October 28, 2012 12:39 pm
Crutches prop up euro, but it’s still lame
The acute phase of the crisis is clearly over – for now. There are some signs of a normalisation in the inter-banking market.
Sovereign spreads have come down. Italy and Spain will both manage to fund their fiscal deficits until next year. The European Central Bank’s longer-term refinancing operations have propped up the banks. The new Outright Monetary Transactions programme, if it is ever activated, will prop up the sovereigns. If you thought of the lethal interaction between banks and sovereign as two drunks in a pub propping each other up, the ECB has given them separate crutches. They can walk. Does this mean that the crisis is over?
If you step back from the latest events and consider the bigger picture, you always come back to the same questions. Is this a liquidity crisis only – in which case the measures taken should be sufficient? Or is it a solvency crisis?
The ECB’s support cannot help in the latter case because the central bank is not allowed, by its own legal definition, to write off or participate in a restructuring of any debt it holds. In case of a disorderly default, the country would lose access to the ECB and would probably have to leave the eurozone. The ECB’s programmes are premised on the idea that this is not going to happen.
Yet, as the preliminary report of the troika – International Monetary Fund, European Commission and ECB – shows, Greece’s debt is clearly not sustainable, even under optimistic assumptions.
Portugal is about to fall into a black hole and so will Spain if the Spanish government continues trying to fix a private sector debt problem through public sector austerity. With a total fiscal correction of close to 10 per cent of gross domestic product (to be achieved over several years) and a fiscal multiplier of 1.5, you are looking at a decline of at least 15 per cent in GDP. In Spain’s case it would probably be higher, as the banking sector’s losses would be much higher in a depression – and there is no additional loss absorption left.
To those of us who look at this as a solvency crisis, nothing much has really changed in the past six months, except that the ECB has taken away the small risk of an immediate accident. To pick up on last year’s most overused metaphor: with the OMT, the ECB has increased the size of the can we are kicking down the road. But we are still kicking.
Eurozone governments’ determination to stop the liquidity crisis is matched only by their refusal to recognise the solvency crisis. The ECB and member states may be infinitely patient in rolling over debt, but unwilling to recognise losses, for example on Greek sovereign and on Spanish banking debt.
I was reminded of that when I read that Germany was now ready to accept a two-year extension of the Greek programme, but there would be no new money, leaving Greece itself to fund the gap – something that is simply not going to happen.
The refusal to let the European Stability Mechanism fund Spanish banks directly falls into the same category. Debt that has arisen in Spain will remain debt of the Spanish state as ultimate guarantor.
Resolution means policies to assure a return to solvency. Solvency is an analytical concept, which itself depends on your assumptions about interest rates and economic growth and, of course, the total burden of debt.
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If you make unrealistically optimistic assumptions about the size of the fiscal multiplier, the global economy and the impact of structural reform on growth, you can make any debt disappear on paper. This can go on until these assumptions are falsified. But it cannot go on for ever.
The latest dreadful confidence surveys are in line with my expectation that austerity will have a very significant negative effect on growth in 2013. The recession in southern Europe, including Greece, will probably continue at least until 2014, at which time debt to GDP ratios are likely to be similar to today’s.
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If you keep piling austerity programme on austerity programme for a sufficiently large number of years, then the policy might eventually work. But that’s a politically unrealistic proposition. Portugal, for example, is already cutting subsistence payments for very poor people to meet the agreed deficit targets.
I believe therefore that crisis resolution still has to happen, but I see no evidence that we are getting there, not even in small steps. I do not expect any change in this situation even after the German elections. Since the crisis is not going to resolve itself, I cannot see any fundamental change in the situation – except that the ECB has removed the risk of accidents in the short term.
To put it another way: if you are optimistic, then surely you must treat this as a liquidity crisis. And then, surely, you must have believed this six months ago. I think this is wrong, but at least it would be an internally consistent position.
What I cannot get into my head is why anybody would be optimistic now when they were pessimistic a few months earlier. Could someone explain this to me?
Copyright The Financial Times Limited 2012.
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