Wall Street Journal Europe
December 6, 2010
by Irwin Stelzer
"Europe is difficult to understand for the markets," says Christine Lagarde, French finance minister. Actually, it isn't.
Investors understand that Greece, its debt scheduled to reach 160% of GDP in 2013, is in a hole from which it will not emerge until it restructures its sovereign debt. Its banks, their profits plummeting in part because of windfall taxes, are shut out of international capital markets. Ireland is a victim of a decision by its government to make its taxpayers bear the cost of the bankers' folly in lending to mad property developers. Spain is in a trap: the more it cuts spending, the more its economy declines, the higher its 20.7% jobless rate soars, and the more likely it is that the deficit will stick at around 10% of GDP. Portugal's people are the poorest in the European periphery, its economy hasn't grown in years and it cannot compete in world markets. Italy's mostly family-owned businesses— over 80% of all workers are employed by firms with fewer than 250 employees —cannot get credit or compete with overseas rivals unless Italy devalues its currency, which its membership in the euro bloc makes impossible. The word of the existing governments in these countries means little, since all are likely to be turfed out in the next elections.
And then there is Germany, the deep pockets of the euro zone. So far, chancellor Angela Merkel has persuaded her voters to allow her to play Florence Nightingale to the euro zone's wounded, or Santa Claus to the economically stricken—pick your metaphor. But—who would have imagined this a few short months ago—the markets are beginning to cast a wary eye on German bunds as the possible extent of Germany's obligations to its euro colleagues and the shaky condition of its banking system become clearer—Andreas Dombert, a member of the Bundesbank's executive board, worries about the banking system's "vulnerabilities and structural weaknesses." Rates on bunds are inching up, and U.S. Treasurys are outperforming them.
Markets also know another thing. Sitting atop this volcano is a bureaucracy that is fractured, indecisive, incoherent and without sufficient resources to contain what it likes to call "the contagion." Euro-zone bureaucrats alternately proclaim an existential threat to their common currency, and attempt to reassure the markets by promising that no nation is too big to bail.
Meanwhile, the bailers wage an internecine war to the consternation of investors who loathe uncertainty.
The International Monetary Fund worries that austerity will produce a downward spiral of spending cuts, reduced economic growth and therefore lower revenues to the treasury, followed by more spending cuts to shore up the treasuries' take, in a cycle that can only be arrested by more spending, now. The European Central Bank opposes such a stimulus, and argues that the path out of this mess is more austerity, which it argues will restore confidence and spur growth.
The euro-zone authorities want to shield investors from losses, lest they raise the price of the capital they make available, while the zone's most powerful member, Germany, insists that investors and creditors share any losses from restructuring. Which causes them to demand still higher premiums to make capital available to struggling euro-zone governments and banks.
Germany's chief government spokesman Steffen Seibert says there are no plans for a joint fiscal policy, while EU Economic Affairs Commissioner Olli Rehn, works on ways to promote a euro-wide fiscal framework. Belgian Finance Minister Didier Reynders calls for an expansion of the bailout fund, and Bundesbank president Axel Weber admits the fund may have to be increased. But Jeanette Schwamberger, a spokeswoman for the German finance ministry, says, "There is no need to expand the fund."
The Tower of Babel has been replaced by the Tower of Brussels.
All of this against the background of facts that the market full well understands. "Facts are stubborn things," wrote John Adams in 1770, "and whatever may be our wishes … they cannot alter the state of facts and evidence." Take that, Lagarde.
The facts are these.
The peripheral countries will have to borrow huge sums in 2011, at growth-stifling interest rates if unaided. Italy, already Europe's largest bond borrower, will tap the markets for €340 billion ($455 billion), Spain will have to sell €160 billion to €180 billion of IOUs, Portugal is estimated to need €40 billion to €60 billion cash. Banks and companies in the euro zone will have to roll over billions more. But the support institutions may not have the resources to help Spain, with an economy twice the size of those of Greece, Portugal and Ireland combined, or Italy, an economy half again as large as Spain's.
The ECB's exposure to periphery countries' sovereign and bank debts is such that a haircut of the magnitude the markets are signaling would virtually wipe out its €78 billion of capital and reserves. Another port of call for the insolvent, the European Financial Stability Fund, hasn't sufficient resources to bail out the larger economies, and will soon be borrowing money to lend to countries that can't repay their current borrowings. And the IMF is hoping to double its lending capacity so that it can lend to heavily indebted countries. Lots of new lending to replace lots of old lending.
Finally, there is the dangerous interconnection of the financial system. One-third of Portuguese banks' foreign lending has been to Greece, Ireland and Spain; German banks have over a $400 billion exposure to peripheral-nation banks, $550 billion if exposure to Italian banks is included. Evolution Securities reckons that German, French and British banks have a €1.2 trillion exposure to banks in the peripheral countries (including Italy).
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
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