January 1, 2012
The market still seems to be moving to every headline out of the eurozone, but it’s hard to remember what’s important. So let’s bring this back into perspective.
Since joining the euro back in 1999, the governments of Greece and Portugal (among other offenders) have gotten used to spending a lot of money. When times were good, it wasn’t a problem — banks and other investors were willing to lend them money on the cheap and their public sectors became bloated.
When the financial crisis hit, however, problems came to a head. Debt levels in Portugal, Italy, and Greece became unsustainable, and taxes in a contracting economy are no longer enough to pay the bills.
Greece, Portugal, and Ireland are still struggling to bring their public debt under control, after receiving billions of euros in bailout aid from the European Commission, the International Monetary Fund, and the European Central Bank (the so-called troika). Some of this aid was provided through a temporary Special Purpose Vehicle called the European Financial Stability Facility (EFSF).
These governments needed this money because it became too expensive for them to borrow cash on the open markets, with speculators demanding high rates for lending and traders even betting on a disorderly sovereign default.
The initial round of aid money helped these governments prop up their banks and pay their bills. The ECB also started buying government bonds on the secondary market in order to keep borrowing costs low.
But now Greece needs more dough to stay solvent. EU leaders agreed back in July that a “selective default” was the only option for Greece. Under this situation, euro area nations will guarantee payouts on Greek sovereign debt, but the private sector will bear take a loss — a “haircut” — on their debt holdings, reducing the face value of those holdings.
Italy and Spain are now crucial to the debate. The former has an incredible level of public debt (120 percent in 2010) and the latter has been crushed by a housing bubble and subsequent banking crisis. The July agreement also expanded the EFSF to €440 billion and allowed the ECB to purchase Spanish and Italian government bonds.
Banking Sector Affected
All these problems are now affecting the banking sector. Sovereign bonds in the PIIGS countries (Portugal, Ireland, Italy, Greece, and Spain) — which just a few years ago were highly rated — have lost their high ratings, forcing banks to fear big write downs that cripple lending. Investors wary about the consequences of a Greek default (and other economic problems) are unwilling to loan out cash, producing a liquidity crisis. This is creating a vicious cycle and funding conditions are getting ever tighter.
This hurts economic growth not only in the euro area periphery but in core countries like Germany and France, which have kept their spending under control. While they are to blame for letting the PIIGS spend freely during the good years, now they’re angry. They don’t want to print more money to allow the PIIGS to get off scot-free because it would deflate the value of their own assets. Taxpayers don’t want more of their money siphoned off.
But they also would suffer horribly if Greece defaulted and the banking system collapsed.
The Past Six Months: An Overview
When the 17 leaders of eurozone countries agreed to a second bailout for Greece back in July:
The economic situation in Europe wasn’t quite as bad as it is now. There wasn’t as much skepticism about Greece's ability to actually make good on the deficit-reduction and privatization goals that were terms of its first bailout. And — perhaps most importantly — there were not as many signs that banks across Europe were having trouble getting access to cash.
All this changed in the nearly three months needed to get approval for the July 21 agreement. Suddenly market attention was focused on the eurozone crisis, and it became increasingly clear that core European banks not in troubled countries are at risk. That fear came to a head with the fall of the Belgian bank Dexia in October.
Later that month, EU leaders met in two summits to alter that agreement, increasing the losses private sector holders of Greek bonds will be taking from an estimated 20 percent to 50 percent. They also agreed to expand the EFSF with IMF involvement and guarantees against losses on newly issued sovereign bonds. They hoped more funding would stop the crisis from infecting Italy and Spain.
But political catastrophe and ensuing investor angst threatened these plans.
Greece neared the brink of disorderly default when then-PM George Papandreou called for a referendum on the newest round of austerity measures necessary to receive troika aid. While that referendum never happened, it raised the stakes of European bailouts — either you do what Germany and France say or you lose the euro.
New coalition governments more amenable to central European demands quickly followed in Greece and Italy, with ex-ECB member Lukas Papademos replacing Papandreou and economist Mario Monti taking over for Silvio Berlusconi in Italy. Mariano Rajoy and the center-right Partido Popular also replaced the socialist party in elections in mid-November. All are making visible process towards passing new economic reforms, but as their economies deteriorate they face more vehement opposition.
Perhaps the only positive news in the last two months has come from the ECB, now under the leadership of Italian Mario Draghi. While it has not taken any action to “cure” the crisis, the central bank has made two rate cuts despite high inflation numbers and undertaken various non-standard measures in an attempt to make money more easily available to banks even as they stop lending to one another.
The most recent EU summit in December also made apparent the newest threat to Europe — deepening divisions between the 17 countries that use the euro and the 10 other EU countries that do not. British PM David Cameron angrily refused to agree to the most recent deal to regulate governments’ spending and contribute more money to the IMF’s bailout effort when EU leaders rejected his proposals that would have protected London’s status as the financial hub of Europe.
The Immediate Context
While EU leaders made progress towards long-term debt sustainability in their December summit, they fell short of talking about a true fiscal union or providing much short-term relief for the PIIGS.
Briefly, optimists speculated that the ECB’s newest non-standard measures to support liquidity in the banking system would effectively “save” Europe by allowing banks to profit from charging Italy and Spain premiums to borrow money. Those actions have made a huge impact on Italian and Spanish borrowing costs, particularly in the short term, but banks and investors remain wary — banks are hoarding cash at the ECB and investors broadly speculate that any relief for Italy and Spain is short-lived.
So long as investors continue to speculate against Italy and Spain, the pressure will increase on EU leaders to do something radical. The EFSF doesn’t have enough money to buy enough sovereign bonds in Italy and Spain to keep speculators from raising their borrowing costs, regardless of leverage from investors and the IMF. Nor will it likely have enough cash to make a big dent in the crisis when the European Stability Mechanism — the permanent European bailout mechanism — goes into effect in July. Combined, funding from the EFSF, ESM, and IMF will total about €1 trillion. Conservative estimates peg funding necessary to “bail out” Europe around €3 trillion.
Getting that cash would be tricky. Forcing bondholders to take losses on sovereign bonds as in Greece — or even threatening that they may have to in the future — doesn’t exactly increase confidence in European sovereign debt. However, EU leaders also don’t want to risk another long, drawn-out approval process by the parliaments of EU states.
Further, the legality of the “fiscal compact” agreed upon in December’s summit is debatable. At best, the measures will be debated at length. At worst, the approval process for such measures could require amendments to national constitutions or popular referendums.
Meanwhile, the stability of the European financial system is still up in the air, despite the slew of new ECB measures geared towards making money more available to European banks.
Investors have high hopes for ECB President Mario Draghi. More and more, analysts appear convinced that only the ECB has the power to truly “save” Europe. In particular, they are hoping for some kind of blanket guarantee by the ECB to buy an unlimited quantity of Italian and Spanish bonds, regardless of the implications for inflation.
However, the ECB argues that this would amount to “monetizing sovereign debt,” something that is illegal under the EU treaty and not within the central bank's mandate. It has also reiterated that its commitment remains to price stability (i.e. keeping inflation under control), not growth or employment.
The euro area is expected to sink into recession next year, and it seems like a matter of time before even Germany starts taking a big hit. If this prediction materializes, it will become even more difficult for governments to meet their spending and deficit reduction goals because spending will constitute a greater percentage of GDP.
Market sentiment in the next few weeks will likely determine the pace at which the crisis will continue to escalate. A smattering of meetings between EU leaders will take place next month, and the next summit of EU leaders will take place January 30.
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