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Sovereign Debt: A Modern Greek Tragedy

May 8, 2012

Part 3: Why Is Europe Having a Sovereign Debt Crisis Now? (8:19)


Many European nations have had high debt burdens for decades, though no developed and industrialized country has defaulted since 1946. So why has a sovereign debt crisis surfaced now? Waller looks at the history of the formation of the European Union (EU), which focused on a monetary union, not a fiscal union. While it established five criteria for membership (concerning long-term interest rates, inflation, exchange rates, deficit-to-GDP and debt-to-GDP), no contingencies were made for a secession or ouster of a nation. In addition, when Greece won entry to the EU in 2000, it met none of the five criteria.

Part 1: Welcoming Remarks, Julie Stackhouse (5:44)
Part 2: The Ability vs. the Willingness To Repay Debt (14:45)
Part 4: Waking Up to the Great Shocks (6:20)
Part 5: Insuring Against Default and Higher Rollover Risk (4:54)
Part 6: Austerity Measures and the Real Default Threats (8:55)
Part 7: The Moral of the Tragedy (8:29)
Part 8: Q&A Part 1 (14:25)
Part 9: Q&A Part 2 (18:18)

More about this and other Dialogue with the Fed events »


Christopher Waller: Now, if any of you have read the Reinhart and Rogoff book, "This Time Is Different," you'll see that defaulting on sovereign debt has been done for centuries. We saw that Greece did it over 2,000 years ago. But it hasn't happened in a developed nation since roughly the end of the Second World War. So this is why the current situation in Europe is a concern. We've seen sovereign defaults in developing nations for the last 60 years, but we haven't seen it in what we would think of as a developed, industrialized country, and now we're staring at that possibility.

But here's kind of the puzzle in all this. Many of the European nations have had very high debt-to-GDP ratios for decades. I'm going to show you that Italy has been over 100 percent or around 100 percent for over 20 years. Why now has this problem surfaced? It's not news to anybody. They didn't wake up one day and go, oh, my Lord, Italy's got 100 percent of GDP. It's been that way for a long time. So here's where I'm going to kind of do a little bit of history and sort of try to tie some of these events together. After World War II the leaders in Europe vowed to never have another war fought on European soil. And so there was a very consistent policy, political movement since the early 1950s to move something towards the United States of Europe. Not maybe literally but kind of in a similar spirit. And in that, was a goal of having a single currency which we call a monetary union—one currency for all these European nations. Now, there's a second part of that which is a fiscal union. So the idea of a federal government is there is a fiscal union much like we have in the U.S. There are taxes collected at the government, federal, national level. But they don't have that in Europe. It's still at the country level. And to do that, you would have to basically give up your sovereignty.

So I've had debates with several people, but my personal view is I never thought any attempt at fiscal union was a serious goal because it literally meant giving up sovereignty, complete sovereignty, and I didn't personally ever think these countries would do it. Now, they went to a plan to merge to this single currency called the euro which we're familiar with. Now, when they decided to do this at the Maastricht Treaty in 1992, they realized that the economic performance of these countries in Europe was quite different and that the only way this currency was going to work is that they've got some convergence on some key economic variables so that these countries seem to behave very similarly, otherwise this wasn't going to work. So in the Maastricht Treaty they set up some criteria. So one of the key criteria was about long-term interest rates, that your interest rate to join this monetary union had to be within 2 percentage points of the average of the three lowest. Okay? You had to be close to the three lowest interest rate countries. On inflation, a similar thing. You had to be within 1 1/2 percentage points of the average of the three best or lowest inflation countries.

And on the exchange rate—remember, they were still running their own currencies—they had to show that they could maintain a stable currency against the rest of the European countries without a major devaluation for two years. So this was the idea. They had to get all their monetary stuff kind of in order before they could do this. Now, a few years later they realized, you know, one of the problems we've seen in history with countries that have high inflation is their fiscal situation gets out of control and governments turn to a printing press to finance their spending, and then they get a lot of inflation problems. So in '97 they added an additional couple of criteria which came in the stability and growth pack. The first was that the deficit-to-GDP ratio could not exceed 3 percent. So you could not be short more than 3 percent of your income in revenues in any given year. And on your debt, your debt-to-GDP ratio could not exceed 60 percent of the preceding fiscal year. So these were called the fiscal criteria. So I've given you five criteria that everybody was supposed to meet in order to get into the euro.

So what was the evidence? Well, I'll just show you the long-term interest rates. It's very clear kind of what happens. So the purple line here is Germany's interest rate. They've kind of been the consistently best economic performer in Europe, kind of controlling for unification. So Ireland slightly above but converges towards Germany by the birth of the euro. Here we have Italy, again, I mean, we're talking about 13, 14 percent versus six or seven. So these are big differences. Again, convergence. Portugal, convergence. Spain, convergence. Greece, ah, trying to get there. They're working hard but it's not quite happening. And a lot of the other ones I showed you look exactly the same.

Now, I spent a large part of my academic career in the 90s studying European monetary union, European economic and monetary union, and there was a big concern that if you're going to form this union and you're going to have all these criteria, how are you going to handle a country that finally says, I want out? Or you say—the big club says to one of the members, you're out. How are you going to handle that? So, including myself, many of us argue that the Maastricht Treaty like any good business plan had to lay out contingency plans and rules for exit or secession somehow. Okay? You had to plan for this orderly disillusion. Let's think of it that way. But for a lot of political reasons, this was not even on the table. It could not be brought up, was just silent. And so my RA said it's basically like this, you can't talk about divorce on your wedding night. No matter how much you know in the back of your head you may have this situation, you just don't talk about it. That will come back to haunt them, by the way, as it often does with us mere mortals.

So Greece won entry into the euro, the monetary union, taking effect in January 2001. Now, the initial starting point was 1998. They had applied for entry and they were denied because high inflation compared to that first criteria, large budget deficits, not 3 percent but 6 percent, very high—I showed you the picture—relatively high interest rates compared to everybody else. They did not participate in the ERM, the exchange rate management, they never even tried. And in 2000 their deficit-to-GDP ratio was 3.7, and their debt-to-GDP was over 100 percent. All five criteria, how many did they meet? Zero. Ah, come on in anyway.