Some thoughts about the European crisis
“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually, and then suddenly.”
(Ernest Hemingway: The Sun Also Rises)

After being relegated to the background by expectations of a new round of monetary easing by the Federal Reserve, the problems in the eurozone have resurfaced again. Here are some of my thoughts about this:

- Greece and Ireland’s problem is one of solvency and not liquidity. Levels of debt in these countries quite simply exceed their ability to honour their debt. Lending to Ireland at a rate of 5.82%, as decided by the Eurogroup and the EU finance ministers on 28 November, will not improve the ability of the country to repay its debt;

- A solvency problem is not resolved by adding more debt to the pile. A company in debt has three main choices: either it restructures its debt, it raises more capital, or increases its ability to repay debt by increasing its cash flow. For a country to 'increase its cash flow', nominal growth has to exceed the interest rate that it pays on its debt. By doing this, the country lowers its public debt to Gross Domestic Product (GDP) ratio and enters a virtuous circle. On the other hand, if the interest rate paid on the debt exceeds its nominal GDP growth, the country enters a vicious circle. Germany is currently in a virtuous circle; the peripheral countries (Southern Europe and Ireland) are in a vicious circle;

- The fact that the core (Northern Europe) countries are managing to finance themselves at attractive rates (partly due to the crisis) while the peripheral countries pay increasingly exorbitant rates further widens the competitiveness gap between these regions. The gap exists because of diverging unit labour costs (labour costs adjusted for productivity gains) and is the main challenge for the survival of the euro in its current state. Diverging trends in labour costs are mainly due to the fact that the peripheral countries did not take advantage of the low interest rates they inherited when they first joined the eurozone to clean up their public finances or undertake productive investments. What the low interest rates did do, however, was to create a situation of excessive consumption and soaring house prices;

- As members of the eurozone, these countries do not have the possibility of resorting to currency devaluation to restore competitiveness. Any rebalancing will have to be done by focusing on labour costs, which must rise much more slowly in the peripheral countries than in the core countries. Given that labour costs are almost stagnant in the core countries, this means that they will have to fall in the peripheral countries. Such an adjustment is painful and would involve a drastic reduction in the standard of living, which is not likely to be accepted by the population;

- The budget austerity measures generally recommended by organisations such as the IMF do not work in the current situation. The fall in public spending and the rise in taxes result in lower economic growth and affect tax revenue. This in turn leads to a worsening in the budget deficit and the debt level and the need to embark on new rounds of austerity measures, and so on. In the past, a country experiencing a crisis brought about by escalating debt or a weakened banking system could resort to austerity packages and currency devaluation, while taking advantage of strong international growth. Today the debt problem, the fragility of the banking sector and weak nominal growth is common to most of the industrialised countries. In this context, large-scale budget austerity without currency devaluation is tantamount to economic suicide;

- The problem in Ireland is mainly caused by the banking sector. The recent crisis was spurred by the increase in the cost of bailing out the Irish banks. Its desire to prevent its banks (which have become too big compared to the size of country) from going under pushed the Irish budget deficit sky-high. Iceland made the opposite decision: it decided to let its banks fail – their debt had risen to over10 times GDP. Iceland is currently experiencing a severe recession, but the country is starting to see the end of the tunnel, thanks also to a sharp currency devaluation. This is not the case for Ireland, where unemployment has already risen to 13% (according to the OECD, unemployment in Iceland is expected to peak at 8.1%) and a brain drain is already underway;

- Overall, the distinction between countries and their banks is becoming increasingly blurred. The reasoning becomes circular - on one hand, we cannot let Greece or Ireland restructure their debt because this debt is often held by German, French or other banks which would then suffer significant losses, putting the world financial system in peril. On the other hand, the vulnerability of the banking sector is likely to require government intervention, which will exacerbate the public debt crisis and the prospect of debt restructuring in certain countries;

- In a crisis situation, any credibility lost by governments is dangerous and likely to create a self-fulfilling prophecy (i.e. investors sell/stop buying a country’s bonds because they expect that country to default. This leads to an increase in the cost of financing of that country and brings about the default expected).  Their credibility is already starting to wear down: the Irish banks behind the latest episode of the crisis had passed the stress tests in summer; Ireland was supposed to help out with the bail-out of Greece, and the announcements of 28 November do not seem realistic. In a recent note , Dylan Grice, the brilliant strategist at Société Générale, showed that the reaction of the European politicians to the crisis was typical of human behaviour when faced with events unforeseen and beyond our control: 

• denial that there is a problem,
• denial that there is a big problem,
• denial that the problem has anything to do with us.

- It is important to note that the rise in bond yields of countries like Spain and Portugal is not due to “speculation”, but to investors’ selling off (or not buying) bonds that they would have traditionally held. As an asset class, government bonds are supposed to offer security, liquidity, low volatility and negative correlation with risk assets. Those of the peripheral countries no longer offer these characteristics and are losing their natural pool of investors (pension funds, insurance companies, etc);

- Since the announcement of the bail-out of Greece in May, the 10-year German Bund yield slipped 10 basis points (0.10%), while in Italy, the bond yield rose by 50 basis points, 110 basis points in Spain, 320 basis points in Portugal and 360 basis points in Greece. These yields do not exist in a vacuum - they are the cost that countries would have to bear for their (long-term) financing needs if they had to go to the market (which will be the case at the latest in 2013 when the stabilisation fund runs out). Rising yields and the increase in credit default swaps (the cost of hedging against payment default) for the peripheral countries shows that investors do not trust the ability of these countries to pay back their debt;

- The survival of the euro in its current form depends very much on Germany. As long as the country believes that the advantages of the euro far outweigh the disadvantages, it will deploy efforts to support the currency. The problem is that the disadvantages could rapidly gain in importance: if Germany guarantees (or pretends to guarantee) the debt of problem countries, its creditworthiness will diminish and its cost of financing will increase (since October, we have seen a sharp increase in long-term German bond yields). Moreover, the country is currently experiencing robust economic growth and many companies have announced salary increases for next year. Germany has traditionally been very sensitive to risks of inflation, and a decision by the European Central Bank to keep interest rates very low (in order to help the peripheral countries) in such a situation could lead to problems in the long run;

- It has always been said that the euro was a political construction rather than an economic one. The current crisis could result in greater political integration and a kind of fiscal federalism. The eurozone would then become a large family where each would take care of the other (and bear the other’s debts). One way or another, this means that taxpayers in the core countries will have to pay the bill for bailing out the peripheral countries (rather than the one for recapitalising their banks if the peripheral countries restructure their debt). It will be very difficult for the core country governments to get voters to accept this situation;

- Current debates about a mutualisation of sovereign bond issues are moving in this direction and are the logical next step with regard to the Eurogroup’s decision of 28 November to downgrade government bonds to the status of subordinated bonds: "In all cases, in order to protect taxpayers' money, and to send a clear signal to private creditors that their claims are subordinated to those of the official sector, an ESM loan will enjoy preferred creditor status, junior only to the IMF loan." In other words, countries having received an official loan from the IMF or as part of the European Stability Mechanism (ESM) will have to pay this back first before paying back government loans. This decision means that in future, there is a greater risk that government bondholders will not get their investment back in full. And this will do nothing to solve the issue of the problem countries’ ability to finance themselves in the market at reasonable rates;

- Barring the implementation of a fiscal transfer mechanism, it is difficult to see how we can keep the euro in its current state, avoid debt restructuring in certain countries, protect the banks and come up with a solution for the Greeks and the Irish that would allow them to sort out their problems over a reasonable time frame. If anything is done, in my opinion, it will be necessary to try to break the ‘country-bank’ problem I talked about in the seventh point above. This could involve the recapitalisation of banks considered systemically important. In the current environment, I don’t think that the private sector will want to be involved in such recapitalisation, at least on a large scale. It would thus be up to the governments to inject the necessary capital by setting up a fund whose objective would be to recapitalise the problem banks in the eurozone region (why is Ireland forced to save its banks on its own when the failure of its banks would have a greater impact outside than inside the country?) I think that such a fund would make more sense than the European Financial Stability Fund (EFSF) set up recently to support eurozone countries in difficulties. Once the banks would get back on their feet again, the next step would be to examine how to restructure the debt of certain countries;

- In the end, the advantages of keeping the euro should be compared to the cost of the solutions required to save it. Burdening future generations with colossal debt just because the break-up of the single currency is 'politically unthinkable' is not acceptable.