Eurozone Sovereign Debt Crisis at Critical Point

The contagion to Italy is a turning point in the euro zone crisis. I feel we have reached a point where the wrong decisions could mean disaster. However, I continue to hope that the Europeans will recognize how destructive the current bailout policies have been.

I was on BNN yesterday to talk about the debt crises in the US and Euroland with host Paul Waldie and guest Brian Milner from the Globe & Mail. The link to the video is at the end of the post. Let me outline some of my current thinking.

Here’s the overarching frame:

If I had to simplify the sovereign debt crisis to one sentence I would say this: As some euro zone sovereign debtors are near insolvency, a liquidity crisis has begun in which various ‘creditors’, the various national taxpayers and bondholders, must fight to determine how to apportion the losses.

This is not a zero sum game, however, because the magnitude of the losses also depends on how various actors play their hands. For example, austerity decreases output and increases the likely losses. A unilateral default followed by panic and contagion would do so as well. The players know this and are trying to play their hand in order to maximize their own narrow interests…

the Troika is likely to shade their policy responses toward the interests of the French banks, allowing them to delay a default and extract as much in principal and interest as they can before that default occurs…

Eventually, the extend and pretend approach will fail after successive rounds of the same policy response in Greece, Ireland and Portugal. Eventually, a combination of four things will occur:

  • the people in the periphery countries rise up and overthrow the existing order forcing a default;
  • the poor economy that austerity entails forces leaders to move to the hard restructuring route as fiscal consolidation fails
  • markets become skittish about Spain or Italy, which cannot be bailed out. So EU leaders will cut Greece loose
  • popular unrest in core countries against bailouts grows so severe that they force a hard restructuring or default

The political economy of the European sovereign debt crisis

So what has just happened is that markets have “become skittish about Spain or Italy, which cannot be bailed out.” Greece’s budget gap has also widened. They have failed to meet targets.  The EU continues to think it can extend and pretend – the fact that sources inside the ECB are saying the Euro bailout package must be doubled for Italy tells you that. But the reality of the marketplace is quite a bit different.

Ambrose Evans-Pritchard notes:

Spanish yields punched even higher, through the danger line of 5.7pc. The bond markets of both countries [Spain and Italy] are replicating the pattern seen in Greece, Portugal, and Ireland before each spiraled into insolvency. And the virus is moving up the European map. France alone has $472bn (£394bn) of exposure to Italy and $175bn to Spain, according to the Bank for International Settlements.

"We believe the European sovereign crisis might be entering a new phase with contagion reaching the larger economies," said Jacques Cailloux, chief Europe economist at RBS.

Core bank exposure to Italian debt an order of magnitude larger than periphery combined.

Handelsblatt is reporting that German euro government bonds have reached a record low yield of 2.67% (link in German). Meanwhile Spiegel notes that Italian euro government bonds have reached a record high yield of 6.016% (link also in German). This is divergence on a massive scale. And to Ed Hugh’s question “Can Italy Grow Its Way Out of Debt?” The answer is clearly no if bonds are yielding 6%. And since Italy is a core member of the euro zone and the zone’s third largest economy with deep connections to Germany, this has finally made the sovereign debt crisis a systemic one.

What does one do then? For me, this is an easy question. European leaders have said they cannot allow Greece to default because it would create contagion of the Lehman Brothers variety. Well yes, it could. That’s why the French restructuring plan was so convoluted. But I say: “the contagion is already here and Greece hasn’t even defaulted yet.” I say: “in fact, it is because Greece has not defaulted that there is contagion to begin with.” In short, if what you’re doing creates a mess and threatens to collapse the system, do something else.

At the risk of being shrill, I will repeat why Greece needs a hard restructuring, underlining the key part:

To my mind, this all speaks to the overriding need for policy makers to ascertain who is illiquid and who is insolvent and to as demonstrably as possible subject the insolvent and the solvent to the most differential treatment one can muster. At the end of the day, what people want to know is who is insolvent and who isn’t. Once they know, they can fight over who takes the losses. And those creditors that cannot take the losses will have to be recapitalised or resolved. Everyone else gets to live another day.

Stuffing bondholders in Greece and Ireland

My takeaway from the Lehman crisis was that fear creates liquidity problems for nearly everyone.

One problem with financial crises is that perfectly healthy companies, perfectly healthy financial institutions can go bankrupt just because they temporarily lack the funds to pay their creditors. This is what the lack of liquidity in our financial system can do. The real problem of crisis is that healthy institutions are often dragged down with unhealthy ones, leading to a dead weight loss and a negative feedback loop in the real economy.

Solvency, 9 Sep 2008

I wrote this before Lehman Brothers failed knowing that a failure would create the panic and dead-weight loss that it did. These things are knowable in advance!

Similarly we are now seeing Italy face the music. I think of Italy the way one might have thought of Morgan Stanley in 2008, vulnerable but not the most vulnerable and certainly not undeniably insolvent like Lehman Brothers.

So what you do is you treat Morgan Stanley differently than you treat Lehman Brothers. You treat Italy differently than you treat Greece. And I am not talking about bailouts. Anyone can be bailed out whether they are solvent or not. “At the end of the day, what people want to know is who is insolvent and who isn’t.” And they can only do that by seeing the insolvent defaulting and treated one way and the solvent being treated a very different way.

I don’t think the Europeans get this. Here’s what I think will happen. The Europeans will continue with the extend and pretend approach but add more firepower to their arsenal by buying up Spanish and Italian debt to punish speculators. Reports are that this is already happening (link in Spanish). Willem Buiter of Citi believes the ECB will thus be forced to revive its bond-buying program to protect Italian debt auctions or the auctions will fail.

Meanwhile we will get bank stress tests, which will reveal some failures. There will be a dog and pony show to make it seem like these tests were the pinnacle of regulatory stringency. And we will see a lot of bloviating about how strong European banks are after they have raised the necessary capital. Greece, Portugal and Ireland will continue their austerity. And despite Greece’s failure to meet targets – and Portugal’s likely failure too – because austerity increases deficits, we will get more of the kind of bloviating about fiscal responsibility that you see in the US right now.

I don’t think for one second that this will engender any confidence in the markets about European debt. So eventually, after living in a constant state of stress, we will get hard restructuring and full monetisation i.e. rate easing. It’s either this or a full-blown collapse of the single currency, something that will require a lot more stress than we have seen to date.

With that, here’s the video clip: Headline : July 11, 2011 : News of the Day – Part Two.

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