The party’s over
It’s time to call it a day
The postwar era of illusionary trade-offs – an expensive social model without the robust postwar growth – is now fading into history in the Eurozone.
In May 2010, the Eurozone crisis began with turmoil in Greece. In the coming weeks, a new round of instability in Greece will pave way to the end- game in the Eurozone.
As Nat King Cole put it, “the party’s over.”
From Greek tragedy to Brussels’ awakening
Last December, EU leaders agreed on a new bailout fund involving the IMF, the acceleration of the European Stability Mechanism (ESM), and a fiscal compact between 26 of the EU member states (with the UK opting out).
The new compact restates many of the old goals of the Stability and Growth Pact (1997), which was violated about 100 times before the onset of the global crisis – but with sanctions indicating that “now we really mean it.”
Currently, the “Troika” – the EU, IMF and the European Central Bank (ECB) – expect substantial progress on the voluntary restructuring of Greek debt.
In May 2010, the European Union and the IMF agreed on a rescue package worth EUR110 billion, which was to be paid out in a series of tranches. Some EUR73 billion ($93 billion) has already flowed into Greece.
The current conflict, however, centers on the planned second bailout package for Greece, worth EUR 130 billion ($170 bn) and agreed to in principle at an EU summit last October. Greece needs the first payment of this fund in March to avoid insolvency. Part of this package is the 50% debt haircut for Greece that is now under negotiation.
Again, there are three options on the table: tougher austerity measures, larger debt restructuring, or additional funds.
If the Troika asks the Greeks to impose even tougher austerity measures, growth will be extinguished and social turmoil will deepen. In the absence of substantial policy shifts, political obstacles against additional funds are increasing in the Eurozone. Finally, the ongoing debate over the proposed 50% debt restructuring is a distraction since what is now needed is a probably a 90% haircut.
Since May 2010, the Troika has promised Greece altogether EUR 240 billion ($312 bn). Since last October and the Troika’s debt sustainability study, it has been clear that much more is needed – another EUR 250 billion in the course of the next decade.
At the time, I, along with others, criticized those figures for unrealistic assumptions. Behind the façade, this is now acknowledged. As the Troika’s projections are falling apart, Brussels is in for an expensive awakening.
A more realistic approach would have spared the Greeks of unnecessary suffering and the Eurozone from unnecessary escalation and contagion. Now the former is unavoidable and the latter is far more difficult to contain.
The Eurozone’s dilemmas comprise fiscal and monetary policies, banking crisis, the ECB risks, liquidity and solvency dilemmas and pro-growth policies.
Bank recapitalization. Despite rounds of not-so-stressful stress tests, the Eurozone banking crisis continues to deteriorate, as indicated by recent (and impending) downgrades of large banks. In November, the Eurozone countries agreed that 70 major euro banks must raise EUR106 billion ($150 bn) by mid-2012, and more recently the target has been raised. As the Eurozone is sinking deeper in a recession, it is only prudent to expect bank turmoil, especially as Brussels’ projections of the euro banks’ capital needs continue to ignore massive losses that these banks would accrue from debt restructurings.
Liquidity. After the Euro Summit in December, the zone will continue to rely on the current EUR 440 billion ($570bn) liquidity fund, while the EUR 500 billion ($650bn) European Stability Mechanism (ESM) will come into effect already in mid-2012 (and will no longer need unanimity in urgent decisions). Eurozone and other countries also agreed to lend EUR 200 billion ($260bn) to the IMF via their central banks. Unfortunately, even these liquidity facilities remain inadequate. With Standard and Poor’s decision to punish nine euro-zone countries with downgrades and to strip France and Austria of their AAA ratings, the effectiveness of the rescue funds is eroding like ice in hot sun.
ECB Risks. And unlike the Fed, the Eurozone central banks absorbed substantial amounts of potentially toxic debt during the global crisis. Ultimately, the ECB is accountable for their debt, which must still be defused. Since May 2010, the ECB has purchased sovereign bonds from crisis-stricken euro-zone member states worth EUR 213 billion ($280 bn). An estimated €55 billion ($71 bn) of that are Greek bonds. But the ECB risks are only accelerating, due to the collaterals that banks must post when they borrow money from the ECB.
Since the onset of the global crisis, financial institutions from debt-stricken Eurozone countries such as Greece, Portugal and Ireland have borrowed extensively from the ECB. In turn, the ECB has provided euro banks with massive amounts of liquidity. In December, the ECB injected European banks with EUR 500 billion ($650 bn) with long loan periods of three years. The assumption is that the debt and the collaterals are sustainable.
Fiscal flaws. Until recently, most European economies have engaged in front-load austerity measures and promises of long-term fiscal support. It is almost as if the 1930s deflation, mass unemployment and Keynes had never occurred. In the absence of adequate short-term fiscal support, the position of the middle and working classes across the Eurozone, are bound to deteriorate, while pockets of poverty will expand. As economic crisis will get worse before it will get better, social instability will increase, which, in turn, will contribute to greater volatility in politics.
Monetary reversal. Under Jean-Claude Trichet, the European Central Bank (ECB) hiked rates when it should have cut them. Under new chief Mario Darghi, the ECB policy is being reversed, belatedly. Unfortunately, there is no longer much room to maneuver because, as Fed’s efforts suggest, monetary policy alone cannot reverse economic fortunes.
Insolvencies. The Eurozone crisis could be contained only as long as it involved primarily economies, which account for less than 3% of the Eurozone GDP (e.g., Ireland, Greece, Portugal, etc.). As the highlight shifted to Spain and Italy, which together account for almost 30% of the regional GDP, the game entered a new stage. As in the case of the small euro countries, bailing out Spain or Italy would require covering their public financing requirements for three years. The associated loans would amount to about $2.1 trillion. If the IMF were to fund one-third of the total, as it did in the case of the small peripheral countries, its share would amount to $700 billion. In turn, the Eurozone countries would have to raise $1.4 trillion, which currently exceeds the available capacity of the rescue fund by over $1 trillion.
Pro-growth policies. In order to sustain their competitive strengths, the euro nations need to engage in pro-growth policies, which require substantial structural reforms, including more flexible labor markets, higher retirement ages, greater investment into innovation, and so on. The problem with the current stress on austerity policies is that they are undermining the remaining competitive strengths in the Eurozone.
“All dreams must end”
Officially, all EU countries are expected to maintain a balanced budget with a deficit limit to be enshrined in all national legislations or constitutions and quasi-automatic sanctions. Unofficially, even German Finance Minister Wolfgang Schauble has been seeking ways to circumvent a constitutional amendment requiring balanced federal budgets in Germany in 2016, to have greater flexibility in crisis situations – which are to be expected.
The S&P decision to penalize nine Eurozone countries with downgrades is only the first in a series of downgrades that will follow in the coming months.
After the dust settles, the Eurozone we know today will look very different. The region’s problems are systemic and pervasive. In structural terms, Greece already looks like an emerging economy.
With the current European policies, it is not just the disease but the doctor who is slowly but surely wearing away the patient.
As Nat King Cole put it:
The party’s over
The candles flicker and dim
Now you must wake up, all dreams must end
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