HISTORY is repeating itself – and much more quickly than we seem to realise. The consensus view appears to be that Portugal, Italy, Greece and Spain – the PIGS – will by hook or by crook be given a bail-out if they need one, just as Dubai, RBS and AIG eventually were – and that this would be the right thing for the European Union to do. Yet these are dangerous and lazy assumptions that could end up costing investors and financial institutions almost as much as the subprime and CDO crisis of 2007-09.
They imply a childish, “all can have prizes” view of the world, where no investor ever loses out (and taxpayers always carry the can); that the weaker eurozone countries should be allowed to remain profligate (while more sensible countries are punished); and that moral hazard and extreme risk taking should become the new normal. Even more importantly, nobody actually knows whether or not Germany would sign off a bail-out. The belief that it would smacks of the kind of blind complacency last seen when investors thought Lehman Brothers would never be allowed to fail. It was – and everybody was shocked. But grossly mismanaged countries have defaulted on their debts in the past – why would the PIGS by any different?
There are two equally unconvincing answers to this question. The IMF stepped in over Eastern Europe last year, preventing a major contagion. It is unlikely to do so this time: its budget may not be big enough and it would feel that it was treading on the EU’s toes. So what about Brussels itself? The EU is caught between two provisions of its constitution. Article 125 rules out bail-outs in ordinary circumstances: “The union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State”. However, Article 122 provides a loophole: when “a member state is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the council, on a proposal from the commission, may grant, under certain conditions, union financial assistance.” The trouble is that the recession is merely the trigger for this new credit crisis: the underlying reason is longstanding political incompetence and governments that lived beyond their means. We are not talking about a tsunami or earthquake.
Nobody knows which way the courts would go if the EU were to attempt to push ahead with a rescue regardless.
Investors keep misjudging risk. With subprime they thought the US housing market would never suffer price drops, an idiotic error. They also bought the idea that cleverly tranched CDOs could protect them from disaster, equally wrong but more forgivable. In this case they assumed that buying the bonds of a euro member meant that they would somehow be protected, an elementary error which confused monetary policy – controlled by the competent European Central Bank – and fiscal policy – controlled by corrupt and incompetent national governments. Sure, the Maastricht Treaty was full of supposed limits on the public debt but these were toothless and routinely ignored. So yet again investors allowed weak debtors to borrow at lower rates than their true riskiness warranted.
The EU may step in to bail-out bust governments or it may allow them to default. Either way, we will all pay a steep price.