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Posted by: Andrew Bell
Wednesday 13th July 2011
There is little dispute that there is a solvency issue for some European governments – they have too much debt for any plausible mix of tax rises, spending cuts and structural reforms to work. Unless some of the debt is forgiven, paid back on less demanding terms or defaulted on, their economies will be locked into a depression. Eventually their electorates would force a change in policy.
Two factors are exacerbating this problem and lengthening the list of countries whose bond markets have experienced a buyers’ strike, pushing rates up. The first is European policymakers’ failure to agree on the extent and terms of any “rescue”. Once a decision has been made to bail out one government, the slower and more grudging the implementation, the longer investors have to consider who might be in almost the same boat – a sort of “balloon debate” game of market Darwinism. The second failure relates to the negative impact of austerity measures on economic growth. Austerity might be required but, without economic growth, efforts to improve budget deficits will be negated by recessionary effects on tax revenues and government welfare spending.
Europe’s focus on austerity in the midst of Mediterranean recession is a modern-day replay of the outdated focus on the gold standard in the 1930s. Squeezing deficits in uncompetitive economies (often after calling in the IMF) needs an offsetting growth boost, to prevent the process from being self-defeating and render it politically tolerable. In the UK’s case, devaluation provides a stimulus, a remedy denied the peripheral Eurozone economies which have lost their way within the Eurozone but cannot devalue. If the Euro were to be hypercompetitive against other regions, laggards within Europe might be able to hold their own in global markets but the opposite has occurred, with tough talk on inflation having pushed the Euro higher over the past year.
Having initially (in the good times) ignored the structural problems in the smaller economies of Greece, Ireland and Portugal, Northern Europe then almost waited for them to drown before rescuing them. Instead of bringing them to dry land, they left them bobbing in a rip tide while the lifeguards had a conference to develop an appropriate policy on lifesaving.
Having failed to contain a limited solvency problem (owing to disagreement over whether to punish those in need or treat them), Europe has allowed it to ramify into a systemically threatening problem of weak confidence and a drying up of liquidity. Italy, with the continent’s largest debt mountain (though not the worst deficit problem) has seen its debt costs rocket since early July. Finances which were manageable with 4.9% rates become debatable at 5.9% (seen this week) and impossible at 6.9%. This has dramatically raised the stakes, while making the choice of policy more clear-cut, even for European policymakers.
It is virtually inconceivable for Europe to countenance a default by Italy. By leapfrogging Spain, the markets have put pressure on an economy which the EU could not allow to default or exit the Euro. Although it is an understatement that official policy moves have not so far commanded confidence, even Europe should now realise that the choice it faces has become unambiguous – put a cordon sanitaire around the default zone and adopt looser monetary policies (or at least ensure existing policies are reflected in bond markets) or face a break-up of the Eurozone, which would have heavy economic, banking and political costs.
There now seems to be a willingness to countenance a de facto Greek default, since the previous strategy of deferring the inevitable has failed. However, a default in current conditions would have to be accompanied by forcible measures mentioned to reverse the current contagion.
Whilst taking a positive outcome for granted would represent a triumph of hope over experience, if Europe does not rapidly restore confidence, it would represent a policy failure of epic proportions. Faced with the threat to two economies that would be too big to rescue, with dangerous implications for European banks’ capital ratios, it seems likely that policy measures previously ruled out (e.g. rate cuts, a weaker Euro, official purchases of problem debt, unsterilised liquidity provision (QE) and loans at below market rates) will have to be ruled in. For the Eurozone to accept this and its political implications for economic governance may prove as uncomfortable as a hen laying an ostrich egg, though interesting to watch.
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