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French President Nicolas Sarkozy shakes hands with German Chancellor Angela Merkel and Italian Prime Minister Mario Monti on Nov. 24, 2011, in Strasbourg, France. The three were meeting to seek agreement on how to resolve the Eurozone debt crisis.
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How did Europe's debt crisis get so bad? Download PDF
The European sovereign-debt crisis has intensified and grown rapidly over the last month. Until late October, the crisis centered on a chronic problem tied largely to the failure to stabilize Greece’s finances. Since then, the crisis has spread rapidly to Italy, Spain, and, most recently, France. Europe is now battling an acute systemic debt crisis that threatens the global financial system and the global economy. This worsening crisis constitutes the largest single threat to the US economy and its financial system.
Key points in this Outlook:
The European sovereign-debt crisis has intensified and grown rapidly over the last month. Until late October, the crisis centered on a chronic problem tied largely to the failure to stabilize Greece’s finances. Since then, the crisis has spread rapidly to Italy, Spain, and, most recently, France. Europe is now battling an acute systemic debt crisis that threatens the global financial system and the global economy. This worsening crisis constitutes the largest single threat to the US economy and its financial system. The unsuccessful effort to stabilize Greece’s economy, concluding with another dramatic all-night meeting of European leaders late in October, provided the catalyst for the spread and intensification of Europe’s sovereign-debt crisis. The specific measures put forward, which I will detail in this Outlook, unintentionally underscored the systemic nature of Europe’s crisis. Once the scope of the resources and measures required only to contain the crisis to Greece were laid out, it became painfully clear, as the Economist noted in its October 29 issue, that European treasuries do not have adequate resources, “both to guarantee outstanding debt and maintain their own credit ratings.”[1] In other words, the more France and Germany commit to loan weaker European countries like Greece, Italy, and Spain, the less creditworthy they become. Deterioration of France’s creditworthiness has already boosted its borrowing costs in recent weeks and has caused it to join those advocating more bond buying by the European Central Bank (ECB).Greece as a Catalyst for a European Crisis
The details of the October proposal for the rescue of Greece that served as a catalyst for the sharp intensification of Europe’s debt crisis are revealing. The European Financial Stability Fund (EFSF) that the European community tentatively agreed to in July was to be at the core of Europe’s plan to enable smaller peripheral states like Greece to roll over and service their debts.
The EFSF was initially set at €440 billion, but the fund’s actual resources available to support Greece and other peripheral borrowers turned out to be considerably less due to extant commitments to Portugal, Greece, and Ireland and the probable need to recapitalize the banks that hold much of the questionable sovereign debt of European governments. Beyond that, the major contributors lined up to guarantee the funding for the EFSF were Italy, Spain, France, and Germany. This meant that if, for example, Italy, Spain, or France were to draw on EFSF support, they would in effect be guaranteeing repayment of an increase in their own debt. Lending to oneself is not reassuring to one’s creditors. Only Germany could manage the requisite increase in borrowing required to significantly increase the resources of EFSF at an attractive interest rate below the open market rate available to most sovereign borrowers. And Germany’s resources, while substantial, are not unlimited."Sufficient borrowing power does not exist among Europe's trusted sovereign governments to guarantee the debts of Europe's less trusted sovereign governments." --John Makin
Inadequacy of EFSF funding led to efforts to“leverage” its lending ability. Given that about €200 billion of the original €440 billion in EFSF resources was available to guarantee lenders against the first 20 percent across their losses on government bonds, some claimed that the EFSF could be “levered up” to guarantee €1 trillion in new debt. This reasoning was flawed because part of the proposed Greek rescue package included 50 percent write-downs on outstanding Greek debt. That disquieting revelation caused markets to focus on financing needs outside Greece. Spain and Italy alone need more than €1 trillion over the next three years to pay interest on and roll over existing debt. Those nations—both of which are supposed to act as guarantors of enhanced EFSF lending capacity—will need to borrow substantially more to finance ongoing budget deficits over that same period. The circularity of such reasoning has contributed to the sense of crisis in Europe.The problem of financing future deficits brings forth the “conditionality conundrum.” Under this conundrum, Germany—and, until recently, France—the only credible lenders to an internal European transfer mechanism like EFSF, have insisted that extra fiscal stringency in the form of lower government spending and higher taxes should be required of any government that receives loans from other European governments. The International Monetary Fund (IMF), which often contributes to such lending efforts, insists on the same “conditionality.” Though understandable from the lender’s point of view, conditionality is self-defeating in many cases. Its result, slower growth and more debt, has hurt confidence, clearly illustrated over the last eighteen months by Greece. That country received an aid package in the second quarter of 2010 in exchange for its pledge to drastically cut government programs while boosting tax collections. While clearly needed as part of a medium-term move towards fiscal health, the drastic spending cuts and tax increases imposed on Greece resulted in such a persistent budget deficit and sharp drop in Greek fiscal growth that its ratio of government debt to GDP rose sharply in response to these conditions. In effect, the attempt to improve Greek creditworthiness actually harmed it.This outcome, considerably worse than architects of the 2010 Greek bailout had predicted, obliged Greece to seek a second, larger aid package in mid-2011 which, despite the drama of the late-October meetings, has yet to be completed. The economic collapse in Greece since mid-2010, along with the expected additional stringency demanded as a condition for the extra loans being negotiated in 2011, precipitated a collapse of the Greek government in November 2011. Now, an interim technocratic government is attempting to negotiate conditions that would enable a rescue package for Greece.The ongoing effort to contain the 2011 crisis in Greece, a relatively small European country, has raised other issues that expedited the emergence of a systemic, acute European debt crisis during the first few weeks of November. The terms of the Greek rescue package included a “voluntary” 50 percent reduction in the value of Greek bonds held by its creditors, which include European commercial banks and the ECB. A 50 percent cut in a Greek bond’s value constitutes a default. If it is imposed on lenders who have purchased insurance on their Greek bonds, those lenders can be compensated for their losses by the sellers of that insurance. (The insurance vehicle is called a credit default swap). However, as the architects of the Greek rescue package discovered, if the lender accepts a voluntary write-down of an insured government bond, which was probably sold by an overleveraged lender who may not be able to honor it (think AIG after the Bear Sterns collapse), the holder need not be compensated for the loss. The write-down proposed on the debt of Greece reminded those who had purchased insurance on their Italian, Spanish, and French bonds that the guarantees might not be valid, either by decree or in view of the inability of those who wrote the insurance policies to honor them. As a result, lenders to Italy, Spain, and France began to demand higher interest rates on their loans to those countries. The result was increased probability that those economies would slow while their debt accumulation rose further because of the need to pay higher interest rates on current and future borrowing. The write-downs on sovereign debt introduced as part of the proposed Greek package reminded markets that sovereign governments could default, or at least pay back significantly less than the face value of the debt being carried on their balance sheet. For Greece, this expedient was required as way to lower outstanding debt and to induce Greece to accept the additional fiscal stringency its creditors demanded. However, its creditors became subject to a write-down to the value of their claims as a result of the size and prospective increase in outstanding Greek debt.As part of the pressure they applied to force Greece to accept the October 2011 rescue package, German Chancellor Angela Merkel and French President Nicolas Sarkozy pointedly asked the faltering Greek government whether it wanted to remain in the European Union. The effect on the markets of this pressure, given the prior assurance from these leaders that any exit from the European currency union was “unthinkable” and “impossible,” was to remind them that a breakup of the European currency areas was indeed possible. More specifically, if Greece were to resort to a disorderly default on its debt, thereby precipitating involuntary debt losses by its creditors, or simply leave the monetary union altogether, the acute phase of the crisis could spread rapidly to the rest of Europe.As the crisis intensified during October, increasing fears that it could not be contained and chances of debt write-downs created contagion risks that sharply boosted yields on Italian bonds by mid-November, despite the ECB’s increased purchases of Italian bonds. Interest rates on Italian ten-year bonds rose from 6 percent to over 7 percent, compared to 1.7 percent yields on German ten-year bonds. If the European Monetary Union were credible, such “spreads” between Italian and German interest rates should be close to zero since both Italian and German bonds are denominated in the Euro and the ECB is supposed to treat them as perfect substitutes. Rather, as contagion has intensified and an acute systemic crisis has emerged based on the rising probability of a collapse in Europe’s currency union, yields on all European government bonds except Germany’s have risen substantially, and even Germany’s yields have begun to rise slightly. French ten-year bond yields have risen to two percentage points above German yields after having been less than a percentage point above German yields for the last several years. (See figure 1.)
The Real Crisis Lies inside Europe’s Banks
The rise in interest rates on Italian, French, and Spanish bonds has coincided with a drop in the market value of trillions of dollars’ worth of those bonds held largely by European households and thinly capitalized European banks. As a result, the stock prices of European banks have dropped sharply, while borrowing costs in the interbank market, where banks borrow and lend overnight, have risen sharply. The rising uncertainty about the liquidity and solvency of Europe’s banks has slowed down growth in much of Europe, including Germany, which only increases the difficulty of managing growing debt burdens. Beyond that, since European governments would be called upon to underwrite losses by their banks, fears about bank solvency have further elevated government borrowing costs.European banks need to recapitalize to replenish their reserves that provide the leeway to absorb losses on government bonds. The falling prices of their stocks and balance sheet impairments have meant that these governments have had to rely on EFSF resources to help raise funds to recapitalize banks, but those resources have already been more than used up to provide funding to weaker sovereign governments like Greece and Portugal.
During November, markets have realized belatedly, after having tried to organize a second rescue package for Greece, that sufficient borrowing power does not exist among Europe’s trusted sovereign governments—that is, Germany—to guarantee the debts of Europe’s less trusted sovereign governments, which now include Italy, Spain, and France. Slowing European growth and rising interest costs outside of Germany have created a dynamically unstable feedback mechanism whereby an intensifying financial crisis slows growth and raises borrowing costs, further intensifying the financial crisis."If the ECB does not play the role of lender of last resort, it is hard to see how the European Monetary Union will hold together." --John Makin
Europe has three alternatives, none of which is very attractive, given the rapidly intensifying financial crisis it faces: (1) borrowing more money from outside Europe, (2) having the ECB buy more government bonds as a lender of last resort, or (3) simply allowing the European Monetary Union to collapse. Under a collapse, nations either return to their preunion national currencies or join new, smaller currency areas. Some used to think that the current union might divide into two parts, leaving northern (“hard”) and southern (“soft”) currency unions. But systemic pressures have grown so rapidly since the failure of the Greek rescue that the hard currency grouping would now include only Germany and possibly Finland and the Netherlands, if those three countries could agree on a single currency arrangement. Further, a single hard European currency would appreciate rapidly and pose problems for exporters that operate in the hard currency area, including Germany, the world’s largest exporting nation. It is not clear that the soft currency countries would be able to form a currency union or, given their experience with the extant union, would be eager to do so.Hopes that the EFSF could borrow from abroad to buttress support for the Greek rescue package were floated during the failed October rescue effort. Some suggested that China and, perhaps, other Asian countries would be willing to lend to Europe with the IMF acting as guarantor or conduit for the funds. Predictably, such hopes have floundered as the deplorable state of the European Union’s finances has become more obvious to China’s pragmatic leaders, who are already concerned about exposure to heavily indebted Western countries. The remaining option, establishing a lender of last resort with the ECB as an outright buyer of government bonds, is with good reason highly controversial and risky. The ECB has already purchased, by various estimates, about $200 billion of government bonds from countries such as Greece, Italy, and Spain, some of which have lost value. The ECB would be exposed to further losses on those bonds should governments default or should the monetary union collapse. Further, by purchasing bonds, the ECB reduces the incentives for indebted governments to curtail spending and raise taxes as a condition for receiving the loans. Specifically, the ECB has been holding back its lending to Italy as its new technocratic government under Mario Monti tries to force fiscal reform on a reluctant Italian citizenry.By monetizing additional European debt, the ECB, of course, risks higher inflation, anathema to the German government and central bank, whose president sits on the board of the ECB. Both Chancellor Merkel and ECB President Mario Draghi have explicitly rejected the lender of last resort role for the ECB. Their position is slightly undercut by the fact that the ECB has already purchased nearly 200 billion of European debt and may have further exposure because of additional quantities of European government debt that it holds as collateral for loans to European banks.If the ECB does not play the role of lender of last resort, it is hard to see how the European Monetary Union will hold together. Advocates of the union would see its collapse as a serious blow to a viable European community, one with shared goals and muted German hegemony that creates harmony that was absent for much of the first half of the last century. Europeans will ultimately have to consider this important political dimension of the monetary union.The European Monetary Union, as it stands, has engendered overborrowing by most European countries, which under current conditions probably will not be able to fully repay their debts. Sustaining the current regime of a single currency in Europe simply demands too much adjustment pain, too much interregional transfer of funds from Germany to the weaker members of the European Monetary Union, and too much risk to Europe’s banks and their counterparties in the United States and elsewhere to be economically or politically viable. Putting Germany into a currency area with Greece, Italy, and Spain, among others has not transformed those economies into cost-conscious and efficient economies like that of Germany. In fact, lending them Germany’s ability to borrow as the currency union has done has made them less competitive because of the subsidy of overconsumption that has resulted from the access to easy credit engendered by membership in the European Monetary Union. The ECB Will Move to Quantitative Easing
The financial crisis that erupted in 2008 in the United States and resurfaced in 2010–11 in Europe was driven by two false beliefs. The notion that housing prices never fall preordained the US financial bubble. The assertion that sovereign governments do not default preordained Europe’s financial crisis. With both platitudes proven untrue in the space of a little over two years, the global financial system is teetering on the edge of a choice between collapse and an attempt at aggressive reflation. The latter option, quantitative easing, has been an initiated by the US Federal Reserve, which has boosted its balance sheet by about 200 percent since 2008 without fully arresting the crisis in the United States. The ECB boosted its balance sheet by a relatively tepid 80 percent as the crisis spread to Europe and escalated further.Given the global risk tied to the total collapse of Europe’s financial system, the ECB will, in the end, probably be forced to triple its balance sheet as the Fed has done. It seems unlikely that Europe’s stubborn central bank would be prepared to risk a systemic financial collapse that would include the destruction of the monetary union it has been charged with preserving. That said, in a crisis, mistakes are made. The ECB may too long delay administering what it sees as a bitter inflationary medicine. If that happens, we will see the painful result of an even-more-painful deflationary medicine. Note1. “No Big Bazooka,” The Economist, October 29, 2011, 31.
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