Happy New Year for the Euro?

Readers of this site will know that I’m strongly pro-euro – but I fear that the year 2011 will see the project unravel. Despite the recent Brussels summit creating a ‘permanent mechanism’ for resolving debt crises, a further sovereign debt crisis looms, and the major players, France and Germany, seem unwilling to take the necessary steps to avoid it.[1]

The arithmetic of the next sovereign debt crisis is simple. Take Greece where the debt-to-GDP ratio, which was 120% in 2010, is expected to reach 160% in two years’ time. Most of this money is owed to French, German and British banks. At Europe’s insistence, the €110bn bailout package put together last May carried a punitive interest rate of 5% and required Greece to undertake massive cuts in public spending equivalent to 9% of GDP in 2010-11.

As any economist will tell you, for the debt ratio to fall, the rate of growth of the economy must exceed the rate of interest on the country’s debt. But Greece’s growth rate in 2010 is expected to be negative (-4%), and unless confidence is restored, the economy will shrink further in years to come, meaning the debt ratio will continue to rise. Moreover, the country needs to finance €70bn annually in maturing debt obligations over the next few years. As Nouriel Roubini recently argued, it is now almost certain that Greece will default on its debt.[2] Exactly the same logic holds for Ireland where the rate of interest imposed for the EU bailout is 5.8% and economic growth has turned negative – that’s why on December 18^th, Moody’s slashed their credit rating.

While default or restructuring is probably the least worse outcome for Greece and Ireland, the ripple effects for the rest of the eurozone will be negative, increasing contagion. Overseas banks holding Greek eurobonds will take a haircut estimated at 50-70% of their holdings, in turn spreading panic about the potential costs to bond markets of refinancing maturities of countries such as Spain and Portugal next year. For the period 2011-13, sovereign debt maturities in Spain, Portugal and Italy alone amount to €691bn. Were bailouts required in these countries, the €750bn EU/IMF European Financial Stability Facility (EFSF) established last May would be rapidly depleted. Bond markets know this, making them even more hesitant to lend to these countries. That’s why refinancing and associated insurance costs are currently rising for these countries.[3]

The major players – France and Germany – have been unwilling and/or unable to agree on even the simplest formula for sharing out the risk, namely, Mr Junker’s proposed eurobond. Nor for that matter has the nature of the crisis been fully understood. At the summit in Brussels on 16 December, Mrs Merkel continued to insist that profligate public spending lies at the heart of the debt crisis.[4] What she appears unable to see is that while a few countries like Greece have run up large public debts, in countries like Ireland and Spain the problem is one of excessive private debt resulting from a credit bubble.

In 2007, Ireland ran a small surplus on government account while its debt ratio in 2008 was only just above 40%. What hurt Ireland was the government’s decision in 2008 to bailout its banks who, having lent massively to the housing market, found themselves insolvent when the bubble burst. Equally, the Spanish problem is mainly about an overleveraged private sector. Spain’s public debt ratio is 2009 was 54%, well within the Maastricht 60% limit. But since the collapse of the country’s property boom, the government has been struggling to restructure the banking system, mainly by merging and refunding a large number of its cajas (savings banks). A combination of banking bailouts and recession triggered by the property collapse has thrown the country into recession, lengthening dole queues and widening the public sector current deficit.

German insistence on a stronger and more punitive Stability and Growth Pact as part of any eurozone bailout mechanism proposed for 2013 ignores the fact that eurozone crises have largely originated in the private sector. But the crucial weakness in the deficit hawk argument is that it ignores the politics of currency union.

If a currency union of disparate states of differing income and productivity levels is to work, strong central institutions are required, particularly in the area of economic governance. Without the redistributive fiscal powers of a eurozone Treasury, the centrifugal forces of diverging relative cost structures ultimately lead to trade imbalances.[5] Because members can no longer devalue, pressure to restore competitiveness leads to ‘internal devaluation’, or what amounts to beggar-thy-neighbour policies by means of wage cutting. In such a situation, a large external shock hurts the weakest most. Eventually the economic and political costs to the weaker members of remaining within EMU become so high that departure becomes a genuine option.

Default is merely a way of passing on part of these costs to those member states whose banks hold the debt. Either the core states recognise this and cede some of their sovereignty for the sake of currency union, or they pay the price which the union’s disintegration will entail. That is the choice Europe faces in the New Year.

Endnotes

[1] See http://www.bloomberg.com/news/2010-12-16/eu-agrees-to-create-post-2013-crisis-tool-as-bloc-spars-over-current-steps.html

[2] See http://www.guardian.co.uk/business/2010/dec/16/greece-debt-rescue-eu-roubini

[3] See http://financeadvices.com/the-cost-of-refinancing-european-debt/

[4] See http://www.spiegel.de/international/europe/0,1518,735355,00.html#ref=nlint

[5] See Martin Wolf, FT, 30-11-10;  http://www.ft.com/cms/s/0/259c645e-fcbb-11df-bfdd-00144feab49a.html#axzz18NiCRrMZ

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