NCPA - National Center for Policy Analysis

Will They Stay or Will They Go?

June 13, 2011

The likelihood that the euro zone will fail to avoid at least some departures, if not total collapse, reflects its poor initial institutional design.  Countries were joined together that were unlikely to be able to survive as a common currency zone, and there were no credible institutions in place to enforce long-term fiscal discipline or to coordinate the resolution of exigencies, says Charles Calomiris, the Henry Kaufman Professor of Financial Institutions at the Columbia University Graduate School of Business.

There are three distinct problems related to euro zone membership that confront the "PIIG" group of countries that include Greece, Portugal, Ireland, Italy and (depending on its bank bailout policies) Spain:

  • Over-indebtedness.
  • High deficits in combination with over-indebtedness.
  • And non-competitiveness.

These problems are distinct and pose different challenges for policy.  The relative weight to attach to each problem also differs across the euro zone countries that are currently under the greatest pressure. 

  • First, debt sustainability refers to an excessive amount of debt relative to gross domestic product, which must be addressed through some form of default and restructuring.
  • Second, high deficits add another dimension to that problem -- a country that defaults on its debt will find it difficult to fund its continuing deficits through new issues of sovereign debt into the market.
  • Also, countries with overvalued exchange rates face the difficult choice between a protracted period of recession as their wages and prices decline to restore competitiveness, or departing from the euro zone and immediately beginning their recovery.

All three of the fundamental problems listed above are severe for Greece.  It is a matter of simple arithmetic that Greece's debt is not sustainable.  Greece's deficits are also large, and it would be challenging for it to succeed in credibly promising to shrink those deficits to obtain sufficient short-term financing in arrears to avoid leaving the euro zone as it restructures its debts, says Calomiris.

Source: Charles Calomiris, "Exiting the Euro Crisis," Hoover Institution, May 26, 2011.

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