A circus run by clowns?

Eurozone Debt Crisis

By Percy S Mistry

Eurozone debt crisis contagion has spread slowly but surely as foreseen in the FE (May 19-20, 2010). It now threatens to pull Italy—EU’s third largest economy—into an implosive recessionary spiral. It also risks throwing all of Europe back into deep recession. That is not the fault of the American rating agencies, as Europe’s politicians and bureaucrats (the Eurocracy) believe.

Rating agencies are merely reflecting the reality that what has been tried has not worked. But they are being shot as messengers of bad news. Their credibility is being questioned because they colluded in the 2008 financial debacle through ill-judged ratings of worthless financial contracts. This time though, they’ve got it right. The Eurocracy is wrong.

It is clear that the efforts of Europe’s political leaders, the ECB and IMF, to resolve the Eurozone’s debt crisis (Eurocrisis) have failed so far. They seem to have learnt nothing from the searing experiences of emerging, indebted countries in the 1980s and 1990s. That is a disaster, not just for Europe, the EU and the EMU but for the world. If Europe’s leaders—particularly Germany’s—continue dithering, indulging in wishful thinking with endless policy and tactical reversals, and refuse to grasp the nettle, they will inadvertently precipitate a sharp, deep global recession which may last for an unpredictably indefinite duration. Not only that, they will increase the eventual net fiscal cost to themselves of being dilatory, in dealing immediately and decisively with the Eurocrisis, from around 300-500 billion euros to over 2 trillion euros over the next five years and inflict additional costs on the rest of the world of at least half those amounts.

The Eurocrisis embraces not just PIGS (Portugal, Ireland, Greece, and Spain). Its government, the EU, ECB and IMF are reluctant to acknowledge it openly but Spain is definitely in crisis. The Eurocrisis also includes Iceland, which is not in the EMU. It may soon envelope—beyond Italy—countries such as Belgium and, on the basis of debt/GDP ratios (which global financial markets are increasingly concerned about), possibly the Netherlands as well.

Global financial markets are now in an initial shark-baiting frenzy of betting against over-indebted EU countries. Such activity can only intensify over the coming months, leading to self-fulfilling prophecies. To avoid that, the leading countries of the EU—Britain, France and Germany—now need to go well beyond orthodox playbook measures in wrong-footing markets and burning them. They need to do so before the momentum against holding EU public debt becomes unstoppable and the European banking and non-banking financial systems (insurance, securities and pensions) collapse as a consequence.

Judging from the recent movement of their share prices, the Eurocrisis already infects Europe’s banking system. European banks have not yet recovered from the 2008 financial crisis. They are woefully undercapitalised as any stress tests would show; especially if they included the possibility (inevitability?) of a default by all of the PIGS and a 20% probability of market-induced ‘effective default’ by Italy within the next two years. If the Eurozone’s debt crisis continues to be handled in the inept way it has been so far, then Europe’s banks won’t just be taking a haircut. They will be amputating nearly all their functioning limbs. Almost all of Europe’s banking system will have to be effectively nationalised and their balance sheets shrunk. That would bring on a new kind of European Dark Age.

Europe’s banks’ effective collapse will affect the world. But European banks are not the only ones at risk. The 20 largest global financial institutions, as well as banks, central banks, insurance companies and pension funds in emerging markets (like Brazilian banks’ holdings of Portuguese debt), and sovereign wealth funds have significant holdings of now-contaminated Eurozone debt; especially Spain’s and Italy’s. British banks hold a huge portfolio of Irish public and mortgage debt. It is probably worth less than half of original face value. If they need to provide for losses of even 20% against those, they will become effectively insolvent. This crisis risks bringing fragile global securities and derivatives markets in debt instruments to a virtual halt.

The situation is now so far gone that there is no longer time for Europe’s ostrich-like leaders to go on burying their heads in the sand, leaving their ungainly rear ends exposed, as they have been doing for the last two years. They must accept reality. So far, they have adopted an illusory debt crisis management framework that requires four odd conditions to be met: (a) no face value default of Euro-denominated public debt, (b) rollover funding on a quarterly basis to ensure that default does not occur, via underfunded relief mechanisms such as the recently established special European Financial Stability Fund (EFSF), alongside the IMF, as well as other stabilisation funds from the EU, (c) a commitment to tough adjustment and austerity measures, including public spending cutbacks accompanied by across-the-board tax increases in crisis countries, and (d) an obligatory rollover of public debt holdings by official and private creditors with a premium interest rate being imposed (on indebted countries that cannot even afford subsidised interest rates) to compensate creditors for rollover risk! That such an obviously perverse condition can be imposed in the midst of debt crisis management of broken economies shows how bankrupt and nonsensical official European thinking has been.

Attempting to impose these four conditions has achieved the opposite of what was intended, which was bringing fiscal (and external) accounts back into balance and putting these economies back on a growth path that makes debt stocks and a future debt-service capability more affordable. Eurocrisis economies cannot deploy independent exchange rate and monetary policies as tools of adjustment. The burden of adjustment therefore falls entirely on fiscal and wage policies, resulting in a rapid deterioration in standards of living, a sharp rise in the cost of living, and a sudden sharp reversal of cradle-to-grave entitlements for income support, various kinds of social benefit payments (for housing, children and disability), healthcare costs, education costs, general unemployment welfare and pubic pensions. In turn, that compromises, in the short and long term, their ability to grow out of their debt problems.

No EU country has yet come to terms with the reality that it can no longer afford rapidly escalating social overhead expenditures, given dismal fiscal situations and rapidly deteriorating demographic profiles. Their governments would be committing political suicide if they did so. But, sooner or later, that reality must be confronted before Europe goes bankrupt. And, in that tale, there are embedded lessons to be learnt by India and China in avoiding similar structural mistakes in creating by stealth the same debilitating social overheads in their fiscal systems. Moreover, what were intended to be social safety nets in Europe have instead become embedded systems of perverse structural incentives that damage the EU’s ability to compete with emerging countries that do not have similar overheads. The present fiscal and debt crises of the Eurozone and EU are directly related to the structural weaknesses of their fiscal make-up.

So, what should be done? The answer is obvious. No other options will work. The EU must now arrange for a bond swap that exchanges all the public debt of PIGS for a single Eurobond whose quality is underpinned by the joint and several guarantees of all European countries. Such a Eurobond can be issued either by the EIB or the EFSF (which already deploy a joint and several guarantee) to become operationally functional immediately. Eventually, in the fullness of time, all EMU members should issue public debt only in Eurobonds that reflect the EU’s overall creditworthiness, rather than in bonds that reflect only individual national creditworthiness.

In the medium term, an accompanying European Debt Issuance Agency (EDIA) must be created with real teeth and draconian enforcement powers to prevent countries like Greece misleading their peers in the EMU about what their real fiscal positions are. No EU member should be permitted to issue public Eurobonds without the approval of the EDIA. In turn, EDIA would assiduously monitor the fiscal situation of every EU member country in real time. That, in effect, would mean creating an agency that takes a step towards fiscal union. Let’s face it: common currencies like the Euro that have a central bank but no central treasury to back them up simply will not work in the long term. To be sustainable and have any credibility or longevity in global markets, a single common currency like the Euro can only be a first of many steps towards fiscal and eventually political union. If fiscal and political union are ruled out from the trajectory of unification, then the single common currency ought to be abandoned sooner rather than later as a bad idea that was implemented prematurely in hope rather than practical reality.

Whether or not the bond swap proposed should be done at discounts reflecting the debt service realities of PIGS and others needs to be carefully considered. If the discounts reflected market values, presently being signalled by CDS premia, that would certainly precipitate a European banking crisis. So, further mechanisms would need to be thought through as to how discounts (which realistically should be applied) could be imposed in a manner that did not further damage the already precarious positions of most EU banks and financial firms. There are ways in which that can be achieved, but elaboration of those is for another day.

EU governments need to act quickly to take steps along the lines suggested above. They are consonant with the principles underlying the Juncker-Tremonti proposals and those of many others who have had more experience with managing debt crises over the decades. If they do not, then Europe and the world will pay a heavy price for their ignorance and negligence. They should accept that what they have done so far has only worsened the situation. They need to change tack: decisively and immediately. Time is not on their side.

The author is chairman, Oxford International Associates Ltd

* Published in print edition on 15 July 2011