Why Worry about the European Economy?

The ONS figures were dreadful: it’s not just that the UK’s growth performance in Q4/2010 was seriously negative and this is bound to have a spill-over effect in 2011. Add the January rise in VAT and mounting pressure on the Bank of England to raise interest rates, and things on this side of the Channel look truly bleak.

To make matters worse, I’ve seen two pieces recently that have left me thinking that 2011 is not going to be an enjoyable year in the rest of Europe either. One has to do with the rising debt-to-GDP ratio of the most vulnerable Eurozone countries; the other argues that there is a rising risk of meltdown of some of Europe’s largest banks. Whatever you may or may not think about the EU, trouble in Europe means trouble for Britain.

Readers of my monthly column for Social Europe Journal will know that I have already warned repeatedly that fiscal contraction and zero growth in the Eurozone’s most vulnerable member-states (the so-called Club-Med countries) in combination with punitive interest rates demanded for EU-led bailouts, will lead to rising sovereign debt/GDP ratios in these countries. Nor are matters going to improve after 2013 when the ad-hoc facility becomes the European Financial Stabilisation Facility (EFSF), mainly because in order to maintain its triple-A rating, the €440bn fund must remain over-collateralised; i.e. it can in reality only lend out about €250bn in total, a good deal less than what is like to be required, and at a punitive 6% interest rate.

But back to bailout interest rates. Simply stated, as long as bailout interest rates (which are the likely EFSF rates) remain on the order of 6% (about 300 basis points above benchmark German bond yields) while growth in these countries remains weak or non-existent, the arithmetic of indebtedness looks very gloomy indeed.[1] The obvious question is whether lowering bailout interest rates – by means, say, of a common Eurobond as suggested by Mr Junker – is the answer? My own view is a qualified ‘yes’; a common Eurobond would not solve the Eurozone’s trade imbalances, but it would relieve part of the pressure on indebted countries (and of course on their creditors).

Writing for his FT blog, Gavin Davis backs the notion of lowering interest rates, referring to a paper by Joseph Lupton and David Mackie of JP Morgan (JPM).[2] The paper compares future projected debt/GDP ratios for Spain, Greece, Ireland and Portugal under two assumptions: the first is that market interest rates rule (i.e. even higher than the 6% EFSF rate); the second is that they are immediately cut to a mere 1% above German benchmark yields. The only problem is that the debt/GDP results are not greatly encouraging.

The Lupton & Mackie table used by Davis appears above.[3] As will be seen, the 2010 debt/GDP ratios were: Spain (64%), Greece (141%), Ireland (97%) and Portugal (83%).  Note that regardless of whether the interest rate subsidy is introduced, these ratios are higher for all countries in both 2015 and 2020 than in 2010 – the only exception being Portugal where assuming an interest rate subsidy, the 2020 ratio has fallen from 83% to 80%. JPM estimates that using a subsidy to fund Greece, Ireland, Portugal and Spain through 2020 would cost €111bn – or just 0.3% annually of the combined GDP of Germany and France, so cost cannot be the objection.

The objection currently advanced by Germany is the old chestnut about ‘moral hazard’; subsidised lending would provide no incentive to reduce southern profligacy. By contrast, my own reading of these figures is that subsidised interest relief (in the form of a Eurobond or whatever) is not enough. Even if Mr Junker wins the argument, which I think he will, economic chaos is still on the cards.

We tend to forget that sovereign debt crises and banking crises are merely two sides of the same coin. At the end of 2009, for example, consolidated claims of French and German banks on the four most vulnerable members were 16 per cent and 15 per cent of their GDP, respectively. For European banks, as a group, the claims were 14 per cent of GDP. In the words of Martin Wolf, ‘any serious likelihood of restructuring would risk creating sovereign runs by creditors and, at worst, another leg of the global financial crisis.[4]

To understand this problem, have a look at a new piece by Professor Mark Blyth of Brown University in the US. Speaking of the European crisis, Blyth says:

What was a crisis of banking became, in short order, a crisis of state-spending via a massive taxpayer put, and with sovereign bondholders’ interests being held sacrosanct while their investments were diluted (if not polluted), the taxpayer had to shoulder the costs twice: once through lost output and new debt issuance; and then twice through the austerity packages held necessary to placate the sovereign bondholders.[5]

He goes on to point out that too little attention has been paid to the role of Europe’s banks, who in the past two years were happily dumping northern states’ sovereign bonds for high-yield Club Med bonds. But private actors will want to hedge their positions, buying equities, real estate and the like. A problem arises when these markets go south, leaving banks holding risky bonds with little cover. Their only option is to ‘dump good to cover bad’ – but if all players do so together, the strategy yields perverse results. If I know you’ll dump Greece, I’ll dump Ireland, and you’ll then dump Spain to stay ahead of me, so I’ll dump Italy and so on.

With everyone trying to go liquid, liquidity for everyone suddenly becomes nearly impossible to achieve. As Blyth says, you can keep passing the ‘put’ around, but there comes a time when somebody has to pay up. The taxpayer cannot pay forever (because he or she is or soon will be on the dole), and the EFSF is just a special purpose vehicle with little cash and much rhetoric about which bondholders have grown deeply cynical. There’s a limit … and it’s called Spain. Spain’s government and private bonds are held by banks all over Europe. Blyth concludes that the Germans know this – their theatrical rhetoric is merely designed to postpone the mother of all bank runs.

I’m only a bit less pessimistic. I agree with Blyth that a massive bank run may be hard to avoid, but when the crunch comes, the Germans may prefer the ECB’s printing presses and some (temporary) inflation to Europe-wide financial collapse, since the latter would drag down not just German banks but their EU-dependent export-led growth model as well.

Even more interesting times ahead ….

Endnotes

[1] See http://www.social-europe.eu/2011/01/happy-new-year-for-the-euro/

[2] See http://blogs.ft.com/gavyndavies/2010/12/19/is-germany-acting-in-its-own-interests-on-sovereign-debt/

[3] See http://ftalphaville.ft.com/blog/2010/12/17/440661/how-to-save-the-eurozone-by-jpmorgan/

[4] See http://www.ft.com/cms/s/0/0c382c9c-0237-11e0-aa40-00144feabdc0.html#axzz1C2vbemOj

[5] See http://crookedtimber.org/2011/01/18/the-end-game-for-the-euro-german-rules-and-bondholder-revolts/

No related posts.