The respite in the European debt crisis is over. Surging Irish bond yields have ushered in the second, more dangerous phase of the crisis. Last weekend’s rescue of Ireland failed to placate bond markets; now, Portugal, Spain, Italy, and the euro itself are under threat.

Unconvinced by bailouts, markets are now focused on solvency, not liquidity. To different degrees, embattled countries must not only repair public finances and fix banks, but also simultaneously restore competitiveness and growth—a challenging combination to say the least. One of three outcomes is foreseeable: a long slog in troubled countries as they implement austerity and deflation; debt restructuring, with the euro remaining intact; or fragmentation of the euro area. All of the scenarios are bad, but the last one could spell economic catastrophe. Policy makers now face a stark choice: to press forward with a de facto fiscal union, or to confront the risk of defaults and the unraveling of the euro area.

Why the Relapse?

In May, European leaders and the IMF responded to the first phase of the crisis with a €750 billion European Financial Stability Facility (EFSF) to prevent the crisis from spreading further. Greece remained effectively cut off from markets despite progress on meeting its agreed targets, but a relative calm returned.

In late October, however, Irish banking losses were revealed to be even larger than feared, and German officials called for establishing a sovereign debt restructuring mechanism for private creditors to share in losses associated with financial rescues. This was subsequently clarified to apply to debt issued after mid-2013 and as part of making the EFSF permanent. The German proposal would require a modification of European treaties, a hugely cumbersome and risky task requiring referenda in many countries. Panicked by the possibility of the first default by a rich sovereign nation in modern times, bond markets quickly turned on Ireland, which on November 28 was forced to tap the EFSF for €67.5 billion in support.

Despite this rescue, bond yields across Europe have continued to rise, unlike the general decline after the May bailout. Borrowing costs have risen not only in Portugal and Spain, but also in Italy and Belgium. 

What is causing this rise in yields? After all, budgets have been cut, as have public-sector wages; debts in Portugal and Spain are expected to average 73 percent of GDP in 2010, 30 to 50 percentage points lower than in Greece and Ireland. Furthermore, the EFSF backstop is still in place, and its funds remain largely untapped.

Yet markets remain unconvinced, for several reasons.

First, resolving the euro crisis requires growth. Debt burdens are rising rapidly, reflecting large primary deficits and surging interest charges on new and refinanced maturing debt. Without growth, debt burdens as a share of GDP will continue to increase, ultimately calling into question troubled countries’ solvency. In Portugal and Italy, growth rates were slow before the crisis—around 1.5 percent—and are expected be even slower in the years after. The long-term outlook is highly uncertain in Spain, where economic activity is impeded by troubled regional banks, high private-sector debts, and construction’s disappearance as the driver of growth. Ireland’s configuration of problems is similar to that of Spain, but the enormous hole in the balance sheet of Irish banks dwarfs all other problems.

The loss of competitiveness in Greece, Ireland, Italy, Portugal, and Spain (GIIPS), outlined in Carnegie’s report Paradigm Lost, compounds the difficulties. Thus far, with the exception of Ireland, these countries have failed to claw back any of their competitiveness lost inside the euro area. Trade balances similarly point to a slow adjustment at best.1

Without significant improvements in competitiveness, the GIIPS’ ability to grow will be restricted and markets will remain skeptical. However, restoring competitiveness is a catch-22: in the absence of currency depreciation, it requires wage and price deflation that will necessarily make debt burdens harder to bear.

Finally, the EFSF is now seen as clearly insufficient to deal with Europe’s troubles. If market pressures force a Spanish bailout, an additional €400 to €600 billion would likely be required to support Spain.2 At €750 billion, some of which has already been committed, the EFSF could not rescue Spain and retain market confidence in its ability to protect other countries, most notably Italy. In addition, with Italy and Spain together guaranteeing 30 percent of the EFSF’s European contribution, a problem in those countries would put great strain on the finances of France and Germany, where debt levels are already high. 

Moreover, the EFSF only buys time and offers no solution to solvency. By providing liquidity at high rates—Ireland’s rate of 5.8 percent over seven-and-a-half years is almost identical to the rate it was afforded in a debt auction in September—it does little to remedy the adverse debt dynamics. Conditions attached to the EFSF have the potential to reestablish fiscal order and competitiveness in the euro area, but only over many years, and only if the political will to undertake painful reforms persists.

The Next Act

Unless policy changes, the EFSF is likely to either crack under the weight of Spain and Italy or simply delay a string of sovereign defaults. Europe still has policy options, however; depending on which are pursued, how external forces—notably the global recovery—evolve, and how markets respond, three scenarios could unfold in sequence, each progressively more painful, unless the circuit of fear is broken.

Scenario 1: Muddle Through

If sovereign defaults or a break-up of the euro area are to be prevented, stopping the crisis from spreading beyond Portugal is essential. For this to be achieved, the periphery must convince markets that it is containing deficits and reestablishing growth; the European Central Bank (ECB) must commit to more expansionary policy, including more liquidity injections into banks and government bond purchases; and the EU will need to commit to augmenting the EFSF.

If sovereign defaults or a break-up of the euro area are to be prevented, stopping the crisis from spreading beyond Portugal is essential.

As part of these changes, countries in the periphery must find ways to achieve a competitive realignment inside the EU. This will require higher inflation and wages in the core and falling domestic demand, wages, and prices, as well as more rapid productivity increases, in the periphery. Still higher unemployment may be the inevitable result.

If, through market processes or policy choices, demand growth accelerates in the core—which accounts for a large share of periphery exports—the likelihood that the crisis is contained increases greatly.

Scenario 2: Debts Rescheduled, Euro Area Remains

As we argued in Paradigm Lost, Greece will almost inevitably have to reschedule its debt at some point. Other GIIPS may be forced to do the same if the crisis reaches Spain or Italy and the EFSF and ECB facilities are not increased dramatically to support them. 

These sovereign defaults could take a soft or hard form. The soft form would include rescheduling debt at much longer maturities and a lower interest rate. This could be done quite elegantly: private creditors could accept the change in terms in return for a full or partial guarantee from an expanded EFSF.

Because rescheduling would not reduce the principal owed on debt, austerity would still be needed, as would price adjustments to restore competitiveness. Nevertheless, rescheduling and reduced interest charges would buy more time and likely make both adjustments more palatable.

Under a hard restructuring, investors would take a hit on principal as well. Depending on how large the haircut is, a banking crisis could erupt—France and Germany hold over €700 billion in debt from Ireland, Spain, Portugal, and Greece. Resolving such a crisis would require another large dose of government support for banks throughout Europe. The defaulting countries would almost certainly fall back into recession amid a collapse in confidence and capital flight.

Scenario 3: The Euro Area Breaks Up

If the periphery countries decided debt restructuring was their only viable option and deemed a massive banking crisis probable anyway, one or more countries could see exiting the euro area as the least bad option for recovering lost competitiveness and returning to growth.

This is not an option any country would take willingly. Capital flight, a catastrophic recession, and widespread household, corporate, and banking defaults would hit exiting countries. The logistical challenges of introducing a new currency would be immense. Furthermore, these countries would borrow at a significant premium well into the future, and depreciation would also drive up import prices, leading to higher inflation. Nevertheless, an immediate devaluation would help restore their competitiveness, boost exports, and probably reignite growth within one to three years.

One or more countries could see exiting the euro area as the least bad option for recovering lost competitiveness and returning to growth.

The core countries would also suffer a huge shock. Defaults in troubled countries would be more widespread than in scenario 2, triggering a deeper banking crisis that would require even greater government support. Simultaneously, the smaller euro area would see appreciation and competitiveness loss. Together, these forces would likely push the core back into recession, which would in turn limit the improvements in the export performance of the periphery.

A less painful but still traumatic version of the euro area break-up scenario would see a German exit. If further bailouts required Germany to bankroll its larger as well as smaller neighbors, and ECB liquidity injections were seen to threaten a sharp rise in inflation, German public opinion might force such an outcome. A return to the stronger deutschmark would reduce German competitiveness and hurt export performance. Banks could also suffer as the value of euro-denominated assets fell.

Euro depreciation and looser monetary policy would likely follow in the periphery, making the competitiveness adjustment easier and enhancing growth there. Sharp fiscal adjustments would be needed, however, and debt rescheduling could still be necessary, especially since depreciation would make foreign-currency loans more expensive to repay.

Without its German anchor, and the prospect of its financial support, the truncated euro area would potentially experience an even greater loss of confidence. The European project could perhaps survive this scenario, but it would suffer an enormous setback.

The Choice

The three scenarios starkly illustrate the fundamental choice facing euro area leaders. They will either enter deeper into a de facto fiscal union (of which the EFSF is the harbinger) and accept much closer coordination of their economic policies, or they will confront the likelihood of sovereign defaults and the possible break-up of the euro area. Ultimately, European leaders must target one outcome, and decisively and uniformly pursue it; otherwise, the piecemeal policies and half-hearted efforts put in place to address the crisis so far will fail and all on board will drown in the gathering storm.

Uri Dadush is the director of Carnegie’s International Economics Program. Shimelse Ali is an economist in Carnegie’s International Economics Program. Bennett Stancil is a researcher in Carnegie’s International Economics Program.

1. From January through August, trade deficits in Italy and Spain worsened considerably compared to the same period last year; only Greece saw significant improvement. Those in Ireland and Portugal were little changed.

2. The rescue packages provided to Greece and Ireland are roughly three times the size of their respective government deficits in 2009. They also represent approximately 45 to 55 percent of GDP. Based on these two metrics, a Spanish rescue would likely be between €400 and €600 billion.