FORGET about all the nonsense, the acronyms, the double-speak and the details of last night’s communiqués from Europe’s leaders. The reality is this. A country that has too much debt and cannot repay it by raising taxes or selling assets faces three choices: it can default; try and inflate or depreciate the debt away by debasing its currency; or get another country to pick up the bill. Cutting out the verbiage and obfuscation, all three of these options were discussed in some form at yesterday’s near-useless summit.
Option one is often best in the medium-term for countries – but triggers massive pain in the short-term for national economies (Argentina’s society and middle class almost collapsed after its 2002 default, before bouncing back) as well as those who lent them the money (banks, insurers and pension funds) or who insured the debt. A large enough uncontrolled default could affect the entire world.
The good news is that a managed write-off of Greek debt is on the agenda; the bad news is that it may not be big enough to prevent another Greek bankruptcy in a couple of years’ time. Yesterday’s meeting was vague about this. EU officials said that negotiations on bank haircuts on Greek debt may not be concluded by the weekend. There is a general – but faulty – consensus that the process must be passed off as voluntary not to become a “credit event” which would then trigger credit default swaps (CDS) having to paid out (but what, then, is the point of CDSs? It is a disgrace that people are being robbed of the insurance they have purchased). They also want to “ringfence” Greece by claiming that it is the only country that will see write-offs. What is really needed is maximum Greek haircuts and maximum “private sector” contributions; a managed default in all but name.
Some Eurozone financial institutions had no choice but to load up on Greek debt for regulatory reasons and one should feel sorry for them; but others chose to do so. Such is life; there must be no more socialised losses and privatised gains. Many institutions will have to raise more capital to compensate for the write-offs (€106bn in total, the European Banking Authority says) – but the idea that everybody should have 9 per cent Core Tier I capital by June 2012 is dangerous as it could lead to a credit crunch and reduced lending, rather than safer banks.
Option two is not possible for individual Eurozone countries as their debt is, in effect, denominated in a foreign currency they do not control. But trying to use the ECB to monetise national debt is equivalent to doing this. Pushed to the extreme, it can trigger hyperinflation – or, more likely in the current environment, excess liquidity which ends up blowing new bubbles in asset markets. The ECB has an exposure of €590bn to the PIIGS nations, up from €444bn only 4 months ago.
Option three is what the bailout fund – which will now be leveraged to just €1 trillion, possibly with the help of Chinese money – would achieve. Again, it is not quite clear what is being planned here, the potential role of the IMF, the structure of the mooted special purpose investment vehicle or how the leveraged fund would be turned into an insurance scheme for Italian debt. It is amusing that the EU is now embarking on the sort of financial engineering and off-balance sheet structures it loudly blamed from the crisis of 2008.
Yet even if emerging nations are willing to put their money into such a dodgy venture, Germany and other EU member states would still pick up some of the tab. It’s not quite another Versailles Treaty, where Germany was saddled with reparations for years, but it could still eventually become that way. The stark truth is that the debt will not go away: it would just be spread around the global economy. This is a recipe for disaster – moving sub-prime mortgages around the system did not reduce or abolish their risk. Risky assets are correlated.
Even if the bailout fund can be leveraged to €1 trillion, there will not be enough resources to fully backstop Italy and Spain. Open Europe has the numbers: Italy will have to borrow between €825bn and €907bn over the next three years, depending on budget policies. Spain will have to borrow between €500bn and €602bn. A 1 percentage point increase in yields would boost Italy’s interest payments €43bn over the next five years. Some money from the leveraged-up bailout fund will also be needed for other countries – and then there will also be other expenditures, such as on recapitalising some banks. The sums are massive. Yesterday’s “agreement” is barely a draft blueprint and is largely devoid of numbers and detail. But even taken at face value, this is not a plan that will save the Eurozone.
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