The Financial Times is reporting that Portugal is likely to need an extension of the three-year bailout plan it received in 2010. This is a disaster for the euro zone and I am writing this post to explain why. The most pressing issue is bailout fatigue in Germany. And this is important given that it is an election year there in 2013. But equally problematic is the mounting social unrest through the periphery. Here are some thoughts on the political and economic ramifications of peripheral countries requesting more bailouts.
First, there are five countries which should now be thought of as a part of the European periphery because of the level of economic and bond market distress. They are Greece, Ireland, Portugal, Spain and Italy. There are three other countries which are troubled but are small enough not to warrant a lot of discussion. They are Cyprus, Malta and Slovenia. Then, there are three other countries within the ‘core’ region which have to varying degrees exhibited some contagion during market stress in the past. hess three countries, France, Belgium and Austria are what I would consider the last line of defense for the euro zone because a breach into these countries would fatally undermine the current strategy. And finally, there are the others, which seem largely absent from the discussion of contagion, though their bonds do sell off because of minor jitters from time to time. These countries are Germany, the Netherlands, Luxembourg, Slovakia, Finland and Estonia. That rounds out my classification of the euro zone countries. Let’s concentrate on the periphery.
The first thing to note is that the periphery can be loosely grouped in two because three countries, Greece, Portugal and Ireland, have already received Troika bailouts under harsh austerity conditionality. Spain and Italy have so far escaped this fate. Yet, even within these groups, there are vast differences, and it is those differences which are shaping the political response to the euro zone’s sovereign debt crisis.
To date, the policy response has been one that is a quid pro quo of bailouts for austerity. And the reason this has been the framework is threefold. First, the bailouts are an absolute must if Europe wants to prevent default. In each case where there has been a bailout, it came after all other options had failed to lower interest rates for sovereign borrowers. Ireland, Greece and Portugal each resisted until the borrowing costs became too painful. But, the austerity as pre-condition is a political necessity in countries like Germany and Finland where the opposition to bailouts is high. What voters in these countries want to know is that their tax dollars are not going to support countries which continue to spend considerably more than they receive in tax revenue. This forces politicians to impose a deflationary policy response in order to meet the expectations of the core country electorate. But austerity is not just about political necessity. It is also about ideology. European elites want southern countries, which are known to be less geared to the market-based economic model, to adopt the market-based market model fully. And they see this crisis as an opportunity to impose this model on the countries because they have been unable to do so in the last ten years and believe this is the underlying root cause of uncompetitiveness in southern Europe.
Now, I have strong opinions about the validity of the arguments being used to promote these policies. But this is not the forum for addressing those. My goal here is to note them as the core policy goals at stake in the current situation. What the mix of bailouts and austerity to promote pro-market policy goals has meant is economic depression and a debt deflation in Greece, Spain, Portugal, and Ireland, and to a degree in Italy as well. Greece is where these policies have been most severely contractionary. But in Spain, Portugal and Ireland they have also been contractionary. The end result has been lower GDP and tax revenue, resulting in missed targets and the potential for more bailouts. In Greece, where the situation has been most dire, the result was default and haircuts followed by a restructured debt and austerity program that has continued Greece on the debt deflationary path with no end in sight. The situation in Portugal is better and is best in Ireland.
We know the situation in Greece, where Angela Merkel is meeting with the government today to exhort them to stay the course. But, even in Ireland the economic forecasts continue to be revised down. Ireland’s manufacturing sector is expanding while it is contracting elsewhere in Europe. And most of the loan losses seem to have been recognized. After Germany’s constitutional court gave the European Stability Mechanism a clean bill of health last month, Irish bond yields rallied down to the best levels since 2010. Ireland has even issued some debt into the market instead of relying on the bailouts as the only source of financing. But property price continue to fall, economic growth has not met expectations and the central bank has been forced to revise down growth forecasts. Young people are leaving the country in droves as unemployment remains elevated at 15%. Now, people are talking about mortgage cram downs and debt forgiveness to jump start the economy. And this is a success story.
In Portugal, the government claims to have had success with austerity but an intervention by the Prime Minister on Facebook announcing yet more austerity last month caused a huge wave of protest which soon sparked a mass weekend of protest across the Iberian peninsula. Now Moody’s is warning that Portugal will not be ready for prime time when the three-year bailout program is over. The FT writes:
Portugal may need to extend its bailout programme beyond the scheduled three years as a weak economy and a public backlash against austerity threaten to delay Lisbon’s plans to regain access to government bond markets, two rating agencies have warned.
Moody’s said on Friday that a “recent emergence of social upheaval” suggested regaining market access would be slow, “perhaps requiring an extension of financial support” beyond September 2013, when Portugal is currently scheduled to resume issuing long-term debt.
What will this mean in a year of German election? I think it means problems. Germany is now under constant threat from the ratings agencies of a sovereign downgrade. The economy there is slowing, although it is in much better shape than in most of the euro zone. Meanwhile, German workers are themselves hard-pressed to meet their financial goals given low wage growth. The totality of this has to be that German voters will punish any party that favors more bailouts for the periphery. See my weekly write-up on German sentiment regarding bailouts from July. It is still the operating narrative here.
So there will be no more bailouts for Portugal (or Ireland or Greece). That means they must be able to tap markets (unlikely), default (not politically feasible except in Greece) or have their debt monetized in the newfangled ECB-led austerity regime (likely).
The logic here is that Spain and Italy were too big to fail, meaning that German Dutch and French banks would be exposed to enormous losses in the event of a sovereign credit event in either Spain or Italy. And so it is imperative that neither country default. Yet, given the size of these economies and the logic I ran through on Portugal, it is clear that no traditional bailouts are forthcoming. Instead, the EU has moved to a monetization bailout model with the ESM and the ECB acting in concert to ensure low rates while the country makes the same structural reforms and undergoes the same austerity that we saw in the traditional programs. With this structure available to anyone who needs it, Ireland and Portugal will also be eligible for such a program. Greece will not as they have already defaulted.
The implications then are the following:
- Austerity will continue with all the debt deflationary consequences that entails. There is no discernible effort by policy makers to change this, not in France where Hollande is raising taxes to cut deficits nor in the Netherlands where the austerity-faction has been voted back into power and not in Germany where there is a general election in the fall. Tis will mean that growth will continue to slow in Europe.
- Protests will increase. The level of public protest in Spain and Portugal has picked up pace and I expect this trend to continue. Spain has a terrific amount of bad debt to write down and this guarantees more government bailouts and/or writedowns. The bait and switch bank preferred share sale there is becoming a hot button political issue as well. But Rajoy has the votes and he will get what he wants. As Rajoy’s program will mean more economic pain, the Spanish government will feel the full brunt of political protest and resurgent economic nationalism.
- Portugal will be forced into an ECB monetization scheme. Their present program will end and yields will still be too elevated for Portugal to access capital markets without ECB help. The question here is how Portugal gets its 2- to 3-year bonds into the market at a reasonable rate. Does the ECB have to set an explicit target in the secondary market to support this? That is a first ratcheting we need to consider in the ECB’s new monetization scheme.
- Spain will be forced into a program because the writedowns are too large to contain without one. Moody’s is right that official projections for writedowns are too low as property prices are still contracting and bank balance sheets are stuffed with these assets or loans with these assets as collateral. Regional governments will add to the distress even as the municipal bankruptcies begin. Parla, a part of the Madrid region seems to be headed that way according to El Economistsa.
- Spanish and Italian debt will catch a bid nonetheless. This is the irony of the monetization program because the ECB backstop ensures that investors starved for yield are willing to risk their balance sheets in exchange for short-duration plays in Spain and Italy. The important question is what happens to the market for sovereign debt when austerity conditions continue the debt deflation and capital flight I believe this is the next crucial step in the crisis and the outcome is unknown.
- Greece will re-default and be ineligible for the ECB program because they will have missed targets. The question, therefore, is what happens to Greece How can Greece be kept in the euro zone after a re-default? And will this default have meaningful haircuts that include the ECB and other public-sector debt holders? If not, Greece may be forced out of the euro zone in a disorderly way in 2013 already.
- Ireland has a chance of leaving austerity in the past, especially if it can get a workable cram down/debt forgiveness bill through its legislature. The country has already accessed the private bond markets at least twice and yields can be expected to come down if the economy holds. However, if the economy slips further, Ireland will re-couple to the periphery.
- Italy will avoid a program in my view. The country is very near a primary surplus and Italian debt has been consistently trading inside of Spanish issues. Italy does not have the mortgage debt overhang that Spain does. Instead, Italy’s problem is more like Germany’s regarding low domestic growth levels and the emphasis therefore will be on a domestic reform agenda.It’s not clear to me that Italy will re-couple to Spain if this agenda is not fully implemented given the difference in the economies.
Overall, the situation looks best for Ireland and Italy. With Spain too big too fail, Spanish debt under two year also is a reasonably attractive risk. But, beyond this there are a lot of questions. How the ECB and Portugal finesse a new austerity program is unclear. I think implicit yield targets might be necessary. And in Spain, the capital flight and debt deflation make the outcome there troubling. ECB buying alone is to enough to remove the default and redenomination risk there. That makes Spain a less safe bet than Italy. Greece could leave the euro zone and is completely unpredictable.