by Jacob Funk Kirkegaard, Peterson Institute for International Economics
Testimony before the US Senate Foreign Relations Subcommittee on European Affairs
November 2, 2011
Senator Shaheen, members of the subcommittee, it is a pleasure to testify before you today on the European debt crisis and its strategic implications for the Transatlantic alliance.
The European debt crisis is characterized by an extreme degree of complexity, as the correct diagnosis is not one, but at least four deep, overlapping, and mutually reinforcing crises—a crisis of institutional design, a fiscal crisis, a crisis of competitiveness, and a banking crisis.
None of the four crises can be solved in isolation, and no single comprehensive solution to end the crisis promptly is available to EU policymakers, meaning the drawn-out inconclusive crisis containment efforts witnessed in Europe since early 2010 will continue.
At their summit last week, euro area leaders agreed on a new set of measures, which while inadequate in scope to end the crisis and calm financial market volatility, will help mitigate a new dramatic economic deterioration in Europe. The risk of catastrophic spillovers from Europe to the US and global economy has therefore been reduced.
The euro area has agreed to a voluntary bond swap with private holders of Greek government debt resulting in a 50 percent reduction in the nominal debt value. This is an urgently needed measure, which however will not independently restore Greek fiscal solvency. Meanwhile, as concerns over fiscal sustainability in the euro area stretches also to Italy, a country "too big to bailout," the principal challenge is how to avoid contagion and how to ring-fence Greece so as to avoid a generalized undermining of the "risk free status" of euro area government debt.
To achieve this goal, substantial financial support will in the years ahead have to be made available to Greece, as well as Ireland and Portugal. Such resources should overwhelmingly come from the euro area, with a component provided by the International Monetary Fund (IMF). Ultimately, though, euro area fiscal stability will only be achieved through longer-term domestic consolidation and reform efforts, particularly in Italy.
The Greek debt swap is a voluntary transaction that looks unlikely to trigger sovereign default swaps. Apart from the superficial political pride European leaders can maintain by being able to rhetorically deny that a euro area default has taken place, a potential short-term source of dislocation in the financial markets has hereby been removed, as little is known about the extent of the gross CDS exposure to individual financial institutions, including those in the United States—although the net outstanding contract value of Greek credit default swaps (CDS) amounts to less than $4 billion.
However, the lack of payout after a 50 percent reduction in debt may ultimately lead to the demise of the sovereign CDS product class for at least industrialized nations. Financial markets will be certain in the future to doubt whether any advanced economy sovereign debt restructuring will trigger CDS protection. Given the multiple hedging purposes for sovereign CDS, this may ironically lead to increased financial market volatility in the future, including here in the United States.
Euro area leaders secondly agreed to raise the capital requirements in banks to 9 percent core tier 1 equity and adjust for the effects of market prices of sovereign debt. This is a helpful further step, which will also help insulate US financial institutions against the risk of sudden bank collapses in Europe but will not make Europe's banking system "stable and well capitalized." Substantially more new capital and an end to the solvency concerns surrounding several euro area sovereigns themselves will be required to restore market confidence in the stability of the European banking system.
Thirdly, euro area leaders agreed on two options to boost the financial firepower of the European Financial Stability Facility (EFSF). Both are, however, almost certain to fail. Option one, "to provide credit enhancement to new debt issued by Member States"1 is meaningless from a systemic euro area stability point of view. When the overlap between the insurer and the insured is as big as in the euro area, the beneficial financial effects will be minimal.
Option two foresees the creation of special purpose investment vehicles open to investments from "private and public financial institutions and investors." However, few if any such investors exist with the willingness and ability to invest the hundreds of billions of euros required to make a material difference for European financial stability. China will not bail Europe out and certainly, it would not be prudent use of US taxpayers' money to contribute, just as the statutes of the IMF in all probability will prevent it from participating.
Fortunately though this does not matter, as the EFSF's principal purpose is political not financial. The two EFSF options described are a smokescreen created to provide political cover for the European Central Bank (ECB) to remain directly involved in the European crisis stabilization measures. This is critical, as only the ECB commands the resources to stabilize Europe.
Europe is America's largest trade and investment partner, and extensive cross-ownership of large financial institutions exists. It is consequently inescapable that the US domestic economy will experience a further negative external shock from any rapid deterioration of the European debt crisis.
However, the possible direct actions by US policymakers have been limited by the fact that it is, despite increasing global spillover potential, still at heart a domestic economic crisis inside another sovereign jurisdiction. The ability of the US government to bilaterally affect the outcome of the European debt crisis is consequently and appropriately limited.
Yet, since the beginning of the euro area crisis, US government representatives have exercised important indirect pressure through multilateral channels, especially the IMF and the G-20, to expedite the European crisis resolution process and push it in generally beneficial directions.
The debt crisis will lead to substantial changes in European political, economic, and defense potential. The crisis will with certainty lead to a more institutionally integrated euro area, potentially enabling a more coordinated projection of the continent's remaining capabilities, in turn potentially creating an enhanced European partnership role for the United States. The fact that the United Kingdom is unlikely to be part of a deeper integration of the euro area will, however, especially from the perspective of the United States, be a complicating factor.
The multifaceted character of the European crisis ensures that it will only be solved through a lengthy and volatile process. Yet ultimately Europe's crisis can and will be solved through the use of overwhelmingly European financial resources.
I thank you for the opportunity to appear before the Subcommittee today and look forward to answering any questions you might have.
The remainder of my written testimony provides additional background information concerning the complex origin of the European debt crisis [provided in previous Congressional testimony, "The Euro Area Crisis: Origin, Current Status, and European and US Responses"].
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Policy Brief 11-13: Europe on the Brink July 2011
Working Paper 11-2: Too Big to Fail: The Transatlantic Debate January 2011
Book: Transforming the European Economy September 2004