Last weekend, participants in the 17 European nations that use the common currency, the euro, reached agreement to more strictly control government deficits. As excessive borrowing caused the credit crisis in Italy and other Mediterranean states, the purpose was to calm investor fears about the ability of those governments to put their fiscal houses in order and pay their debts.
Initially, markets responded well—interest rates on existing Italian debt fell a bit. However, after a brief euphoria, those interest rates rose above 7 percent. If rates stay that high, the Italian government simply won’t be able to roll over existing bonds at rates that it can afford and would face ultimate default.
Investors are rejecting the euro deal, because the agreement does not effectively meet the funding needs of Italy and other Mediterranean governments, address the weak balance sheets of European commercial banks, or fix the underlying structural flaws in the euro architecture.
The €440 billion European Financial Stability Facility is providing short-term funding—guaranteed by 17 Eurozone member states as a whole—to tide over the more troubled governments.
However, those bailouts impose huge cuts in spending and tax increases. Coupled with austerity plans also adopted by France and other healthier European states, those packages are pushing Europe into a recession that could last several years.
The economic contraction will be most severe in Mediterranean countries, and their GDP could easily plunge so much that tax revenues fall faster than their governments can reasonably cut spending. If they cut spending too much in the face of a contracting private sector, civil unrest could force their governments to exit the euro, and bondholders stand to lose a great deal in such a panic.
The bailout package for Greece required private bondholders to take a 50 percent haircut, but the more recent deal to save the euro included assurances that future Eurozone bailouts would not require private participation. Those promises have done little to comfort bondholders. If the governments can’t raise taxes to pay what they owe, the EFSF will be inadequate in the face of widespread panic, especially if the Eurozone splinters.
Just as the U.S. bank bailout in 2008 and 2009 failed to address the problems of private borrowers, for example homeowners, the Eurozone bailouts fail to address the woes of commercial banks and private debtors too. European banks are at risk two ways—they hold large amounts of Italian, Greek and other troubled governments bonds, and many of their private loans could fail in the oncoming recession.
Short-term dollar loans from the Federal Reserve to the European Central Bank do little to help this mess. The ECB is lending those funds to European banks against dollar denominated loans to large multinational corporations, but those loans do not resolve the banks vulnerability to the potential failure of euro-denominated government bonds and private loans. Commercial banks obtain considerable financing in the bond market, and much of that financing must be rolled over in 2012. Bond investors will be quite apprehensive about renewing financing to banks with such shaky assets.
The Eurozone lacks the resources to resolve the current crisis for the same reason it got into this mess. It lacks a central government that taxes, spends and issues bonds to help member states finance social programs, infrastructure and other public purposes, and to assist member states in distress.
The Eurozone, as a whole, cannot issue the often proposed “Eurobonds” to raise the funds necessary to both stabilize the finances of Italy, Greece and other troubled countries, and to fix European banks, because it lacks the taxing power to back up such debt. Only fools would invest in long-term bonds backed up by future voluntary contributions of 17 member governments, because insolvency of even one large government could cause bonds to fail.
In 2008, the U.S. Treasury issued $750 billion in new U.S. government bonds to create the TARP and bailout U.S banks. Quite aside from the €440 billion in the ESFS, the Eurozone would likely need more than €500 billion, and perhaps €1 trillion, to bailout its banks. It can’t raise that kind of money without the capacity to tax and issue bonds.
To get their economies going again and pay their debts, Italy, Greece and other troubled debtor countries must earn euro by exporting more than importing, and accomplish budget surpluses.
This would require Germany and other northern creditor states to endure trade and budget deficits and would require a profound shift in the cost competitiveness of the Mediterranean versus northern EU economies. That could only be accomplished by currency devaluation or years of deflation to drive down wages in Italy, Greece and other southern economies.
As both the Mediterranean states and Germany use the euro, devaluation is not possible. Wage deflation would require years of severe austerity and recession that is not politically sustainable. Investors know this even if European leaders like Angela Merkel and Nicolas Sarkozy won’t admit it.
In the end, the austerity and budget disciplines in troubled countries must be accompanied by the creation of a genuine European tax and spending authority that would assume responsibility for guaranteeing their debt.
Short of this the euro can’t survive.