What’s wrong with the eurozone?
Greater efforts needed to arrest financial contagion
By Robert Klemkosky
The 17 countries that have adopted the euro as a common currency are now experiencing what the United States did in 2008-09, except the asset classes are different — sovereign debt for the eurozone versus housing in the United States. But the commonality is credit, given to countries versus homeowners.
The basic problem with the eurozone from day one is that there is one monetary policy, run by the European Central Bank, but 17 fiscal policies that allow the countries to tax, spend and borrow independently.
It is primarily the southern tier of countries of the eurozone — Greece, Portugal, Spain and Italy — plus Ireland that are of concern because of budget deficits and sovereign debt. All of their debt levels relative to GDP are higher than average, so these five countries have gone to austerity programs, a fancy name for cutting the size of the budget deficit.
But these austerity programs may have exacerbated the problem by starting a vicious economic cycle for these countries; smaller fiscal budgets may lead to slower economic growth, which will lead to lower tax revenues and higher deficits, which may lead to more budget cuts. Most Keynesian economists believe that this may be the likely scenario in these times of already slow economic growth in the developed countries.
The end result is that the five eurozone countries have accumulated debt that the bond markets think excessive. This is reflected not only in the interest rate on their debt relative to Germany’s, for example, but also in the cost of insuring their debt against default. Billions of dollars of credit default swaps have been purchased either as protection against default or to speculate on a potential default by Greece and other countries. An interesting question is who is selling the insurance? Remember AIG.
A big problem with a default on European sovereign debt would be the impact on the European banks. The role of banks in Europe is more significant in terms of financing business than in the United States as European companies rely less on the capital markets for funding.
Thus any problems with the banking system will be reflected quickly in economic activity. Another problem with European banks is that more of their funding comes from short-term loans versus deposits. Money market funds, especially in the United States, have already cut back on their holding of short-term bank notes (commercial paper) and if this market freezes up, as it did in the United States in 2008, it will be a big problem for the European banking system.
A third problem with the European banking system is that the European Central Bank has allowed banks to hold European sovereign debt as if it has zero risk and thus no capital required. A default of Greek debt will result in substantial losses for eurozone banks, especially in Greece, France and Germany. The banks are not that well capitalized and significant losses on sovereign debt will have repercussions for the whole financial system, not only of Europe but all developed countries.
The solution to the crisis thus far has been slow, politically laborious and perhaps inadequate. The European Central Bank has purchased the sovereign debt of Greece, Italy, Spain and several other European countries. The International Monetary Fund and eurozone countries pledged a $153 billion aid package to Greece in 2010 and $157 billion more this year.
But this aid is contingent upon Greece meeting certain austerity hurdles which it has not met to date. Also, a European Financial Stability Facility has been set up with commitments of $630 billion from eurozone countries to support the debt of member countries, although this has to be ratified by the 17 European parliaments.
Are the above funds sufficient to handle the sovereign debt problems of several eurozone countries and the potential impact on its banking system? Probably not. Greece alone has debts of $500 billion and is the country with the lowest credit rating, CC by Standard & Poor’s.
If the pledged funds are not sufficient, the eurozone countries may not have the will to do more. The reality is that a currency union is not a political union; the voters and then the elected politicians have more loyalty to their own countries than to a common eurozone.
So if the five affected countries cannot or do not have the political will to reform their public sector, tax collection and spending, the rest of the countries will not have much incentive to provide further help. A common eurozone bond has been proposed as well as a common euro fiscal policy. Both appear to be dead in the water.
The immediate problem is Greece. Its sovereign debt is selling 40 cents on the U.S. dollar. Greece has several options: it can try to muddle through with political reform and eurozone aid; it can default on its debt; it can restructure its debt by offering less than 80 cents on the U.S. dollar already proposed; or it can exit the eurozone. None are attractive choices, but the market is saying that the probability of Greece defaulting is close to 100 percent. Probably the best that could be hoped for would be an orderly restructuring if that is even possible.
If Greece’s problems cannot be isolated, the big worry is contagion. Fear, risk and uncertainty will quickly spread to other eurozone countries and its banking system. Once that happens, there won’t be much hope for the European economy as well as the economies of all the developed countries. Contagion has already started and has affected markets and economies throughout the world.
This has already impacted the South Korean stock market, the won and growth expectations going forward. The probability of a global recession has increased dramatically. If that happens, the whole eurozone mess becomes even uglier. Hopefully, politicians and finance ministers will wake up and face reality and do what needs to be done.