Along with German Chancellor Angela Merkel, French President Nicolas Sarkozy has had to hold the eurozone together.
Rob Farhat
Events of the last month have seen a major setback to the world economy’s recovery. When the greatest financial crisis since the Great Depression hit in late 2008, a prolonged recession was thought to have been avoided thanks to an internationally coordinated bank bail-out and fiscal stimulus. However, while a collapse of the banking system and a second depression was averted, unemployment is still high and almost three years later, growth remains sluggish, with fears of a double dip recession badly hitting market confidence.
But if one thing is certain about Europe’s current crisis, it is that the root of the problem lies with sovereign debt. For good or bad, governments spent 5% of world GDP rescuing the banking system. On top of that, a combination of fiscal stimulus, automatic stabilisers (e.g. unemployment benefits), and plummeting revenues has created large fiscal deficits, increasing developed economies’ sovereign debt levels dramatically.
According to the Keynesian view, prudent fiscal policy involves running deficits during recessions, but it also involves running surpluses (i.e. spending less than a country earns in tax revenue) during economic expansions. Put together, this is called counter-cyclical fiscal policy, and aims to stabilise the cyclical nature of the market economy. Unfortunately, much of the Europe’s developed economies were already running deficits during the economic expansion in the run-up to the crisis of 2008, meaning that their overall debt levels were too high or on the wrong path to begin with (Italy being the biggest culprit here, with a debt to GDP ratio of over 100% since the 90’s).
Put simply, in order to finance deficits countries borrow funds from the markets by selling government bonds. These carry an interest rate, which is all that is paid until maturity, at which point the principle is paid. In reality, while debt is repaid to bondholders at maturity, this money is then borrowed again, or “rolled over”. So in the long run, the most important factor is a sovereign’s debt to GDP ratio. A ratio of no more than 60% is considered sustainable; 80% is dangerous territory, while anything around 100% sends alarm bells ringing and financing debt becomes increasingly difficult and expensive.
The story so far: kicking the can down the road
In early 2010, it became increasingly clear that Greece’s sovereign debt level was unsustainable, making it unable to finance its debt, i.e. sell bonds, in the sovereign debt markets. This led to the EU’s creation of the European Financial Stability Facility (EFSF), a €750 billion fund to provide assistance to eurozone states who have been shunned by the markets. Of course, the claim was that this would be a last resort mechanism, and that Greece would be the only customer. But as we know, contagion spread to Ireland and Portugal, who both eventually found themselves unable to raise funds in the markets and had to resort to the EFSF.
While the fund solves these countries’ inability to access financing from the markets, it does little to bring their debts to sustainable levels. There are two standard ways for a country to reduce its sovereign debt to GDP ratio: one is to run fiscal surpluses, achieved through spending cuts and tax increases, and the other is through economic growth. And herein lies the crux of the problem for Europe’s periphery. The current arrangement attempts to solve Europe’s debt woes by imposing harsh austerity measures in the form of severe budget cuts and tax hikes while simultaneously relying on economic growth to reduce the debt level’s proportion of GDP. On the one hand, the austerity measures are necessary to address the severe disparity between government spending and tax revenue (Ireland, for example, spent over 93% more money than it received in revenue in 2010), not to mention avoiding moral hazard. Besides, without their bailouts Greece, Ireland and Portugal, would be unable to finance their debt and hence would have to cut spending far more drastically anyway. But imposing such harsh austerity measures also has a highly detrimental affect on growth, and as long as the amount a government has to spend on interest payments outweighs economic growth, reducing its debt level is near impossible without an improbably large fiscal surplus. Greece certainly fits into this description, and Ireland and Portugal probably do too.
So in essence, the plan does little to bring the periphery’s sovereign debt to a level at which they could conceivably borrow from the markets again, and merely serves to “kick the can down the road” by delaying the inevitable. Certainly Greece shows no hope of being able to borrow from the markets in the near future. Now, the market panic has spread to Spain and Italy. The problem with Spain and Italy is that the sheer size of their economies and debt are too large for the rest of the eurozone to afford to bailout. The markets know this, which contributes to the panic.
A couple of measures have been taken that have managed to bring down yields for now, but they are likely to only prove to be a quick fix. The European Central Bank intervened in the market and bought Italian and Spanish bonds, as they have done for Greece, Ireland, and Portugal in the past. This decreases interest rates as it acts as an increase in demand for sovereign debt, but the amounts involved are not enough to alleviate the problem entirely, and the practice raises serious questions about the ECB’s political independence. Moreover, the more the ECB invests in peripheral countries’ bonds, the more it stands to lose in the event of a default.
Default – orderly or disorderly
Many economists argued since late 2009 that Greece’s debt problems were insurmountable to begin with, and that the country should have been allowed to undergo an orderly default before contagion spread to the rest of the periphery. This increasingly looks like the correct prognosis, and once it became blatantly obvious that the initial bailout hasn’t worked, even European leaders recognised that Greece’s debt level is unsustainable, and that some sort of private sector contribution is required. The resulting plan is typically vague and unambitious. It merely attempts to convince bondholders to rollover €37 billion worth of maturing bonds for new bonds that will mature in 30 years. In other words, no actual reduction of Greece’s debt level, and more “kicking the can down the road.” Nothing the markets are fooled by.
At over 150% of GDP, close to half of Greece’s sovereign debt needs to be written off in order to bring it down to a sustainable level. At levels approaching 100% of GDP, a case can be made for a smaller haircut for Ireland and Portugal too. The European core’s main aversion to even an orderly default on this scale is down to the exposure of their (i.e. Germany and France’s) banks to the periphery’s sovereign debt and the recapitalisation this would inevitably require. However, Greece, Ireland and Portugal’s combined GDP is only 6.3% of the eurozone’s total and in the case of Greece, a default has already been factored into the markets, so we would not see a Lehmann Brothers-esque market collapse. Furthermore, consider the following principle: take Ireland for example – its taxpayers have had to foot the bill for its banks’ reckless lending to property developers by absorbing their losses. The same principle can be applied to the very European banks who lent to Anglo Irish and co. – these were reckless loans too, and so why can’t they accept losses on these loans, and have their taxpayers foot the bill? No taxpayer should ever have to pay for its banks’ reckless business practices, but if we are to accept that it is better than the alternative, then surely some of the burden should be bourn by our supposedly more prudent neighbours.
While Greece, Ireland and Portugal’s economies may be small enough to contain an orderly default, Italy and Spain are another matter entirely. As the third and fourth largest economies in the eurozone, a default on either of these countries’ sovereign debts would have calamitous effects on not just the eurozone, but the world economy, and could bring down the euro altogether. But in fact, their fundamentals don’t look so bad compared to their smaller neighbours. While Italy’s debt to GDP ratio is very high at almost 120%, it has been at that kind of stratospheric level since long before the creation of the eurozone, and it is in fact running a primary surplus (i.e. a surplus if you ignore debt interest repayments). Spain’s debt to GDP ratio is just above a respectable 60%. Both countries’ main problem is that they suffer from low growth, but the recent market speculation that has been directed against them undoubtedly could have been avoided had the periphery been dealt with decisively.
The “bombshell”: Eurobonds
However, sound fundamentals are irrelevant if the markets aren’t willing to lend. While the last couple of weeks have seen a reprieve for sovereign debt yields, the debt crisis has certainly not come to a conclusion. What the eurozone needs is strong, decisive, and unified action, and many economists are adamant that this should come in the form of Eurobonds – jointly backed debt for the euro area as a whole. The eurozone’s overall debt to GDP ratio is a relatively healthy 85%. Moreover, creditors are more willing to lend to larger economies, as they are considered more likely to pay them back.
However, while this may be ideal for the eurozone as a whole, and especially for the peripheral nations, it is certainly not to the creditor nations’ liking – i.e. Germany and France. Pooling their debt with the likes of Greece and Italy would mean accepting higher interest rates, and so in essence would involve some kind of fiscal transfer. Germany and its more “sensible” pals would never accept just handing over its hard earned cash to the EU’s more profligate members without some kind of system of control, so we would likely see greater fiscal co-ordination, and possibly even a eurozone finance ministry. This article won’t delve into the political ramifications of such a transfer of economic sovereignty, but I will express concern over Angela Merkel and Nicolas Sarkozy’s suggestion as to what form it might take. Rather than create a centralised and impartial European economic governance that does what’s best for the eurozone as a whole, their idea involves imposing the French, and more importantly, German economic model on the rest of the eurozone, by harmonising tax rates and other such matters that are best left to sovereign’s own governments. While Germany is undoubtedly the eurozone’s economic success right now, what works for Germany wouldn’t necessarily, and in fact cannot work for the rest of Europe. By definition, not all countries can be net exporters – trade is a zero-sum game, so for some countries to have a trade surplus, others must have a trade deficit!
So in essence, there is no easy answer to Europe’s sovereign debt crisis. It is clear that the current arrangement is not working, and more decisive action is needed. The potential outcomes either involve some form of fiscal transfer from the European core to the periphery, and hence tighter European economic integration, or the alternative is a break-up of the eurozone, and with it potentially the great achievements and benefits of the European Single Market. In all likelihood, this crisis still has a lot more twists in store for us.
