Stumbling Into the Eurozone Solvency Crisis

In fall 1991, the Soviet Union collapsed. In fall 2008, the laissez-faire capitalism of the advanced economies imploded. Several nations – especially in the Eurozone, the United States, and Japan – have been stumbling through crises.

This crisis mode has often been portrayed as a moderate, incremental and piecemeal solution to the European turmoil. In reality, it has the potential to make the crisis far more painful, disruptive and pervasive.

 

Record debt levels in peacetime

In the Eurozone, there is a temptation to see the soaring public debt levels as a severe liquidity crunch, which is considered to be a fall-out from the global financial crisis. If only the crisis had been averted, the argument goes, the debt levels would not be a problem. But that is an illusion. In reality, the record-high debt levels reflect a solvency crisis, which is a result of 25 years of laissez-faire capitalism in the most advanced economies.

In the past, public debt has soared when it had been used, in most advanced economies, as the ultimate shock absorber, especially during times of war and conflict, such as World War I and II. In peacetime, public debt has climbed in bad years, but without declining much in periods of growth.

From the mid-1960s to the mid-1980s, primary spending increased quite rapidly in the advanced economies, reflecting predominantly a surge in health care and pension spending.

The negative effects of the global financial crisis may diminish by the mid-2010s. At the same time, however, advanced economies will have to cope with the massive challenge of reducing debt ratios when ageing-related spending – especially pressures from health care systems – will put additional pressure on public finances.

Addressing these fiscal challenges in a comprehensive way would require pro-growth structural reforms, gradual and steady fiscal adjustment, stronger fiscal institutions and adequately equitable burden sharing among the relevant stakeholders.

And yet, the effort to stumble through the crisis has effectively mitigated attempts at such comprehensive reforms – as evidenced by the current debate in the Eurozone.

Running behind

During the past year, the efforts by the European leaders to support the struggling crisis economies share one common denominator: they have consistently been running behind the developments. 

In March 2010, Jose Mario Barroso, President of the European Commission, introduced the 10-year Europe 2020 strategy for revising the economy of the European Union. Aiming at “smart, sustainable, inclusive growth,” the strategy proposed raising the employment rate of the European labor force, investing 3% of GDP in R&D, reducing greenhouse gas emissions by at least 20%, compared to 1990 levels, and reducing the number of Europeans living below national poverty lines by 25%.

The Europe 2020 strategy sums up the European model of social market economy with a strong environmental approach, commented EU Council President Herman Van Rompuy.

Only weeks later, realities caught up with the well-intentioned European leaders. By early May, the Europe 2020 strategy was dead on arrival as European authorities were feverishly putting in place an intervention mechanism to preserve stability in the Eurozone.

In order to continue consultations over the crisis, Italian Prime Minister Silvio Berlusconi and French President Nicolas Sarkozy cancelled trips to Moscow to mark the anniversary of the end of World War II.

Perhaps that was only appropriate; after all, as Greece’s debt turmoil was spreading to Ireland and Portugal, and possibly even across the Atlantic and the Pacific, the postwar economic order was rapidly fading into history.

From One Crisis Scenario to Another

For a year now, European leaders have opted for stumbling through the crisis. However, as the crisis continues to linger and has increasing potential to escalate, some of these leaders are now more willing to contemplate debt rescheduling in order to overcome the Eurozone debt crisis.

In the stumbling through scenario, the crisis has been perceived as a severe problem of liquidity. The difficulties in the banking sector are acknowledged, but downplayed. Efforts focus on insulating the sovereign debt incrementally, one country at a time. Upgrading competitiveness is considered a German obsession, something that is marginal to the debt crisis proper. In brief, times are bad, the argument goes, but let’s not be pessimistic.

In the debt rescheduling scenario, the crisis is still described as a liquidity problem, although the solutions are predicated on insolvent sovereigns. The difficulties in the banking sector are acknowledged, and the 2010 stress tests are considered not-so-stressful. The focus is on debt rescheduling, either at much longer maturities and a lower interest rate, or by letting investors take a hit on principal. Competitiveness, for all practical purposes, is not perceived as a problem. In brief, get the macro fundamentals right, the argument goes, and the sun will shine again.

For a year, the European leaders have been stumbling through the Eurozone debt crisis. But now they find themselves increasingly forced to shift to the debt rescheduling mode.

The effort to stumble through a perceived liquidity crisis in one country after another has proved to be a way to stumble into a systemic and pervasive solvency crisis.

(Futile) Efforts to Restore Fiscal Sustainability

Since May 2010, the Eurozone has witnessed several efforts to restore fiscal sustainability.

Some countries have opted for fiscal pain, seeking to increase taxes or cut public spending, as exemplified by the strong austerity measures of James Cameron’s Conservatives in the UK.

Interestingly enough, in the first quarter of 2011, as the Eurozone grew by 0.8%, German economy grew three times faster than the UK. In Britain, growth lingered at 0.5%, following a plunge of the same size in the fourth quarter of 2010, which had resulted in warnings that underlying growth was flat.

These developments are hardly surprising, even if that is the way they continue to be reported. As severe austerity measures reduce the propensity to consume, growth suffers. Keynes is probably turning in his grave and paraphrasing Yogi Berra: “After seven decades, déjà vu, all over again.”

Other countries have increased recourse to revenues from monetary issuance by the central bank. This option, however, is restricted to the rare and few, including the United States. But as economies are more interdependent globally than ever before, quantitative easing policies in advanced economies aggravate inflation, potential asset bubbles and soaring food and oil prices in the emerging and developing economies.

As the Brazilian finance minister, Guido Mantega, recently put it, wealthy countries are attempting “to export their way out of difficult economic situations” by printing money and keeping interest rates low.

Still, others have put their faith into the higher growth rate of GDP. But, for all practical purposes, only the large emerging economies have managed to maintain a growth rate of 5-10% in the aftermath of the global crisis. Most advanced economies continue to suffer from lingering growth of 0-1.5%.

Deepening Political Backlash

Since May 2010, most PIIGS economies – especially Greece, Ireland, Portugal – have struggled to fulfill the conditions of the bailout packages/ At the same time, they have been negotiating on lower interest rate on public debt, in order to avoid, or at least to defer default.

These episodes of turmoil, hesitation and resolve have been possible as long as the turmoil has been confined to economies that represent less than 2.0%-2.5% of the total Eurozone GDP – and as long the Eurozone’s AAA-rated countries have been willing to finance what many of their citizens perceive as fiscal abuse by Southern Europe’s “Club Med” nations.

This period, however, came to an end with Finnish election in mid-April, when the populists Euro-skeptics quintupled their support. It reflected the ongoing political backlash that is already under way in AAA rated countries.

In Germany, Chancellor Angela Merkel’s poll ratings have also suffered with the marathon of state elections, which have hurt the ruling government coalition, especially as the bill for bailing out deficit-hit states has been mounting.

In Greece, debt has ballooned to more than 140% of GDP, the highest in the euro’s 12-year history. Ireland’s debt has surged fastest to almost 115%. In Portugal, Italy, and Spain, the debt level is already 99%, 133% and 78%, respectively. Unsurprisingly, Greek bond yields have soared since mid-April, when German Finance Minister Wolfgang Schaeuble said that Greece may need to restructure its debt, breaking with the official stance of European governments and the European Central Bank.

In Japan, debt as a percentage of GDP has passed 204%, and the aftermath of the triple crisis (earthquake, tsunami, and nuclear crisis) will contribute to rising debt levels. In the United States, the comparable figure is now close to 100%. Treasury Secretary Timothy Geithner has been able to defer the debt limit of $14.3 trillion to August 2, but a deeply polarizing debate is inevitable.

In early May, finance ministers from Germany, France, the Netherlands and Finland met their Greek counterpart, Giorgos Papaconstantinou, in Luxembourg as part of efforts to draw a line under the Eurozone’s sovereign debt crisis. As the eurozone’s vital AAA-rated economies, these creditor nations – Germany, France, the Netherlands and Finland – are the key to Europe’s bail-out fund; the €440bn European Financial Stability Facility, which is viable – but only as long as they stand behind it.

In Germany, the debt level is now 81% and in France it is about the same as in Portugal; that is, 97%. (Even in UK – despite harsh austerity measures – it has climbed to 89% of GDP.)

As aggregate euro-area debt is moving closer to the 90% level, it weighs heavily on long-term growth prospects. In turn, a debt restructuring, while necessary, risks triggering a banking crisis.

Restoring Eurozone fiscal sustainability, really

Fiscal erosion in the Eurozone can only be restored with a much larger effective liquidity support facility (twice as big as the current scheme). However, fiscal sustainability cannot be really addressed until the ongoing crisis is recognized as a solvency crisis.

In order to overcome such a crisis, it is vital to restructure the unsecured debt of EU zombie banks and recapitalize the systemically important ones among them. The “too big to fail” syndrome is not an American problem; it is pervasive to the Eurozone and Japan – most advanced economies.

Amidst the financial crisis, taking more debt to deter another Great Depression was justified, but it is not a long-term solution. Currently, Euro leaders seek to bail out one crisis economy after another by eroding the fiscal credibility of ever-fewer AAA-rated Euro economies. Like the legendary Baron Münchausen, they are trying to escape from a swamp by pulling themselves up, by their own hair. In reality, restructuring the debt of the insolvent Euro economies is no longer a matter of principle, but just a matter of time – and time is running up.

Finally, there is the issue of European competitiveness. Lisbon Review ranks nations, according to their economic performance, competitiveness, and reforms.  In the recent Review (2010), East Asian countries, on average, left behind both the United States and the Eurozone. Meanwhile, European investment in innovation has been relatively stagnant for years. In the long run, upgrading European competitiveness through innovation is critical to restore fiscal sustainability.

Last fall, IMF researchers estimated that, under the current and future pressures on public finances—large primary gaps and rising health care and pension spending—public debt would spiral out of control in the absence of fiscal adjustment. Under unchanged policies, the net debt-to-GDP ratio of the G-7 economies would reach 200% by 2030 and exceed 440% by 2050. In other words, the leadership of the advanced economies has been a gross failure – and the bill will be paid by generations to come.

Today, many observers would concur that the dissolution of the Soviet Union was a process of systematic disintegration. With laissez-faire capitalism, the turmoil of fall 2008 did not come out of the blue. It was built by systematic and pervasive secular trends, which were instigated by historically record-low interest rates, hollow faith in the self-discipline of markets, and the erosion of financial institutions.

Now is the payback time.