Is a queue forming at the EU’s fiscal soup kitchen?
– Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. –
Back in the prehistory of the euro zone, I wrote an article in the Times trying to work out how the game currently being played out in Europe would end.
Re-reading it, I think on balance I stand by my 1997 forecast.
Of course, back then it seemed far more likely that the major default threat would come from Italy or Belgium – Greece wasn’t even a member (and seemed unlikely at that stage to be admitted), but otherwise the endgame still looks the same to me.
The situation is as follows. Greece’s national debt is over 110 percent of its GDP, a figure which is growing by 12 percent or more every year (we cannot be sure, because there is widespread suspicion that the government is understating its deficit).
Given that Latin American countries have been often defaulted with far lower levels of debt, the markets are worried – which is hardly surprising, since Eurozone members are in exactly the same situation as third-world countries borrowing in dollars.
It cannot be emphasised enough that, at least in principle, the euro is nobody’s domestic currency, in the sense that no national government or central bank has the right to print it in order to repay its debts. Printing euros is the sole prerogative of the European Central Bank and its governing council, made up of representatives of all the euro zone member countries.
It follows that, without assistance, Greece will need to generate a substantial surplus in order simply to cover the interest on its debt, let alone to start repaying the principal. In recent weeks, the markets have woken up to the danger that Greece’s problem will be exacerbated when the ECB starts to raise interest rates from their crisis levels towards a more normal range, as it is expected to start doing soon.
Hence, the dilemma facing the European authorities. Should they contribute to paying off Greece’s debts, or should they allow it to default? A bailout was explicitly ruled out in the treaties establishing the European Monetary Union, but until recently the markets either ignored the possibility of default or assumed that the no-bailout clause would be overridden if necessary with little fuss. Their sang froid was reinforced by the banking authorities who insisted that Government debt should be treated the same whichever country issues it, a regulatory requirement which could quite reasonably be interpreted as an implicit guarantee.
Obviously, bailing out Greece would not place an intolerable burden on EU budgets, since it is a small country with debts which are insignificant relative to the European economy. The difficulty is that Italy, the euro zone’s third-largest economic power, has a debt-to-GDP ratio similar to Greece’s, and for Belgium – smaller, but emblematic for the EU in a way Greece will never be – the figure is around 100 percent, so there could be a queue forming at the EU’s fiscal soup kitchen.
Recently, Germany has been talking tough, trying to shake the market’s confidence in a bailout, with considerable success, as can be gauged from the fact that it currently costs over 4 percent to ensure against a default on Greek debt and 1½ percent for Italian debt. But is it really likely that Germany will be able to hold the line in the councils of the EU, against the assault of at least 5 countries which are potentially facing a default meltdown: Portugal, Italy, Greece, Spain (the so-called PIGS), plus Belgium? Add the fact that France will certainly want to take the line of least resistance, whereas Germany can probably count only on the support of the Dutch and Austrians, and the battle looks unwinnable.
What happens next? I suspect that brotherly feelings are no more prevalent inside the EU than anywhere else. As voters in surplus countries realise they face years of paying taxes to support their less responsible euro brethren, I expect them to react in either or both of two ways: with new political movements which may well turn ugly, and with increasing demands on their politicians for more spending. After all, if they can’t beat ‘em, they may as well join ‘em in what I previously called the euro zone’s poverty trap. The medium-term outcome will be a flood of euros as member governments’ debts are monetised, with obvious consequences for the currency.
There is one very important caveat to this conclusion, however. In the last decade, both Britain and the U.S. have followed fiscal policies every bit as irresponsible as Greece, and while neither is likely to default formally, both will ultimately inflate away their debts, so the prospects for the pound and dollar are every bit as grim as for the euro. The real significance of the euro zone debt crisis is that it makes it absolutely clear that, much as we may need a new reserve currency to replace the dollar, the euro is in no position to fill the role. The renminbi is still unconvertible and subject to all sorts of restrictions by the nervous Chinese economic policymakers, but if they could only find the courage to dive into the pool, they would surely scoop the gold.