In the early 1990s, with many European countries struggling to maintain their competitiveness in an increasingly global economy, Europe’s political elites waged a successful campaign to adopt a European Monetary Union (EMU), with a common currency at its heart. Underlying the treaties that formally created the EMU were a series of implicit agreements among its founders. Europe’s new currency would be modeled on Germany’s Deutschemark and managed by a European Central Bank modeled on Germany’s Bundesbank. To ensure the common currency’s survival among diverse member states, countries joining would strive to harmonize their fiscal policies and to adhere to strict budgetary discipline (as delineated in Maastricht Treaty rules and the Stability and Growth Pact). Collectively, these steps would enable member countries to enjoy significantly lower borrowing costs, approaching Germany’s. And in a virtuous cycle, such lower borrowing costs would promote growth – giving weaker EMU signatories room to undertake the structural reforms and fiscal belt tightening they would need to remain members in good standing over the long term.
How did this vision play out? Sovereign borrowing costs for the EMU’s constituents did in fact collapse and converge toward Germany’s Bunds. Sure enough, these lower borrowing costs spurred a decade-long, credit-fueled growth boom throughout Europe. But instead of using this boom period to conduct needed economic repairs, EMU countries spent their growth dividends on various excesses. In Spain and Ireland, the excesses took the form of massive private sector housing bubbles. In Greece, Portugal, Italy, Belgium, and France, they manifested themselves in continued fiscal profligacy that saw public debt to GDP ratios soar. Significantly, no EMU member except Germany seized on the good times to embrace difficult measures that would improve its competitiveness (e.g., nominal wage reductions, longer working hours, etc.). Indeed symbolically, the direction in which Europe moved was better captured by France’s decision in the year 2000 to vote itself a thirty-five hour workweek.
Jim Rogers famously remarked that bubbles always last a lot longer than anyone thinks they will. By 2008, ten years after the Euro’s launch, sovereign credit spreads among EMU signatories slowly began to diverge when, amid the global financial crisis, the realization dawned that the monetary union’s peripheral members had done nothing to improve their economic competitiveness, while their debt profiles had weakened considerably. An important turn unfolded in November 2009, with the revelation that Greece had misreported its official economic statistics to hide its true level of borrowing. In one day, Greece’s estimate of its annual deficit changed from 6.7% to 12.7% of GDP, and its total debt to GDP ratio from 115% to 127%. Europe orchestrated its first debt bailout of Greece in May 2010, extending €110 billion in loans in exchange for assurances that the country would implement strict austerity measures to reduce its deficit to under 3% of GDP by 2014. By Spring 2011, with Greece continuing to miss austerity targets contemplated by the May 2010 bailout and a return to capital markets to roll Greek debt impossible, it became clear European authorities would need to undertake a second bailout or risk disorderly outcomes.
We might not be in the position we find ourselves in, had European leaders recognized in 2009 that Greece was bankrupt and had organized a debt default that brought down its debt to GDP ratio to 50% with the imposition of structural reforms to make sure Greece did not end up in the same situation again. Instead Europe treated a solvency issue as a liquidity issue to further the illusion that no European country will be allowed to default. This not only kicked the proverbial can further down the road, but made it much heavier and harder to kick in the future. In the end it was all for naught as European leaders recognized that Greece had to restructure its debt. However, too little debt was written off which did not fundamentally help Greece, but shattered the illusion that no European country would be allowed to default. Like the US crisis which started once the illusion was shattered that real estate prices could not fall, the shattering of this illusion that European countries cannot default extended the crisis from Greece and the countries that “look” most like it, Portugal and Ireland, to Spain and Italy.
On Sunday, July 10, 2011, the Financial Times reported that European policymakers, in a circling of the wagons, had decided that a selective default in Greece could not be avoided. Private sector holders of Greek sovereign obligations would be required to accept “haircuts” on their bonds as part of the second bailout package European authorities would extend to Greece. In one fell swoop, the implicit guarantee of the EMU – that no member would be allowed to default – was proved false.
The importance of this development is difficult to overstate. It required the market to price a risk premium back in to individual Eurozone countries, and for sovereign spreads to diverge at least back to where they were pre-EMU (“at least” because members are today significantly more indebted). The convergence toward German Bunds that allowed all other EMU members to enjoy such low borrowing costs for years must now necessarily unwind. Herein lies the explanation for why Italy’s spreads, which had traded within a stable range throughout prior stages of the European crisis despite Italy’s 120% debt to GDP ratio, suddenly blew out – with 10 year borrowing costs exceeding 6% – on July 11th 2011, the first trading day after the Financial Times story. For months before then, ECB President Trichet had sought to avoid the outcome the FT reported, insisting that no Eurozone member be permitted to default even “selectively.” He lost the fight to Chancellor Merkel. There is no going back.
A country’s fiscal deficit typically becomes unsustainable when the long-term interest rate on its debt exceeds its long-term GDP growth rate. Under such circumstances, a country can’t reach the escape velocity required to grow its way out of the problem, and instead falls into what George Soros has called a “death spiral.” It can theoretically escape the death spiral arithmetic by running sustained primary budget surpluses for years, but this is a trick no deeply indebted sovereign has accomplished in modern times. The politics of austerity tend to be too tough. Furthermore, for those few countries willing to try it in earnest, austerity generally comes too late, resulting in higher deficits and debts as its impact on growth outweighs the benefits of spending cuts. The remaining options are default, restructuring, or inflation – a camouflaged form of default.
Italy is the world’s seventh largest economy and the Eurozone’s third, after Germany and France. As mentioned, its public debt to GDP ratio currently stands at 120%. Over the past decade, the country’s real GDP growth rate has averaged less than 1% p.a while nominal GDP growth has averaged 2.9% p.a. Apart from fine leather goods, high fashion, and its cuisine, Italy is also well known for labor unions rivaling Britain’s pre-Thatcher and for a culture of tax evasion that rivals Greece’s. For a country with Italy’s level of indebtedness, growth profile, and resistance to structural economic reforms, a fiscal deficit that is barely sustainable funding near German Bunds becomes untenable funding at 5 – 6%.
Liquidity support from the ECB or the European Financial Stability Fund (EFSF) can provide a Band Aid, but cannot fix what is at the crux a solvency problem. Italy now finds itself in a situation akin to a subprime or Alt-A borrower who took out a floating rate, interest-only loan that they could afford at the “teaser” rate in an environment where home prices were rising, but cannot afford once the loan resets and their home equity is under water. This ticking debt bomb is the ultimate relevance of the decision to permit a selective default in much smaller Greece: by exploding the myth that there can be no defaults in the EMU and forcing the market to re-price sovereign credit risk throughout Europe, the decision to “let Greece go” has raised borrowing costs for other peripheral European economies, notably Italy, to levels that make it impossible for them to repay their debts. Because, post Greek default, Europe’s remaining peripheral economies face long-term funding costs that exceed their GDP growth potentials, default or restructuring has become inevitable for them.
The current patchwork approach to solving the problem is only extending the pain and making it worse in the future. The issue is that there is no political will to do what it takes. Except for the recent Greece elections, incumbents like Sarkozy have been repeatedly voted out of office. Populist anti-European parties are gaining votes across Europe. There is a revolt in Greece and Italy against austerity even before the any of the more severe austerity programs have taken effect.
For those optimistic about the prospects for European fiscal unity, American history offers an illuminating counterpoint. In the 1790s, after the Revolutionary War and the formation of the United States, Treasury Secretary Alexander Hamilton had to wage a grueling campaign before he succeeded in creating a Federal bond to help relieve the unsustainable war debts of individual states. Hamilton’s proposal was voted down five separate times by the House of Representatives before he finally prevailed. One can only imagine what kind of havoc this would have wrecked in today’s complex, highly levered capital markets. Two centuries later, one of Hamilton’s successors, Treasury Secretary Hank Paulson, faced a similarly precarious struggle convincing Congress to approve the TARP emergency bailout of the U.S. financial system amid the worst economic crisis since the Great Depression. Few people recall that Congress actually denied Paulson’s request the first time he asked. It took another 7% leg down in the stock market, and a second, private plea directly from Paulson to House Speaker Nancy Pelosi, before Congress approved TARP. These episodes highlight how difficult it is to effect major fiscal transfers even in a single nation that already shares a common polity, a common treasury, and a common language – a nation in which the motto that appears on the currency is E Pluribus Unum, Out of Many One.
But Europe has no E Pluribus Unum. The EMU consists of 17 distinct nation-states with no common polity, no common treasury, and no single shared language. For most of the past six centuries, the peoples inhabiting the geography of Europe have engaged in serial wars. In this context, the post World War II era of relative tranquility in Europe is a historical anomaly, not the norm. Political leaders from Napoleon to Hitler and on have dreamt of unifying Europe under one vision or another. We would not wager that the likes of Jean-Claude Trichet and Angela Merkel will succeed where the others have failed. Voters on the Continent seem to have other plans.
At this juncture, austerity only makes the debt problems worse. As the Greek case demonstrates, the northern European countries (led by Germany), the ECB, and the IMF have all insisted on immediate, severe fiscal austerity measures as a precondition for helping the PIIGs avert default. This anti-Keynesian medicine is virtually assured to worsen the debt crisis, not improve it. The reason is straightforward: all of the PIIGs economies are now well below “stall speed,” that is, the speed at which austerity produces bigger deficits because its adverse impact on growth outweighs the effects of spending cuts. For austerity to work, it needs to begin at a point when Europe’s peripheral economies are growing at nominal rates of ~4 – 5% per annum. Such growth rates would provide enough of a buffer to allow spending cuts to take place without resulting in a recessionary tailspin that would only increase deficits as well as debt ratios. Of course, nominal growth in the countries in question is flat to negative. Counter-intuitively, what the PIIGs need in the short term is stimulus accompanied by structural reforms to enhance their competitiveness and help sustain growth. The austerity being forced on them instead will likely yield precisely the opposite of its intended result while exacerbating the animus between voters in Europe’s south and north. We are risking the dissolution of the political center in Europe. The rise of extreme left parties like Syriza and extreme right parties like the Front National could actually end Europe as we know it. Europe would face another grave crisis should Monti fall in Italy with no one viable to replace him.
Moreover, none of the “solutions” being discussed address the root causes of Europe’s problems. Albert Einstein remarked “you cannot fix a problem with the kind of thinking that created it.” At the roots, Europe suffers from three structural economic problems: (a) too much sovereign debt, (b) a lack of competitiveness in many of its peripheral as well as core countries, and (c) a poor actual fit for the optimum conditions of a currency union. None of the “solutions” talked about by politicians or the major media outlets come anywhere close to addressing these problems. Instead, they all exemplify the kind of thinking that created the problems in the first place. Expand the EFSF? This does nothing to meliorate the root problems and could actually worsen them if the bailout funds add to the PIIGs’ existing debt tabs and/or prime existing debt-holders. Adopt Eurobonds? This is likewise orthogonal to the root problems, and likewise risks making the ultimate denouement worse by spreading debt contagion to Europe’s strongest remaining balance sheets, Germany and France. Enforce immediate fiscal austerity? This strikes us akin to the Medieval practice of bleeding sick patients into a bucket to “rid” them of their diseases. Until political leaders begin to propose solutions that engage with the root causes – e.g., a Brady bond program tailored to Europe, debt forgiveness, engaging in conversations with voters to present the case for structural reforms – the crisis will persist.
Next in the series, how the consequences of a Greek exit from the euro could be worse than most suspect.