“Debt and Credit, Growth and Crises”Bank of Spain and the World Bank

Madrid, Spain19 June, 2012

1

Greece, Ireland and Portugal likely have “unsustainable” sovereign debt levels

But not themselves of systemic importance Conversely, large peripheral countries (debtors)

and core banking systems (creditors) are systemic And the two are “joined at the hip” Implying possible non linear outcomes And even the breakup of the euro zone

2

In spite of German rhetoric, fiscal excess in small peripherals only a small part of the problem

But general fiscal indiscipline has increased exposure elsewhere and hinders a policy response

Private sector excesses, in response to financial convergence across the zone, were of critical importance

Leading to real divergences in an already “sub optimal” currency area

3

Strongly held economic beliefs, some likely wrong, but already hard wired into European institutions

Different visions of Europe Many different countries with no effective

mechanism for resolving disputes No ex ante mechanisms for either bailouts or exit A “democratic deficit” that hinders leadership and

promotes division Leaving the impression that policy is always

“behind the curve”

4

Short term challenges: meeting contagionRing fence large peripheral sovereigns and core

banksAvoid “triggering events” until ring fencing is

adequate Long term challenges: reducing contagion

Fiscal and financial oversight must move to the centre

Structural reforms affecting growth and “competitiveness”

5

ECB could buy sovereign paper in required quantities, but conflicts with perceived mandate

EFSF and ESM could also buy sovereign paper and/or recapitalize banks, but too small

Initially many schemes for leveraging the EFSF, but non-starter

G 20 could help but many constraints

6

Work with G20 to minimize global shocks Having mismanaged Greece, need to convince

markets that Greece is unique among small peripheral countriesDebt restructuring does not imply leaving the euro

zoneMeasures to ring fence are adequate But restoring confidence remains a “horse

race”

7

A permanent “transfer union” is not politically possible

Going back to the original framework is also not possible; fundamentally flawed

Must build stronger European institutionsTo allow euro zone bond issuesTo curb excesses which threaten banking systemsTo better manage future crisesBut confront “should, could and would” problems

8

All countries would benefit from structural reforms to promote growth and deal with assymetric shocks

Debtor countries must focus on tradables Creditor countries must focus on non tradables All members must embrace the full implications of

being in a monetary union But again confront “should, could and would

problems”

9

An orderly outcome as confidence comes back on the basis of measures announced end June

A disorderly outcome with a widening crisis eventually prompting required policy action

A very disorderly outcome as the crisis widens without an adequate policy response

With serious implications for the future of the euro zone and the broader global economy

10