EURO CRISIS

Is Europe heading for a meltdown? ... This financial crisis is worse than the sub-prime crash of 2008 because the sums are so much bigger and it is governments that are in dire straits. Edmund Conway explains the dangers. Mervyn King, the England Governor, summed it up best: "Dealing with a banking crisis was difficult enough," he said the other week, "but at least there were public-sector balance sheets on to which the problems could be moved. Once you move into sovereign debt, there is no answer; there's no backstop." In other words, were this computer game, the politicians would be down to their last life. Any mistake now and it really is Game Over. Or to pick a slightly more traditional game, it is rather like a session of pass-the-parcel which is fast approaching the end of the line. As the money crisis seems to grow worse in Europe, we have begun to wonder if there are parallels to the 1907 financial panic in the United States that gave rise to the Federal Reserve. The dominant social theme way back then (assuming an active power elite, and we do) was along the lines of "The US banking system is too fragmented and a lender of last resort is badly needed." JP Morgan assembled his rich friends in the library of his exquisite New York mansion and bailed out the market, but only six years later, the Federal Reserve was born, the bastard child of false market-insolvency rumors and a knobby-nosed father (Morgan, himself). There is, in fact, still speculation today that Morgan's camp planted the initial rumors of instability that swept the market and triggered the crash of 1907. Why on earth would he do such a thing? To generate the eventual result: the creation of the Federal Reserve and its passage by the US Congress. This is one perspective, anyway, the "paranoid one" that you will not find in most mainstream history books or college texts. Back to our larger theme. We have written in the past (see IMF Plotting Gold Backed SDRs) that we did not see how on earth the power elite was going to get from fairly abstract monetary concepts like SDRs to an actual worldwide consensus for a more globalized currency (and a global warming "carbon" currency seems, as well, to be a non-starter, at least currently). In fact, we have speculated that the elite could decide on a gradualist approach, setting up a thesis/antithesis dialectic between global money and regional money to move the conversation gradually in the direction of a worldwide currency. But perhaps there is a faster way. Let us see ... The European financial crisis started with Greece and, it's true, Greece's problems are moderate ones for the EU given its size and amount of debt. But this crisis has not been resolved despite the supposed US$1 trillion that has been set aside to discourage "wrong way" speculation in Greek debt. We saw yesterday that the larger market was up because of statements from Chinese leaders that they were not going to sell euros and were perhaps to continue to be a net purchaser. So this is what market confidence has come to: China, a rigid, neo-communist state with a raging property inflation problem is seen by "the market" as a lynchpin of the Western capitalist system. What a hoot. You can't make this stuff up. Anyway, from our perspective, a hypothetical path to a world currency (with some speed) would involve certain very specific elements. It would include, obviously, a very serious sovereign wealth crisis spreading from country to country thoughout at least the Southern half of Europe. This crisis, hypothetically, would be averted by heroic Brussels bureaucrats but not before a significant amount of financial pain was inflicted good and hard as H. L. Mencken might say. It might even involve the dissolution of the euro and the shrinking of the EU itself. But the pay-off for the power elite would be the

ability to float a scenario that proposes a worldwide currency to avert additional difficulties going forward. Here's some more from the article excerpted above: Strip away the details the breakdown of the euro, the crumbling of the Spanish banking system to take just two and what you are left with is the next leg of a global financial crisis. Politicians temporarily "solved" the sub-prime crisis of 2007 and 2008 by nationalising billions of pounds' worth of bank debt. While this helped reinject a little confidence into markets, the real upshot was merely to transfer that debt on to public-sector balance sheets. This kind of card-shuffle trick has a long-established pedigree: after the dotcom bust, Alan Greenspan slashed US interest rates to (then) unprecedented lows, which helped dull the pain, but only at the cost of generating the housing bubble that fed sub-prime. It is not so different to the Ponzi scheme carried out by Bernard Madoff, except that unlike his hedge fund fraud, this one is being carried out in full public view. The problem is that this has to stop somewhere, and that gasping noise over the past couple of weeks is the sound of millions of investors realising, all at once, that the music might have stopped. Having leapt back into the market in 2009 and fuelled the biggest stock-market leap since the recovery from the Wall Street Crash in the early 1930s, investors have suddenly deserted. London's FTSE 100 has lost 15 per cent of its value in little more than a month. The mayhem on European bourses is even worse, while on Wall Street the Dow Jones teeters on the brink of the talismanic 10,000 level. It is obvious that the sovereign crisis can inflict considerable pain. And it seems to have just begun. Yet perhaps our scenario is too simplistic, too conspiratorial. We ourselves have maintained that the problems with the EU and the euro are probably in excess of whatever the elite had expected and they did expect a crisis of this sort, one that was supposed to drive the EU into a closer political union. The idea, however, that the power elite could engage in cold-blooded manipulations of whole countries is fairly difficult to countenance. On the other hand, there are historical speculations that JP Morgan, at the height of his wealth, controlled in some sense up to half of the profitable enterprises in the United States. Wealth can be concentrated and great wealth begets wealth, especially because the current fiat money system that tends to collapse the middle class. Assume somehow that the unrolling sovereign crisis is indeed a prelude to a fear-based promotion seeking a worldwide currency (and perhaps some sort of worldwide central bank to go along with it) and one begins to see the outlines of an especially audacious dominant social theme. Perhaps this theme would be buttressed with other fear-based promotions local and regional wars, even confrontations that utilize small nuclear devices. We're just speculating here, of course, for our window on power elite activities extends only to a modest comprehension of how elite promotions might operate. Yet even in stating this, we should also point out that these themes are promoted by a vast array of institutions media properties, think tanks, NGOs and assorted non-profits, not to mention governmental entities. To accept the idea of dominant social themes is to accept that the elite has tremendous influence worldwide and especially in the West. We're past that point of course. We do accept it. We would also point out that to try to force the issue now of a truly global currency would be audacious in the extreme. Citizens of the Anglo-American axis are up in arms over the poor economy and Europe is smoldering as well. Never has a sociopolitical awakening swept the West as it has now courtesy of the Internet and its continual truth-telling. There is more and more anger over central banking, the West's serial wars, the over-taxation and the general dysfunction of regulatory democracy.

Does what we have proposed skirt the fringes of reality? If the powers-that-be were ready to tolerate a protracted series of sovereign crises in Europe and it may be there is not much more to arrange -alongside perhaps some unsettling wars, it might be possible to traumatize citizens of the West enough to make them amenable to global solution. This solution in our estimation might include the return to some sort of gold standard, but unfortunately not a market-based one. The elite would try to insist on a standard that it could in a sense control and continually manage at least in our opinion.
While the world has been transfixed with Japan, Europe has been struggling to avoid another financial crisis. On any Richter scale of economic threats, this may ultimately count more than Japans grim tragedy. One reason is size. Europe represents about 20 percent of the world economy; Japans share is about 6 percent. Another is that Japan may recover faster than is now imagined; that happened after the 1995 Kobe earthquake. But its hard to discuss the world economic crisis in the past tense as long as Europes debt problem festersand it does. Just last week, European leaders were putting the finishing touches on a plan to enlarge a bailout fund from an effective size of roughly 250 billion (about $350 billion) to 440 billion ($615 billion) and eventually to 500 billion ($700 billion). By lending to stricken debtor nations, the fund would aim to prevent them from defaulting on their government bonds, which could have ruinous repercussions. Banks could suffer huge losses on their bond portfolios; investors could panic and dump all European bonds; Europe and the world could relapse into recession. Unfortunately, the odds of success are no better than 5050.

Europe must do something. Greece and Ireland are already in receivership. There are worries about Portugal and Spain; Moodys recently downgraded both, though Spains rating is still high. The trouble is that the sponsors of the bailout fund are themselves big debtors. In 2010, Italys debt burden (the ratio of its government debt to its economy, or gross domestic product) was 131 percent; that exceeded Spains debt ratio of 72 percent. Debt ratios were high even for France (92 percent) and Germany (80 percent). As these numbers suggest, theres no automatic threshold beyond which private investors refuse to buy a countrys debt. Germany and France are considered sound investments, deserving low interest rates, because their economies are judged to be strong. But investor perceptions and confidence can dissolve in a flash. If private markets lost faith in, say, Italy or Belgium, even the enlarged bailout fund probably wouldnt be big enough to rescue them. The whole scheme is about debtors lending to debtors. It could collapse if investors conclude its unworkable, dump bonds, and demand higher interest rates. What would happen then is anyones guess. Defaults? A banking crisis? Some countries abandon the euro? (This sounds simple; in practice, it would be immensely complex.) The European Central Bankthe continents Federal Reservebuys vast amounts of government bonds? The International Monetary Fund organizes a bailout, financed heavily by China, to rescue Europe?

Europe has arrived at this dismal juncture driven by three forces: (a) large welfare states that were too often financed with debt; (b) the financial crisis that led to recession and has pushed some countries (Ireland, Spain) to aid their banks; and (c) the perverse side effects of the single currency, the euro. The euros role is especially ironic. Adopted in 1999and now used by 17 nationsthe euro was intended to promote prosperity and political unity. Countries could enjoy similarly low interest rates and the convenience of common money. It seemed to work for awhile. But low interest rates in countries like Greece, Spain, and Ireland encouraged unsustainable booms or housing bubbles that, when burst, aggravated recession and budget deficits. Now unity has turned to discord. Countries that back the debt bailoutparticularly Germanyresent the possible costs; countries being bailed out resent the harsh austerity thats imposed as a condition of aid. There is a fragile debtor-creditor consensus that could crumble, posing yet another danger to economic recovery. Its understandable that the scale of human suffering, physical destruction, and nuclear hazards in Japan compel our attention. But we ought to remember that the greater menace to global stability and prosperity lies halfway around the world.

THE EURO IN CRISIS GLOBAL & REGIONAL IMPLICATION Despite unprecedented support from the European Union and the IMF, the euro crisis that began in Greece has quickly engulfed Europe and now threatens the future of the euro. The euro crisis strikes at the heart of the worlds largest trading block and will have ramifications on the rest of the world, from the United States to emerging economies like Turkey and India. In an event hosted by Carnegie Europe, Carnegies Uri Dadush was joined by His Excellency Jaimini Bhagwati, Indian ambassador to the European Union and to Belgium, and Sinan lgen, Visiting Scholar at Carnegie Europe and chairman of the Istanbul-based Centre for Economics and Foreign Policy Studies (EDAM), to discuss the effects of the crisis on the world economy and on its trading partners. The discussion was moderated by Carnegie Europes Fabrice Pothier. Causes of the Crisis Soaring Confidence: When Greece, Italy, Ireland, Portugal, and Spain (GIIPS), joined the Euro, interest rates declined and the expectation was that their economies would converge with those of richer countries in Europe, in terms of both income and stability. However, though incomes rose, Dadush explained, expectations ran ahead of reality and these economies remain today less stable than the European core. Loss of International Competitiveness: The surge in domestic demand that accompanied Euro adoption caused prices of domestic services to rise relative to internationally traded products and of labor to rise relative to productivity. Inadequate Policy Response: When interest rates fell and growth accelerated, governments increased their expenditure. In Greece, fiscal management was disastrous. Although competitiveness deteriorated, structural reforms tended to lag. Ultimately, Dadush argued, the underlying rate of GDP

growth, which was driven excessively by domestic activities, was not sustainable, and the fiscal problems escalated. Global Impact: The View from Turkey and India Turkey: Turkey escaped the crisis relatively unharmed, and while growth decelerated in 2009, it soon rebounded. Effective oversight of banks, as well as the implementation of a strong regulatory policy, resulted in few problems in the banks. A primary budget surplus helped weather the storm. However, Turkey is now concerned by sustainability of its growth given the health of its EU trading partners, lgen explained. It recognizes that the crisis could lead to a more introverted Europe, diminishing the prospect of Turkish membership in the EU. India: When the 2008 U.S. financial crisis caused problems in Europe and throughout the world, trade credit in India began to dry up. The Indian Central Bank had to help, but the governments large fiscal deficit and debt deterred adoption of large scale fiscal stimulus. The fall in trade depressed demand for Indias exports, though since Indias economy remains heavily dependent on domestic demand, this effect was modest. On the other hand, India which is heavily dependent on imported oil - benefited from the large drop in oil prices from $140 a barrel, to $40 a barrel during the worst of the crisis. DOWN GRADING OF CREDIT RATING OF EUROPEAN COUNTRIES Country Portugal Italy Ireland Greece Spain Fitch AAAAAABBBAAA Standard & Poor's AA+ AA BB+ AA Moody's Aa2 Aa2 Aa1 A3 Aaa

The Meanings of the Ratings Moody's Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 S&P AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ Fitch AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ Speculative/Substantial Risk Moderate Credit Risk Upper-medium Grade Assessment Best Quality High Grade

Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca -

BB BBB+ B BCCC+ CCC CCCCC D D D

BB BBB+ B BCCC CCC CCC CCC DDD DD D In Default Very High Risk High Risk

EURO BASIS SWAP

The premium European banks are paying to borrow in dollars through the swaps market is at the most extreme level since the credit crisis of 2008, signaling the rout in equities may have further to go, according to Christopher Street Capital. The CHART OF THE DAY shows the cost of converting euro-based payments into dollars as measured by the three-month cross-currency basis swap, which CSCs Conor Howell said is key for measuring the true euro-zone liquidity crunch. It last week fell as much as 93 basis points below the euro interbank offered rate, or Euribor, indicating a higher premium to buy the greenback.

We are in large European bank failure zone anywhere over minus 150 basis points, said Howell, head of ETF trading at CSC in London. This is driving the equity market. Since the banks are on everyones radar right now this is certainly something you would want to have up on your screen. Banks have led an 18 percent drop in the

benchmark Stoxx Europe 600 Index from its high this year on Feb. 17, extending a global rout that has wiped out more than $6 trillion in equity value since July 26. The selloff prompted France, Spain, Italy and Belgium to impose bans on short selling after Societe Generale SA fell the most since 2008. If we go anywhere near minus 150 basis points we are in trouble, Howell said. It will mean central bank cooperation is just not working. The Federal Reserve pledged last week to keep interest rates near zero through at least mid-2013, though stopped short of initiating further large-scale asset purchases to inject liquidity.

Black Death
The "Black Death" of debt crisis across the euro zone will hurt China by sapping demand for exports, although Beijing's relatively small holdings of euro assets will limit any damage to foreign exchange reserves, the nation's top official newspaper said on Monday. The bleak diagnosis for the euro's prospects appeared in the overseas edition of the People's Daily, the top newspaper of China's ruling Communist Party, in a commentary by a former central bank official and an economist for the state-owned China Development Bank. The commentary in the People's Daily does not reflect a definitive view from China's top leaders, but it suggests the euro zone's successive crises have stirred anxiety and debate in Beijing about the impact on China. "The euro debt crisis has now been going for nearly two years since the end of 2009, and the sovereign debt crisis has spread like the Black Death of the fourteenth century across the euro zone countries," said the commentary, referring to the rodent-borne pandemic that devastated Europe. The commentary came days before French President Nicolas Sarkozy is due to meet Chinese President Hu Jintao in Beijing for impromptu talks that will probably focus on the recent turbulence in global financial markets. "The spread of the euro debt crisis will not have as large an impact on our country's foreign exchange reserves as the U.S. sovereign debt downgrade, because euro assets make up far less of our country's foreign exchange reserves than the dollar," added the authors, Zhang Zhixiang, a former head of the People's Bank of China international department, and Zhang Chao, an economist for the China Development Bank. "But the euro debt crisis will lead to a decline in real demand that will have a far-reaching impact on our country's real economy," they wrote. About a quarter of China's record foreign currency reserves of more than $3 trillion are held in euro assets, analysts estimate. RESTORE CONFIDENCE It was not clear, however, that the commentary signaled China would take a tougher stance in discussions during Sarkozy's visit. Wang He, a researcher with a Chinese government think tank, said Sarkozy and Hu have a shared interest in portraying Europe's troubles as manageable. "Neither leader will miss the opportunity to voice their joint commitment to stabilizing global markets, and that should help to restore investment confidence to some extent," said Wang, who studies European economics at the Chinese Academy of Social Sciences. He also played down the likelihood of Europe's crisis spinning out of control.

"I don't expect Europe to solve its debt problem overnight, but we must see that Europe has the financial capability to prevent it from spreading like a disease," he said. "It is certainly overly pessimistic to say that the euro zone is falling apart." The 27-member EU bloc is China's biggest trade partner, with bilateral trade in goods in 2010 reaching 395 billion euros ($570 billion), a rise of 13.9 percent, according to EU statistics. Chinese exports to the EU reached 281.9 billion euros in 2010, a rise of 18.9 percent on 2009. Chinese leaders, including Prime Minister Wen Jiabao, have repeatedly expressed confidence that debt-laden European countries can overcome their problems and return to healthy growth. During a visit to Germany in June, Wen said his country could buy the sovereign debt of some troubled euro zone nations if needed. But the People's Daily said the euro zone's problems reflected deep-seated institutional failings that needed to be overcome for Europe to recover confidence and strong growth. "The euro zone should reform the institutional constraints to economic development, and show a responsible attitude regarding the links between their countries' and their region's economic development and global economic and financial stability," wrote the two economists. ($1 = 0.694 Euros)

Indian Stock Market Outlook Fundamental and Technical analysis

Indian stock Market closed at a high of above 18000 after two and half years bringing cheers to many stock market investors Last couple of years, starting Jan 22, 2008 have been quite tough Sensex had dipped to 8000 levels from a high of 21000 and we are now back at 18k. So, how does the future look ? Here is my analysis based on certain fundamental & technical analysis. The Indian Benchmark Indices made a short-term low on May 25, 2010 at the levels of Sensex 16022 and Nifty 4807. This slump was led by the breakdown of markets from the highs of Sensex 17970, during the first week of April. As most of us know, this bout of correction was triggered by the Greece Lled European crisis. However, the much-needed rescue package announced by the EU-IMF combo has soothed the nerves of the panicky investors and has fuelled a sharp rally in the Indian markets overtaking the April highs at Sensex 18000 levels. This rally comes at a time when other global indices (including China) are still lurking at lower levels, down from their recent peaks.

What would be Markets Next Course of Action? The usual methodology of working of equity market is that they have almost always factored in the current flow of news and analysis. The future market movement will, more over, depend upon the outcome of the unknown events and predications. Thus, the near-term market movement from here could well be determined by the following 4 factors that could provide a new sense of direction for the key indices:

1. Progress in Monsoon 2. Need for Earnings Momentum 3. Pan out of European Crisis 4. Global Market Cues Even if all these 4 events pan out at reasonable levels, markets may well take a positive cue from the action of the news flow without awaiting the final outcome of the said events. Progress in Monsoon Markets seem to have partially discounted the likelihood of a good monsoon for this season. Further, expectations are built that a favorable monsoon season would play a crucial role in dampening the double-digit (10.55% in June) inflation by the end of this calendar year. A good monsoon will also help in bringing down the price of food articles. In fact, analysts arepredicting a bumper crop this year with the prospects of good rains. Lower inflation will also tend to give extra leeway to RBI in terms of adjusting its monetary policy. Need for Earnings Momentum Markets cannot remain decoupled from the earning prospects of the corporate world for long. Sentiment has to take a backseat sooner rather than later. If the corporate earnings are not as per the markets expectations, it will come up for punishment.Over the last few quarters, corporate India has managed to register robust earnings performance on the back of lower base that prevailed during the recession a couple of years ago.Some amount of fatigue is likely to seep-in starting from June quarter results, as the Indian growth story settles for a time-wise consolidation. Higher inflation, cost pressures, resurgence of high attrition levels and lack of base effect advantage could all take a negative toll on the operational and input costs. Pan out of European Crisis Although the concerns about the European crisis seem to have subsided for the time being, the pressures and negative news flow are likely to crop-up on a periodic basis. In latest, the crisis in the southern Europe flared anew as Portugal suffered a cut in the credit rating of its governments debt by two notches from Moodys Investor Services. The rating agency has said that the Portugal government would remain relatively highly indebted for the foreseeable future. Thus, if the global markets are to again catch a flue on account of the Europes debt drama, it is unlikely that Indian markets would be able to maintain its upward journey for long and is likely to float based on broader global cues. Global Market Cues Global market cues just cannot be wished away, even as we remain partially disconnected from the same for the time being. Some analysts have come out saying that Indian markets may have decoupled from the global cues and reliance. But, I tend to strongly disagree with the notion. Once the global cues go full swing with a unilateral medium-term trend (on either sides), it is unlikely that Indian markets will be able to show resistance by moving in a different direction than that of the world markets. Liquidity and global cues are the driving forces of the stock market direction, in current times.

What is the Technical Outlook? Ok, we have never done Technical Analysis on trak.in here, but here is a start Ive attached the daily chart of Nifty inscribed with my personal views and analysis based on the market movement.

A Summarized Analysis of the Above Chart Patterns: Red Line: The red line sketched above is a stiff resistance zone for the Nifty situated at around 53805400 levels. This zone has twice proved to be a hurdle since the month of April 2010 during the first week of April and second half of June. We can comfortably term this resistance line as a breakout zone for the markets, from the technical perspective. Blue Line: The blue line drawn above is a near-term support zone situated at around 5225 levels, a place where markets took support for back-to-back 5-6 trading sessions in the first week of July. It implies that buying support emerged at such levels and traders are expected to fight it out to protect their interests if markets approach this zone again. Higher Tops and Higher Bottoms: The pink and green circles on the above charts indicate the scenario of higher top and higher bottom. This pattern reflects the market movement in which it takes support at levels higher than the previously established lows and moves towards an upward trend to capture a level which is better than the previously established high. PS: The above chart shows as to how Nifty has pierced an all-important resistance zone of Nifty 5400 level. But, one cannot completely rule out a case of false breakout a situation in which traders latchon to a deceptive move about the market movement and get duped into entering into a wrong positional bet.

The Euro Crisis In One Chart

On this side of the pond, we usually pay as little to attention to Europe as possible. Thats because traditionally, weve found that if leave them alone to enjoy their cheese and gothic cathedrals and thick-cabled social safety net, theyll leave us to enjoy our MMA and NFLand SUVs.

But lately, the U.S. stock markets have gotten pretty worked up in part because of the ongoing financial crisis on the continent, where worries have spread from miniscule parts of the euro zone to core countries such as Spain, Italy and even, to some extent, France. But what exactly is happening? This chart pretty much sums it up. It basically shows borrowing from the European Central Bank Europes Fed from banks in various different countries.

ECB and BofA Merrill Lynch Global Research

As you can see there have been sharp upticks in ECB from Italian banks recently. The implications is that these banks cant get the funding they need out in the marketplace. Why? Well it would seem that lenders think theyre too risky. Well, why do they think theyre too risky? In part because Italian banks own a ton of Italian sovereign bonds. Those same bonds that until the ECB stepped in to prop them up had been losing value quickly in the market as investors became more worried about Italian government finances. Essentially, you can see the decline of Italian government debt prices as potentially the erosion of the capital base of Italian banks. If banks dont have a big enough capital base, they cant lend. And if they cant lend, well, what the heck do they do? On the bright side, these banks can go to the ECB to get the cash they need to stay in business, which is good. On the dark side, this shows that the short term funding markets those crucial pipes of the global financial plumbing system have not been working well in Europe. The Euro is not behaving like a currency in crisis. Currencies in crisis typically undergo dramatic devaluations vis--vis the currencies of their main trading partners. As Chart 1 below shows, this is not the case for the Euro. While the Euro in 2010 was some three percent below its 2007 average level vis--vis the US dollar, this is hardly a

cataclysmic collapsefar smaller than the depreciation of the British pound or the Russian rouble during the same period. While the Euros depreciation against the dollar during 2008-2010 was somewhat larger (nine percent), this can be seen as a correction on the Euros previous over-valuation: during 2001-2008, the Euro had appreciated against the dollar (in nominal terms) by nearly two thirds. The Euros depreciation since mid-2008 can therefore be seen as a long-awaited correction, helping to make European exports more competitive and thereby moderate the impact of the crisis on European GDP. And since this depreciation occurred at a time of global disinflationary pressures, the weakening of the Euro did not have a significant inflationary impact in the EU.

Fiscal policy, and banking/financial market regulation, is the Euro zones real problems. The financial instability experienced by Euro zone countries during 20092010 was triggered in large part by fiscal policies that violated the EUs Stability and Growth Pact, which requires member states to hold public deficits and debt below three percent and 60 percent of GDP, respectively. As the data in Charts 2 and 3 show, the Euro zone countries were on average not in compliance with the Pacts public debt criterion in 2007, before the global financial crisis began. Fiscal balances deteriorated dramatically across the Euro zone in 2008-2009; and despite some progress in reducing budget deficits, public debts grew further in 2010.

These debts and deficits should not be demonized: they reflect attempts by Eurozone governments to use the fiscal space at their disposal to boost domestic demand and lessen the macroeconomic and socio-economic impact of the crisis. Thanks to this fiscal activism, GDP, employment, financial stability, social protection, and public services were maintained at higher levels than would otherwise have been the case. Moreover, at least some of the fiscal red ink associated with the nationalization of bank and companies can be recouped in the future, when shares acquired by governments at fire sale prices during the depths of the crisis can be sold off at a profit. However, this fiscal splurge placed inordinate strains on budget balances across Europe. These strains are also afflicting EU countries that are not in the Eurozone (like the UK) and even European countries like Iceland, which is not (yet) an EU member state. Indeed, as the examples of the UK and Iceland illustrate, being outside the Eurozone offers no protection against the consequences of fiscal excess. Instead, growing numbers of European economiesboth within the Eurozone (Greece, Ireland) and outside it (Iceland)are now caught in debt traps: they are unable to borrow enough on domestic and international bond markets to service and repay their existing public debts. As a result, they have had to turn to the IMF, European Commission, and European Central Bank (ECB) for financial assistance. But irrespective of whether they request such support, many European countries now face the unpleasant prospect of years of fiscal austerity. The sad fact is that fiscal policies in many European countries are today neither sustainable nor credible. In addition to the short-term debt and deficit strains generated by the fiscal response to the crisis, many European countries face serious longer-term fiscal challenges, driven by the economics of shrinking, aging populations and rising public health care costs. These fiscal problems can not be laid at the door of the Euro; they would be present even if the Euro had never been introduced.

Maybe the creation of the Eurozone made these fiscal problems worse, helping to bring matters to their current pass? Some commentators have argued that Euro adoption and the associated virtual disappearance of exchange-rate risk for Eurozone periphery countries (Greece, Portugal) caused interest rates in these countries to fall too far (typically from the 10-15 percent range to the two-five percent range) too fast.[3] Excessive borrowing by the private as well as the public sector ensued, creating unsustainable real estate and stock market bubbles. The popping of these bubbles in 2008 then precipitated banking crises and financial meltdowns, the resolution of which further widened public debts and deficitsparticularly in countries with relatively large financial sectors (the UK, Iceland, Ireland). While there is something to this argument, it faces two weaknesses. First, the reduction in interest rates that followed the creation of the Euro also reflected falling inflation across the Eurozone. Lower inflation and especially interest rates should help, not hurt, fiscal and financial balance. Second, the lions share of the blame for the 2008 financial meltdown must surely lie not with the exchange rate, but with the destabilizing behavior and inadequate regulation of European (and global) financial markets. European banks were brought low not only by debt-financed real estate and stock market bubbles, but also by the proliferation of poorly regulated, often poorly understood financial derivatives. The Euro can hardly be blamed for financial institutions inabilities to manage commercial risk, poor decisions by ratings companies and investors, or regulators failures to set and enforce appropriate prudential standards. Blaming fiscal excess and the crash of the European financial system on the Euro makes no more sense than blaming the crash of the American financial system and the stunningly large American fiscal expansion of 2008-2011 on the dollar. Since the Eurozone is really not the cause of Europes current macroeconomic problems, countries like Greece and Ireland that are in the eye of the storm are unlikely to abandon the Euro any time soon. While the re-introduction of national currencies in these countries would in principle allow governments and national banks to print money to meet their obligations, such monetization could easily push the exchange rate down and prices up. A weaker exchange rate would also drive up the costs of servicing debt denominated in Euros and other foreign currenciesincreasing (not reducing) the likelihood of public- and private-sector debt restructurings and financial panics. The return of exchange rate risk and transactions costs (for purchasing foreign exchange) could limit the foreign trade flows upon which these small, open economies depend.

Under such circumstances, a bailout financed by the IMF and the European Commission, via the 440 billion European Financial Stability Facility (EFSF) created in May 2010, must seem an immensely preferable alternative to policy makers in Athens and Dublin. It is certainly preferable to most other EU member states, whose banks hold public- and private-sector debt issued by Greece and Ireland, and whose own financial stability could be threatened by contagion. In some ways, the Eurozone is becoming stronger, not weaker. While it may have underscored the Eurozones weaknesses, the Euro crisis is also helping policy makers to address them. Monetary unions work best when two conditions are satisfied: (1) wages and prices are sufficiently flexible downwards, in order to facilitate the reallocation of redundant labour away from declining toward growing sectors and areas; and (2) the union possesses a central fiscal authority with the mandate and resources to effect significant fiscal transfers from growing to declining areas, in order to stabilize the latter and improve their competiveness. On (1): Europe has long been viewed as a region of relatively inflexible labour markets (at least, compared to the US and many developing countries); such views often underpin Euroskeptic arguments against the Eurozones viability. However, post-2008 developments in Europe indicate that European prices, wages, and labour markets are more flexible than previously thought. A recent JPMorgan study found that, while GDP during the crisis declined by more in Germany than in the US, employment in Germany remained nearly unchanged, while the unemployment rate in the US more than doubled during 2008-2010. German policies (e.g., the shortening of the work week) apparently prompted a more flexible labour marketresponse, saving jobs and limiting the social impact of the crisis.[4] Also, labour migration from the new EU member states would seem to have helped make European labour markets more flexible, in terms of allowing labour supply to more quickly respond to changes in labour demand. As for downward price flexibility, inflation rates in Europe during 2009-2010 fell to lows not seen in decades. Ireland, Latvia, Spain, and Portugal reported declines in the ECBs harmonized index of consumer prices in 2009, 2010, or both. While deflation can create serious macroeconomic problems, downward rigidities in wages and prices are not among them. On point (2): The EFSF-sponsored bailouts of Greece and Ireland are at the heart of the criticism now being leveled against the Eurozone. To be sure, the creation of a bailout fund raises troubling issues, including the difficulties in reconciling the EFSF with the no bailout clause of the 1992 Maastricht Treaty that created the Eurozone, huge potential fiscal costs, and the possible exacerbation of moral hazard issues. However, as pointed out above, the Euro can not be credibly blamed for the unsustainable fiscal policies pursued by a number of European countries. Moreover, managed correctly, this bailout fund could strengthen the EFSFs (or its successor institutions) ability to serve as a central fiscal authority with the resources needed to effect significant fiscal transfers from more to member states in worse shapeas suggested by optimum currency area theory. Likewise, the EFSF (or its successor) seems likely to be able to tap the capital markets, using long-term pan-European debt instruments to solve Europes immediate financial problems. In addition to helping avoid messy sovereign defaults today, these developments could provide the missing piece of Eurozones financial architecture of tomorrow. Greece crisis and its Aftermath:

Its fellow Europeans, or the IMF, may yet have to organise a humiliating bail-out. Some even talkprobably mistakenlyof the beginning of the end of the euro area.

Last year Greeces budget deficit reached 12.7% of GDP. Worries over whether the Greeks would act to cut it have caused paroxysms in the bond markets: late last month the yield on ten-year Greek government bonds vaulted to 7.1%, the highest since the country joined the euro area and about four percentage points more than that on German bunds, the euro zones safest investment. The panic abated on February 3rd, when the European Commission endorsed the Greek governments plan to cut the deficit to 3% of GDP by 2012. The day before, Greeces prime minister, George Papandreou, had used a television address to announce higher taxes on fuel and an extension of a public-sector wage freeze to include low-paid civil servants.

However, Greece and Europe are not out of trouble yet. The commission says it will watch Greece closely to ensure that it keeps its promises: it expects a report in midMarch on Greeces chances of hitting this years deficit target of 8.7% of GDP. Joaqun Almunia, the outgoing economics commissioner, said he hoped a positive assessment by the commission in mid-May would help restore confidence in Greece, which has one of the worlds largest debt burdens relative to its GDP (see chart 1). If the Greeks do not regain the markets confidence, they may fail to refinance the 20 billion ($28 billion) or so of debt that falls due in April and May. At that point the government would default or would have to be bailed out. And Greece is not the only country about which the bond markets are worried. On the same day as the commission approved the Greek plans, investors were selling Portuguese bonds. The spread of tenyear bonds against bunds widened by 0.16 percentage points, to 1.43 points. A marathon, not a sprint Greece has a long history of fiscal trouble. It has spent half of the past two centuries in default, note Carmen Reinhart and Kenneth Rogoff in This Time Is Different, a history of financial crises. When it became the 12th country to join the euro in 2001, its public debt was more than 100% of GDP. Many thought its chronic budgetary mismanagement might harm the currency. For Greece, membership was a boon. Bond markets no longer had to worry about high inflation or devaluation. Lower interest rates allowed the government to refinance debt

on more favourable terms: the ratio of net interest costs to GDP fell by 6.5 percentage points in the decade after 1995. The underpricing of default risk during the credit boom gave Greece easy access to longer-term borrowing. Lower interest rates also spurred a spending splurge. The economy grew by an average of 4% a year until 2008. But strong GDP growth masked the underlying weakness of the public finances. The public-debt ratio fell, but only because GDP in cash terms grew more quickly than debt. Large budget deficits continued. Once it was safely inside the euro, indeed, Greece relaxed its fiscal grip. The primary budget balance (ie, excluding interest payments) was in surplus in the run-up to membership but has been in deficit since 2003. That did little to cool the economy. Greeces inflation rate stayed above the euro-area average, hurting its competitiveness. The economy relied increasingly on foreign borrowing. The currentaccount deficit widened to 14.6% of GDP in 2008. If Greece had retained its own currency, trouble might have come sooner. But in the months after the collapse of Lehman Brothers, Greece was shielded by euro membership. It could still borrow easily, if not as cheaply, in bond markets even as investors aversion to risky assets peaked last March. The economy was on course for a shallow recession at worst. Greek banks were free of the toxic mortgage securities that felled others. Forecasts for the 2009 budget deficit, at 5% of GDP, seemed almost modest compared with the gaping shortfalls projected for other countries. Yet the reality was far worse, as became clear after Octobers election. The new government said the true deficit was likely to be 12.7% of GDP. Worse, the shortfall for 2008 was also revised up to include unpaid bills to medical suppliers. The mild downturn hurt tax revenues more than the previous administration had let on. The economy probably shrank by 1% last year, but consumer spending fell by more. Value-added taxes, a reliable source of revenue, were squeezed. Control of public spending had been relaxed in the run-up to the election, adding to the deficit. Investors trust in Greek statistics, never solid, was shattered. Two of the three main credit-rating agencies, Fitch and Standard & Poors (S&P), cut their rating on Greek bonds and gave warning that a further downgrade was likely. A debt standstill by Dubai World, a state-backed property venture in the Middle East, made bond investors more nervous about sovereign risk. Greek bond spreads started to widen again. In midDecember the government responded with a fresh plan to cut the deficit. Bond markets were unconvinced. So were the rating agencies: Fitch and S&P cut Greeces grade again, from A- to BBB+. On January 25th the Greek government enjoyed some brief reassurance, raising 8 billion in a sale of five-year bonds. The bank syndicate charged with placing the bonds said it had drummed up 25 billion-worth of orders in a matter of hours from investors attracted by an interest rate of 6.2%. Yet within a couple of days Greek bond yields were on the rise again. Stories that China had turned down an offer of Greek bondsdenied in both Athens and Beijingalso unsettled markets.

Predictably, Mr Papandreou blames speculators for the flare-up in the markets. But he also concedes that his country has been left vulnerable by its own profligacy. If the government wants to restore the bond markets confidence, it will have to be bolder.

The planned cuts to the public-sector wage bill look small when set against such a large budget deficit. They also look timid when compared with the much bolder action taken in Ireland, another cash-strapped euro member. In December the Irish government announced big reductions in civil servants pay, only months after it had introduced a pension levy that cut public-sector wages by 7%. Its courage has been rewarded with lower borrowing costs (see chart 2). Greeces finance minister, George Papaconstantinou, says the main problem in his countrys civil service is over manning, not excessive pay: the right approach is to slow recruitment and allow the payroll to shrink as civil servants retire. Fine, but time is not on his side. To appease Greeces jittery creditors a policy with speedier and more visible results is needed. A big pay cut in the public sector would help. Private firms might then find it easier to follow suit, which would help Greece to regain its cost competitiveness. The government says it will present a plan for pension reform soon. Greece has one of the most generous, and therefore expensive, state pension systems among the 30 mostly rich OECD countries. Workers look forward to a pension of 96% of pre-retirement earnings. Greeks can no longer afford such a comfortable old age. In his television address Mr Papandreou hinted that a higher retirement age would be one plank of reform. A bolder package of budget cuts might secure bond-market finance at tolerable interest rates. The Greek government says it has to strike a balance between budget cuts and keeping its social partners happy. But if it is too kind to public-sector workers, pensioners and so forth, it will struggle to find buyers for its bonds. If the bond markets are closed to Greece, the country will face bail-out or default. Neither option is likely to contribute much to social peace.

Which bucket to bail with? The thought that Greece might fail to carry out the necessary budget cuts has had officials scratching their heads about the form a bail-out might take. When yields soared in late January, nervous Eurocrats were briefing journalists that a rescue package for Greece was being considered. The treaty governing the European Union includes a no bail-out clause, forbidding countries from assuming the debts of others. That clause was inserted in 1991, at the insistence of Germany, at the EU summit in Maastricht, the Dutch town where many of the ground rules for the euro were set down. Other treaty clauses, however, may allow for aid to an EU state in trouble. One remedy would be for Greece to arrange a bridging loan from another euro-zone country in good credit, such as Germany. Such an arrangement may or may not be legal; it would certainly make for terrible politics. Voters in the donor country would be outraged if the rewards of their thrift were used to rescue the profligate. To ensure that good money was not thrown after bad, any loan would need to have conditions attached. That raises another problem. It is tricky for one country to tell another how to cut its budget. When Mexico was rescued in 1994, the Clinton administration at first wanted to manage the bail-out alone. It quickly realised that it would be better to have the IMF ask Mexico to sign up to conditions. For Mexico in the mid-1990s, read Greece today. If Germany steps in, there will be people on the Athens street who will say theWehrmacht is back, an economist remarks.