By Peter Boone and Simon Johnson
The eurozone self-rescue plan announced last night has three main elements:
- 750bn euros in a fiscal support program, with 1/3 coming from the IMF (although this was apparently news to the IMF).
- The European Central Bank promises to buy bonds in dysfunctional markets.
- Swap lines with the Federal Reserve, to provide dollars.
But the European central banks have come in very early – with government bond prices still high – and there is no sign yet of credible fiscal adjustment for Spain and Portugal. The eurozone apparently did not even discuss the situation in Ireland, which seems increasingly troubling.
This is a whole new level of global moral hazard – the result of an alliance of convenience between troubled governments in the south of Europe and the north European banks (and implicitly, north American banks) who enabled their debt habit. The Europeans promise to unveil a mechanism this week that will “prevent abuse” by borrowing countries, but it is hard to see how this would really work in Europe today.
Overall, this is our assessment:
The underlying problem in the euro zone is that Portugal, Ireland, Italy, Greece, and Spain are locked into a currency which means they are uncompetitive in trade terms while they are also running large budget deficits. To get out of this they need large wage and price cuts to restore competitiveness, and they need to make fiscal cuts to get budget balances back at sustainable levels.
Markets decided these adjustments were going to be difficult, so spreads on those countries’ debts widened (i.e., interest rates relative to German government bonds). As the rates go up, this causes local asset prices to fall, concerns over bank balance sheets increase, etc. This combination was causing an incipient run on banks. Any country with its own currency could reasonably devalue in such a situation, but this is not an option within the euro bloc.
All these problems were exacerbated by the appearance that the Germans were going to be unwilling to bail out troubled nations – and would eventually chose to bail out their own banks instead. It is this risk which is now resolved. The Germans have shown willingness to provide very large amounts of money (the 750bn euro support is probably just enough for Spain and Portugal if they got packages in line with that received by Greece) and they would obviously provide more if needed (e.g., for Italy). (Here again is the ready reckoning chart for interlinkages between indebted Europeans.)
However, the solvency issue remains. The Spanish and Portuguese have said they will now cut their budgets further, but already their forecasts were optimistic, and neither has seemed willing to admit they have severe budget problems, so we will need to watch how they implement in the near term. Greece remains simply far too indebted.
As Willem Buiter (formerly Bank of England, now at Citigroup) remarked last week, you have the greatest incentive to default when you are running a balanced primary budget (i.e., after substantial budget cuts) and still have a large government debt outstanding. His point is that the incentive structure of these programs means they will postpone a decision to default which would otherwise be rational now.
There is no discussion of Ireland, which has one of the highest deficits of all the EU nations. This is a vulnerability to the European Stabilization Mechanism – more countries will flock to its embrace.
There is a more subtle issue with the seniority of debt. The EU packages to these countries are all senior to existing creditors. These creditors know therefore that countries which need packages will get senior funds from the IMF and EU, and, therefore recovery values for bonds will be less.
This is perfectly fair since packages come when no one else will lend, but it explains why packages do not reduce secondary market yields as low as people would expect. The yield on Greek bonds needs to stay high given the risk that the bonds could have 70% writedowns if the likely default does happen. The same is true, to a lesser extent, for Portugal, Ireland and Spain. All of these might eventually need to access the 750bn euros and might eventually default. Bond market yields need to stay high.
The decision by the European Central Bank (ECB) to intervene in the markets is very important. That will help keep markets liquid – but the ECB will probably not buy a lot of debt.
Will the ECB buy a great deal of Greek debt? We doubt it since this constitutes a clear, large credit risk. But it will be interesting to watch. If the ECB is not large in the market they will not impact spreads beyond reducing the liquidity risk premium. Today most of these nations have substantial default risk over 5-10 years, so spreads need to stay high – although they will come in from current levels.
The European Central Bank intervention and this package raise enormous moral hazard issues. The ECB’s management was forced into this kicking and screaming. It was only when they realized that the whole euro zone financial system was at risk of collapse that they threw the kitchen sink at the problem. This can now go two ways: either they tighten fiscal policy across the eurozone, and introduce much more rigorous and enforced rules on deficits and profligate credit through banks, or, they let a system persist which is another “doomsday machine” that will live again to grow, and could one day topple them.
To ultimately get out of this mess, the euro zone needs to grow fast enough to allow nations to grow out of debt. The global backdrop here is very positive in the short term. The jobs numbers in the US last week and strong numbers out of core northern Europe suggest the world can grow. No doubt the ECB and the Fed will use the eurozone scare to justify longer loose policies.
It could be that in two years time Europe’s deficits are much lower, the ECB has hardly bought any bonds, and they have successfully managed a Greek debt restructuring while Spain is out of trouble, and Portugal and Ireland are scraping by in limbo but now isolated problems. With the US likely to still be running near 10% GDP budget deficits – who will seem more risky then? This immediate confidence in the US dollar that has come out of this European crisis could very quickly evaporate.
Alternatively, the underlying fiscal problems in Europe could fester – and the “rules” designed to limit moral hazard may turn out to be a complete paper tiger. In that case, the Europeans again have to make a fateful decision: Do they try to inflate out of the debt burdens of their weakest member countries; or do they instead try to manage selective default, keeping in mind that most Greek debt at that stage will be held by other eurozone governments.