Europe’s dangerous new phase

July 18, 2011

By Lawrence H. Summers
The opinions expressed are his own.

With last week’s tumult in Italian markets, the European financial crisis has entered a new and far more dangerous phase. Where the crisis had been existential for small economies on the periphery of Europe but not systemically threatening to either the idea of European monetary union or to the functioning of the global financial system, it now threatens both European integration and the global recovery. Last week’s drama surrounding bond auctions in Europe’s third leading economy should convince even the most hardened bureaucrat that the world can no longer let policy responses be shaped by dogma, bureaucratic agenda and expediency. It is to be hoped that European officials can engineer a decisive change in direction but if not, the world can no longer afford the deference that the IMF and non-European G20 officials have shown towards European policy makers over the last 15 months.

Three realities must be recognized if there is to be a chance of success. First, the maintenance of systemic confidence is essential in a financial crisis. Teaching investors a lesson is a wish, not a policy. U.S. policymakers were applauded for about 12 hours for their willingness to let Lehman go bankrupt. The adverse consequences of the shattering effect that had on confidence are still being felt now. The European Central Bank (ECB) is right in its concern that punishing creditors for the sake of teaching lessons or building political support is reckless in a system that depends on confidence. Those who let Lehman go believed because time had passed since the Bear Stearns bailout the market had learned lessons and so was prepared. In fact the main lessons learned had to do with how to best find the exits, and so uncontrolled bankruptcies had systemic consequences that far exceeded their expectations.

Second, no country can be expected to generate huge primary surpluses for long periods for the benefit of foreign creditors. Meeting debt burdens at rates currently charged by the official sector for credit – let alone the private sector – would involve burdens on Greece, Ireland and Portugal comparable to the reparations burdens Keynes warned about in The Economic Consequences of the Peace.

Third, whether or not a country is solvent depends not just on its debt burdens and its commitment to strong domestic policies but on the broader economic context. Liquidity problems left unattended become confidence problems. Debtors who are credibly highly solvent at interest rates close to or below their nominal growth rates become likely insolvent at higher interest rates, putting further pressure on rates and exacerbating solvency worries in a vicious cycle. This has already happened in Greece, Portugal and Ireland and is in danger of happening in Italy and Spain. (See interactive graphic.)

Debtor countries can only reduce their debts by running surpluses vis-a-vis the rest of the world. If traditional debtor countries are going to start running surpluses, traditional surplus countries must be willing to reduce their surpluses or move towards deficits.

In short, the approach of lending more and more from the official sector to countries that cannot access the market at premium rates of interest is unsustainable. The debts incurred will in large part never be repaid, even as their size discourages private capital flows and indeed any growth-creating initiative. Assertions that the most indebted countries can service their debts in full at current interest rates only undermine the credibility of policymakers when they go on to assert that the fundamentals are relatively sound in Spain and Italy. Further lending at premium interest rates only increases the scale of the necessary restructuring. It is reasonable to argue that the recognition of debt unsustainability in Greece has been excessively deferred. It is not reasonable to argue that Greek reprofiling or restructuring taken alone will address a growing general confidence crisis.

A fundamental shift of tack is required towards an approach that is focused on avoiding systemic risk, restarting growth, and restoring arithmetic credibility, rather than simply staving off imminent disaster. The twin realities that Greece, Italy and Ireland need debt relief and that the creditors have only limited capacity to take immediate losses means that all approaches require increased efforts from the European center. Fortunately the likely consequence of doing more up front is lower cost in the long run.

The precise details are less relevant than having an appropriate broad approach, and of course will need to be aligned with European political reality. But the crucial elements in any viable strategy will include:

European authorities must restate their commitment to solidarity as embodied in a common currency, and the recognition that the failure of any European economy marks the failure of the European economy and is unacceptable. Towards that end they then should make these further commitments.

First, for program countries. Interest rates on official sector debt will be reduced to a European borrowing rate defined as the rate at which common European entities backed with joint and several liability by all the countries of Europe can borrow. A default to the official sector will not be tolerated so there is no reason to charge a risk premium, since charging a risk premium needlessly puts the success of the whole enterprise at risk.

Second, countries whose borrowing rate exceeds some threshold—perhaps 200 basis points over the lowest national borrowing rate in the Euro system–should be exempted from contribution requirements for bailout funds. The last thing the marginal need is to be pulled down by the weak.

Third, there must be a clear and unambiguous commitment that whatever else happens, the failure of major financial institutions in any country will not be permitted. The most serious financial breakdowns—in Indonesia in 1997, Russia in 1998, and the USA in 2008–come when authorities allow there to be doubt about the basic functioning of the financial system. This responsibility should rest with the European Central Bank with the requisite political support and cover provided.

Fourth, countries judged to be pursuing sound policies will be permitted to buy EU guarantees on new debt issuances at a reasonable price payable on a deferred basis.

These measures would do much to contain the storm. They would lead to a reduction in payments for debtor nations, protect states at risk from participation in rescue efforts or from shortfalls in market confidence, and assure that the ECB is able to continue backstopping the stability of European banks.

This leaves the question of what is to be done with sovereign private debt. Creditors gain nothing from breakdown. They have signalled that they will support an approach based on a menu of options. Some will want to sell out of their exposures at prices marginally above their current market value. Others who still regard sovereign European debts as worth par should be provided with appropriate reduced interest rate, longer maturity options Debt repurchases are a possibility if the private sector accepts sufficiently large present value debt reductions. The key standard by which any approach should be judged is the genuine sustainability of program country debt repayments on realistic assumptions.

Much of this will seem unrealistic given the terms of Europe’s debate. It seemed highly unrealistic even 10 days ago that Italy’s solvency would come into substantial doubt. If the political will can be found, the technical economics are not that difficult. But it will require a shift from politically driven arithmetic to arithmetically driven politics. The alternative to forthright action today is much more expensive action – to much less benefit – in the not too distant future. The next few weeks may well be among the most consequential in the history of the European Union.


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Bottom line: German taxpayers, take out your checkbooks . . .

Posted by rboltuck | Report as abusive

Mr.Summers, your emphasis on ‘confidence’ is worrisome. We all know by now that statements of confidence by our politicians need to taken with a large grain of salt. An emphasis on facts and transparency would serve us better. Uncoupling national sovereignty from national currency was a bad idea all along (we would never do it). We are witnessing the neccesary demise of the Euro. I say, let nature run its course. Further intervention of any sort only delays the inevitable break up.

Posted by changeling | Report as abusive

Bottom Line: Banks pay; or govts pay:

i) Banks won’t pay until 11:59 (cf. Lehman);
ii) Summers’ solution assumes banks go for (i), which is individually irrational; so,
iii) If you want a solution on Summers’ timeframe => govts + the IMF will have to cough up more money (think TARP II).

Summers’ solution is fairer, but assume banks take near-term pain over the long-run. In both scenarios, bank stock prices fall.

Posted by notRMusgrave | Report as abusive

extreme leftist policies killed the economies… aging population without any future… sad to be european… they are lazy enough to give birth… a doomed society…

Posted by Ocala123456789 | Report as abusive

Does Larry Summers know no hubris?

Larry’s economic analysis and forecast performance on the U.S. economy over the past 2 decades has been most dismal. His accomplishment in government is a subject of endless bewilderment, even outrage. After all, Larry was a participant with the failed-maestro Greenspan to deregulate financial services to the point of absurdity, and indeed promoted recklessness.

With such as sorry resume, Larry now pops over the Europe and offers his considerable ‘wisdom’ on the complex European situation. He even lectures European leadership on basic economics as if they were his students. Then he, a failed American economist, proceeds to proclaim “it now threatens both European integration and the global recovery”. Larry Summers assigns to himself the considerable genius of what will or will not sustain European integration, as if he was a founding father of the EU.

Does Larry hubris knows no bound?

Posted by TomKi | Report as abusive

Summer’s analysis is wishful thinking and beside the point. What he is advocating is effective Europianization of individual country debt. Apart from the huge moral hazard this creates in the absence of federal fiscal policies, it is not wanted politically by those who would have to provide the money. Greece and other countries if they cannot sustain participation in the common currency will have to exit until their economies have been restructured. For the rest of the Euro area the problem is not the country debt, but the stability of the financial system which would need to be protected.

Posted by Indus88 | Report as abusive

Larry Summers is part of the problem not the solution.

Posted by colt1210 | Report as abusive

The Summers 4 Point plan sounds great for the banks. I have no quarrel with Points #1, #2, and #4, but I have a big problem with Point #.

Under Point #3, banks can take any risks they wish to take and hoard the profits that those risks engender until a collapse similar to or greater than the 2008 collapse occurs and “no matter what”, those banks will not be allowed to fail.

The only way failures of great magnitude can occur without causing banks to fail is by shifting the cost of massive failures to the public.

The public needs a banking system that functions, but they also need a system that fears failure. Shifting the cost of failures to the public leaves banks and their management with unearned solvency and ludicrous bonuses and it leaves the public with poverty, reduced standards of living, austerity measures, and despair.

Mr. Summers, please step out of your academic ivory tower long enough to take a good look at the harm Point #3 has already wrought upon the American people and in the rest of the world.

You have some good ideas, but Point #3 is a deal breaker, perhaps the kindling for a future war.

Posted by breezinthru | Report as abusive

Larry summer is the man who:

1. Deregulated the US financial system
2. Blocked useful people who were trying regulate and create transparency concerning derivatives yes the same financial products that dumped the whole world into recession.
3. Was one of the responsible people arguing it be a great idea for banks to be allowed to leverage themselves up to their neck (33-1).

Cant even believe this guy is still a advisor to Obama..crazy.

As far as Europe, politician have to get their act together and just realize that mainly the countries in trouble have been living above their means for the past 10 years, and will all default in time if nothing gets done.

But with politics and economics in the mixture like this something is bound to blow up, the north isn’t going to be taking care of the south forever.

Posted by DutchChinaman | Report as abusive

A masterful discourse by Mr. Summers on what are the essential wrongs of the Euro and EU governance. Congratulations. I particularly liked the swipe at politically driven arithmetic versus arithmetically driven politics. The whole Euro edifice is built on politically driven arithmetic and has deep and valid historic roots. Mr Helmut Kohl and Mr Mitterrand decided to risk it, knowing full well they were as blind to markets and confidence as much derided leaders from autocratic countries. At the time, I agree the risk was well worth taking but with current leaders’ backgrounds, the Euro stands little chance. Just yesterday I read that in 2010 Mr Sarkozy sniped at Mr Trichet with Mrs Merkel in attendance, when Mr Trichet went about the need for systemic confidence when asking private creditors to contribute to the Greek bailout. Mr. Sarkozy’s snipe was that Mr. Trichet was listening to much to bankers, while they (Sarkozy & Co) were answerable to the public. How much more arrogant can you get? France herself is a big debtor and runs high budget deficits. Where is Mr. Sarkozy borrowing from? From people he commands to lend his country money? And how has he been explaining the budget policies of his country over the last 20 years? What does it say about our democratically elected leaders when they pursue policies dictated by political dogma rather than economic common sense? How much different are they from the Chavezes of this world? At best, they are irresponsible, at worst they are blind to free markets and the accountability of the individual. By all means punish gullible private investors but not when you were the prime driver for their gullibility in the first place. Mr. Sarkozy rode the free Euro cart of deep capital markets, low interest rates and low inflation long enough to now shoulder responsibility for the mess as well.

Posted by lisandro | Report as abusive

I find it particularly amusing how suddenly a compromise is reached just in the nick of time before we default. I honestly wonder if all the hubbub was a political ploy. It seems that way the Congress and the President bickered like abunch of adolescent young people over such vital issues like like our economy and the debt ceiling makes one wonder if anything can be done smartly prudent for the good of our nation. Quite honestly my next greatest concern will Congress and the President be able to smartly and honestly and prudently put compromise into play over the next few years.

Posted by frf | Report as abusive

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