5 January 2011
Whereas 2008-09 was a period when the developed world leaders were scrabbling around for politically acceptable measures about mopping up the mess left behind by years of weak regulation, poor management and reckless lending by banks and financial institutions, 2010 was a year in which the consequence of years of over-leverage started to be felt on national balance sheets. As a result of governmental determination to support failed banks, the sub-prime crisis has become a sovereign debt crisis (blog: Euro crisis morphs)
The transformation exploded into the popular consciousness in March 2010. The trigger was the Greek government’s admission it had been disguising the country’s true indebtedness through accounting sleight-of-hand for many years and would be unable to repay its debts. The bond spreads on Greek debt versus benchmark German bunds went through the roof.
Events came to a head in April when the government of prime minister George Papandreou accepted a €110bn bailout package from the European Union, European Central Bank and the International Monetary Fund, on the condition the country made some important changes to the way in which it was run, including introducing tough austerity measures and renewed fiscal rectitude. Papandreou embarked on a roadshow and told Newsweek his message to US investors would be: “This is the new Greece, it’s a new government making historic changes, tackling bureaucracy with new, one-day startup business shops, downsizing local government, moving into green energy, busting cartelism, and bringing in meritocracy.”
But this wasn’t enough to reassure bond investors who rightly sensed weaknesses in other European countries. (blog: Greek bailout rewrites rulebook). With the prospect of Greek default minimized, they started fretting that other heavily-indebted EU countries, particularly Portugal, Ireland, Italy and Spain might also struggle to service their massive national debts. In an attempt to calm nerves, the EU created a €750bn special-purpose vehicle managed by a former hedge fund manager, dubbed the European Financial Stability Facility. However critics worried this would be too small and was too poorly constructed for the task ahead, particularly if one of the larger PIIGS countries such as Spain or Italy were to get into a downward spiral.
The whole crisis continues to put a massive strain on the EU, whose leaders have tended to play to narrow domestic audience and have therefore seemed incapable of the sort of communitaire thinking that might calm investors’ nerves. German chancellor Angela Merkel exacerbated the situation in October and November with her repeated insistence that, after 2013, bond holders should be made to feel some of the pain with so-called “haircuts”.
Unsurprisingly, euro woes flared up again in November, when the spreads on Irish sovereign debt surged over fears about the black hole at the heart of the nation’s banking sector. Perhaps unwisely, at the height of the crisis in September 2008, the Irish government had sought to shore up Irish banks including the spectacularly bust Anglo Irish Bank, Allied Irish Banks and Bank of Ireland by offering a 100% depositor guarantee.
The Dublin government was reluctantly railroaded into accepting an €85bn rescue fund from the EU and the IMF, largely because other European nations feared that an Irish collapse would have a domino effect on other nations and on many eurozone banks that had lent to Ireland. The so-called bailout came with an average interest rate of 5.83%. Even though it is not a member of the eurozone, Britain chipped in, largely because its banks have €222bn of exposure to Irish debt, according to the Bank for International Settlements.
However the people of Ireland were furious with the government of Taoiseach Brian Cowen, at handing economic power to outsiders, especially since the bail out was conditional on the Dublin government imposing further austerity measures – including further public sector pay cuts and job losses (blog: EU rescue may not be enough).
We suspect that the turmoil in European sovereign debt markets is far from over, especially given the EU’s reluctance to adopt a “Marshall Plan” style solution for its indebted peripheral nations. Some prominent economic commentators, including Joseph Stiglitz, predict it’s now game over for the euro.
In a recently-published afterword to Freefall: America, Free Markets, and the Sinking of the World Economy“, Jospeh Stiglitz seemed pessimistic (blog: We’re turning Japanese). The Nobel laureate wrote: “Europe created a solidarity fund to help new entrants into the European Union … but it failed to create a solidarity fund to help any part of the euro zone that was facing stress. Without some such fund, the future prospects of the euro are bleak.” Stiglitz added that: “Spain may be entering the kind of death spiral that afflicted Argentina just a decade ago. It was only when Argentina broke its currency peg with the dollar that it started to grow and its deficit came down. At present, Spain has not been attacked by speculators, but it may only be a matter of time.”
However on December 16, after ratings agencies threatened to downgrade Spain’s national debt, the eurozone’s political leaders were spurred into action. At an EU summit in Brussels, the leader of the 27-nation bloc agreed to establish a permanent bailout mechanism for any nation whose large public sector deficits threaten the 16-member eurozone. European Council President Herman Van Rompuy said leaders were prepared to do whatever it takes to protect the single currency as the 27 leaders agreed to replace the temporary EFSF with a permanent bailout mechanism by 2013.
Just two sentences will be added to the European treaty, said van Rompuy. These will set out that “member states whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguard the stability of the euro as a whole.” The revised treaty will also state that: “the granting of any financial assistance under the mechanism will be subject to strict conditionality.”
This granted Merkel her wish that any future bailout fund could only be utilized if there was a systemic threat to the eurozone as a whole and not just one single country. The Germans also got their way in ensuring future aid is dependent on strict conditions, meaning countries being rescued will need to accept severe austerity measures that would impose fiscal discipline.
Summing up the meeting, Van Rompuy claimed the heads of government had agreed a joint strategy that would make the European economy “crisis-proof.” Others, including John Carney, are less optimistic. Writing in CNBC’s NetNet Carney argued that Van Rompuy had in fact signed the European Union’s death warrant.
First published on Qfinance December 21st, 2010