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I.

Our base case scenario is for the euro zone to muddle through and the common currency to survive. We put the probability of such an outcome at roughly 80%. ere will still be deep downturns in Greece, Spain, Portugal and Ireland due to severe fiscal tightening. ese countries account for roughly 20% of euro zone GD , and the IMF estimates their peak to trough decline in GDP will be roughly 6%. at implies a -1.2 percentage point impact on overall euro zone GDP growth. Core Europe, including Germany and France, should benefit from the 15% decline in the euro so far this year, which should be supportive of exports in these economies. us, while we have shaved our forecast for euro zone GDP growth from around 1.8% to roughly 0.6% for 2010, we continue to believe euro zone growth will remain positive for the year.

II.

Our optimistic scenario has a much lower probability at just 10% because it requires euro zone countries to sacrifice their fiscal sovereignty for the sake of the

  • e 2008-09 global financial crisis has left many

economies, particularly the developed ones, in much weaker fiscal positions. e average gross government debt-to-GDP ratio for developed economies is projected to rise from almost 91% at end-2009 to 110% in 2015 –its highest level since the Second World War . As the global economy gradually recovers, revenues should stabilize and spending should decline as output and employment increase. However, this improvement will not be sufficient to restore fiscal balance in the developed world. Instead, policymakers will need to tighten their belts and adopt measures to reduce spending and raise taxes. Otherwise, investors will lose faith that developed countries will be able to repay their debts.

Structural Flaws in the Euro Zone

Investor trust has already been breached in Europe. Greece’s fiscal indiscretions have been among the worst of the developed economies. Its starting debt-to-GDP ratio was already at 113% when the crisis began and it is poised to rise to 145% by 2015. e euro zone has been structurally flawed from the beginning with monetary policy controlled from the center, but fiscal policy controlled at the individual country level. e single currency actually enables members to run large deficits. A country with its own currency would see that currency decline and its interest rates rise if it sold large amounts of debt to global investors.

But because euro zone countries share a currenc , there was no market mechanism to warn when a country’s deficit was becoming unsustainable. Indeed, before the crisis, Greek bonds were regarded as a close substitute for the euro bonds of other member countries even though Greek government borrowing was well in excess of the 60% of GDP threshold set by the euro zone Growth and Stability Pact. Interest rates on Greek government debt only rose when investors began to fear default. At that point, the crisis spread to other countries in the euro zone running large budget deficits including Spain, Portugal and Ireland, despite the fact that their overall debt-to- GDP levels were much lower.

Why Hasn’t The European Bailout Worked?

  • e European Union in cooperation with the International

Monetary Fund announced a €750 billion ($955 billion)

1

bailout plan to contain the sovereign debt crisis in Europe.

  • is came on top of a €110 billion bailout package for

Greece. e European Central Bank simultaneously unveiled a plan to purchase public and private debt to “ensure depth and liquidity in those market segments which are dysfunctional.” If necessar , the US Federal Reserve has promised additional support in the form of US dollar swap lines to reduce strain in short-term dollar funding markets globally.

Unfortunatel , the bailout was thin on details, and there was considerable uncertainty in terms of authorization, as much of the package is dependent on individual parliamentary approvals. Moreover, the bailout is just one side of the equation. It does nothing to address the structural flaws in the common currency. However, by reducing their need to go to the markets to refinance existing debt, it should buy some time for the more profligate countries in Europe to get their fiscal houses in order.Even with fiscal reform,some restructuring of Greek debt may be necessary down the road. Nevertheless, it was important that the Greek government adopt austerity measures before restructuring, otherwise there would be no incentive to change behavior.

and

Optimistic,

Case,

Three Scenarios: Pessimistic

Base

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