EU leaders are considering radical reforms to restore confidence in the euro and the finances of Mediterranean states. These reforms and relief efforts for troubled governments are doomed to fail, and it would be better for these states to radically restructure sovereign debt now and exit the euro. Continuing the charade that their situations can be saved will only make the pain worse latter.
Public debt now exceeds 150 and 120 percent of GDP in Greece and Italy. Those ratios continue to rise, because austerity is causing their economies and tax bases to shrink. Longer term, accompanying economic reforms may instigate some growth, but not enough to permit Athens and Rome to pay interest and start retiring principal—simply Greece and Italy are insolvent.
Spain’s debt is only about 75 percent of GDP. However, its banks are heavily burdened by souring real estate loans totaling about €665 billion—more than 60 percent of Spanish GDP. Banks don’t have the capital to cover those losses; however, with their survival essential to national economic recovery, bad real estate loans are an implicit liability of the Spanish government. Altogether, Madrid’s implicit sovereign debt is much closer to 100 percent of GDP and rising rapidly.
Spain, like Italy, must pay more than 6 percent on new ten-year government bonds—Greece, currently receiving EU bailout financing, is not in the private credit market, but when it returns, it will pay at least what Italy pays. Portugal, whose situation mirrors the others, is paying about 9.5 percent.
Even in the unlikely event austerity and economic reforms instigate some modest growth in 2013, it would be inadequate
To keep the debt to GDP ratio from rising, nominal growth (real growth plus inflation) must exceed the interest rate paid on debt plus current government deficits as a percent of GDP. Across the Mediterranean states, the latter sum is likely to be at least 9 percent for the foreseeable future, and real growth plus inflation are simply not going to be that high.
Only the likelihood that Germany and other northern states will bail out the Club Med states keeps the interest rate on Italian and Spanish bonds from zooming past 10 percent and instigating sovereign default.
For Mediterranean states public finances to be manageable, sovereign debt would have to be cut in half through restructuring, and private bondholders, and European banks would take large losses.
Whether assisted by direct loans from EU bailout funds, or through new “euro bonds” backed by the taxing authority of Germany and northern states, aid large enough is not possible, because it would make the sovereign debt of Germany as unworkable as the Mediterranean states.
For Spain, the proposed EU banking union could provide an alternative to direct debt relief. EU-wide deposit insurance, empowering the ECB to regulate banks and guarantee their solvency, and generous purchases of real estate loans by the ECB could recapitalize Spanish banks. However, purchases large enough to be effective would match in size what the Federal Reserve did for U.S. financial institutions during the U.S. mortgage crisis and leave the ECB with limited ammunition to assist banks elsewhere.
Euro bonds and banking unions will require treaty revisions to implement. However, even if Germany and the ECB claimed emergency powers—with the consent of other EU heads of governments and moved ahead quickly—the additional assistance Greece, Italy and Spain received won’t be enough to resolve their problems.
With each partial solution and halfway measure, Mediterranean governments fall deeper in debt. Private investors will eventually lose confidence and abandon Italy, Spain and others altogether, and their economies will collapse and hastily exit the euro.
In such a crisis, vexing issues such as the conversion of sovereign and private debt into domestic currencies and capital controls to avert capital flight and bank runs, simply won’t be addressed. Losses borne by private investors and the pain imposed on ordinary citizens will be much larger than imposed by an orderly restructuring now.
Germany and the others should recognize reality, and facilitate substantial debt write downs and a sane and orderly withdrawal of the Mediterranean states from the euro zone.