threatened with a haircut. At least the Dutch and German Central Banks had the wit to oppose the ECB's purchase of junk governemnt bonds. One thing that must be learnt from the present euro-crisis is that politicians should be kept at arm length from euro-monetary decisions. A second lesson to be learnt is that politicians cannot change economic realities by actions that do not address the fundamental problems.  As for German attempts to restrict hedge fund activities, it is simply like trying to cut a hole in water with a short dagger. Once again we are witnessing valiant attempts by politicians to control the symptoms rather than tackle uncomfortable causes of the present difficulties.

A short comment

Dear Marco Pagano
I strongly agree with your opinion stated in article. Significant limitation of the fiscal sovereignty of eurozone member states, will be necessary. We have known that from the very beginning.  Europe has in my opinion three options: deeper economic and political integration leading to some-kind of United States of Europe (USE), the status-quo which implies marginalization or disintegration with adverse economic and political effects. Only the first option is feasible though hard to implement - is there enough political willingness in Europe?
Limiting the fiscal sovereignty will require the reform of the SGP with newharsh, strict and automatic excessive deficit procedure of some kind, some new automatic fiscal transfer mechanism (structural funds?) and reform of the EU budget. I would not stop here though - much deeper competitiveness-restoring structural reforms are a prerequisite for growth (the growth which could allow the amelioration of this present worst-case scenario) - labor market deregulation, the fall of the European social market model etc.
Despite of the challenges I sincerely hope that EU pushed against the wall will be able to reform itself. We just have to accept it.
Best regards
