Sovereign debt is clearly the critical issue of the moment. In the last few weeks we have seen Europe’s debt crisis morph from what seemed like a package of local issues to what looks suspiciously like a systemic threat. The survival of the eurozone is increasingly a matter for discussion, and the implications are nightmarish. Yet the question remains: why?
In recent days many financial institutions have been poring over the intricate details of the latest European debt stabilisation package. These details are widely available, so let us just remind ourselves what happened in Europe, which was a threefold crisis. There has been a financial meltdown, as the credit bubble broke and the banking system froze. There has been a crisis in the real economy, as demand fell primarily as a result of credit contraction. And there has been a fiscal crisis, as governments took on the costs of bailing out the banks, and re-stimulating their economies.
These are the general terms of the crisis, but the details differ. Greece is really a special case: the prime suspect in debt accumulation all along was the government itself, which borrowed at advantageous eurozone rates and spent the money on goodness-knows-what and then did a fine job of concealing its indebtedness. Greece would be in a sovereign debt crisis even without the financial meltdown. In the case of Ireland, there was a compact between private borrowers and private lenders to pump up a property bubble to the point where it took over as the main driver of the economy. US readers will be familiar with the situation. Then there is Spain – again a property bubble story, although the Spanish never entirely abandoned lending prudence. Consequently Spain, like Italy (which has never experienced a property bubble), is able to pay its official debts as long as the market offers rational rates.
Unfortunately, in the present panicky mood, that is a big ‘if’. For the eurozone states most implicated it will take a debt reduction of the order of 30% just to get down to a debt-to-GDP ratio of 100%. It will also require a sharp fiscal tightening to stabilise government debt ratios at that level. Hard times for bond holders, and for entire economies, for years to come.
Primary Budget Deficits: cyclically adjusted
Source: IMF/Credit Suisse
Yet the eurozone as a whole does not have a debt crisis. If the eurozone were a single state, then even with today’s slow economies the state would have enviable finances. Total government debt is only 83% of GDP, the current account is in balance, and the primary budget deficit is marginal. So why is a fundamentally solvent Europe flirting with scenarios that could see sovereign defaults spread systemically through the zone and even beyond?
The answer is that the eurozone is not a single state, and Europe’s politicians have still not fully grasped that unless it acts a lot more like a single state, the currency union is doomed to fail, at enormous cost.The psychology of the European Union plays an important role. Remember that the EU was born out of the wreckage of two world wars. It is what the Financial Times has recently called an ‘existential’ project – designed to ensure that European states become so bound up with each other’s success that conflict becomes unthinkable. But in effect, this has become the problem. Politicians have come to assume that the EU and the common currency project are so important to Europe that success is the only possible outcome. This is what lies behind the fundamental European disconnect between what should be, and what is. And it is the explanation for the lack of political willingness to get ahead of the curve and commit to bailing out the broken euro economies. Europe is still dreaming that the euro is guaranteed to succeed.
Gross Goverment Debt
Source: IMF/Credit Sussie
Investors have been equally unrealistic. Credit markets have always misread the euro – for years they have treated the currency union as a risk union, and financed Greece on the same terms as Germany. Now the markets are over-correcting mightily, and treating Italy –which is a badly-run but solvent state entity – as if it were next to bust.But blaming the markets is a European habit and a loser’s game. Europe’s politicians showed a belated sign of leadership and realism when in late July they agreed a stabilisation package that was much wider-ranging than previous arrangements. Having moved once, they could move again. Stabilisation financing will have to be increased, more sovereign borrowing will have to be underwritten, and the ECB will have to focus less on inflation issues and more on deleveraging issues. Whether all this can be done and contagion avoided even if one or more member state actually leaves the euro is an open question – there is a fairly strong argument that the withdrawal of Greece from the currency system would act as a fairly strong wake-up call to the other over-indebted members.
But it will be politicians who decide – and what they have to decide is whether they are willing and able to support the fiscal union that was always implied by a currency union. If they can’t – or won’t – cover the costs of union, they will have to cover the costs of break-up. And those costs will be enormous.The euro dream is over. The euro reality might be better than the dream, but it could be a lot worse. It all depends on politics.
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