Before I begin my third and last post on the Euro crisis (read the other two here and here), let’s recap on the two main points I’ve made so far. The first point is that a Greek collapse, as catastrophic as it would be for the Greeks themselves, should not in itself endanger the integrity of the Eurozone as a whole. The second point is that if a Eurozone meltdown is going to happen, it will be because a bigger country, most likely Italy, will be the one crashing out. But the economic and political fundamentals of Italy are no worse than Japan’s which has not faced anything even remotely like the fury which the markets have unleashed upon the hapless Italians. So now this leads me to the third point. The Euro crisis is not a crisis of macroeconomic and debt fundamentals but a market crisis of political confidence displaying all the characteristics of a self-fulfilling prophecy.
The self-fulfilling prophecy is without a doubt the most pernicious of all economic phenomena. It is where rationality gets trampled by the animal spirits which more often than not guide the behavior of economic agents, that is, human beings (you are more likely to find the yeti before you find homo economicus). In financial markets, this is all the more evident and all but the most fervent apostles of the efficient-markets hypothesis (which assumes that markets always perfectly factor in all available information) cannot deny that the behaviour of markets often seems to be guided more by euphoria and paranoia than cool, calculating logic. Self-fulfilling prophecies are the catalysts of bank runs, of stock market collapses, and of turning a small country default into an economic Armaggeddon the likes of which capitalism has not yet experienced in its two centuries of existence. In the latter case, it is because no other economic force has the power to turn a problem of illiquidity into a much more dangerous one of insolvency. Ultimately, this is what markets have created out of Greece and nearly done the same for the smaller troubled peripheral countries, mainly Portugal and Ireland. If they do it to Spain or (especially) Italy, we’re screwed.
From illiquidity to insolvency
How does one go from being illiquid to insolvent? There’s really only one way: by having your bond yields go up so high that the cost of issuing new debt becomes unsustainable and you are forced to default. Governments can only do so much to avoid this. If a country cannot meet an upcoming debt repayment, they can receive a bailout. This is basically a loan at a lower rate than the loan it is repaying but usually with strings attached such as forcing you to adopt austerity measures or structural reforms. Also, a Central Bank such as the ECB (the European Central Bank) can create artificial demand for the bonds of a country whose yields are rising by buying them, which would bring the yields down. This is essentially quantitative easing, in other words, “printing money”. But although this may help an illiquid country, an insolvent one has no way to revert its predicament: it would require bailout money for every new debt repayment, or its yields are so high that no amount of buying could bring them back down to safe levels (typically below 7%) since the market has already priced them as worthless. This is essentially the situation Greece is facing itself with: its yields are an astronomical 25% (higher than the average Sub-Saharan country), and debt repayments are coming in by the billions while the government is basically bankrupt. If Greece were a man, he’d be unemployed, have mortgage, car, and student loan payments coming up next month, have an empty wallet, and have such a bad credit rating that he’d be blacklisted at every bank. His only source of financing would be a loan shark called Vinnie who’s into kneecapping if you don’t pay back his exorbitant interest rates.
The same fate awaits any country who faces the wrath of the market long enough. What’s worse for the big ones, like Spain and Italy is that they don’t even have to get to that state to go broke: if European institutions cannot find the liquidity that they would need in a time of stress, they’d go bust pretty quickly. The figures are frightening. The main European rescue fund, the EFSF, can count on €440 billion of which a chunk of it is already earmarked for Greece’s second bailout (among other things). To effectively cover a default of Spain and Italy’s public debt, they’d need as much as €3-4 trillion (more than the size of the entire German economy), although perhaps half of that would suffice to calm markets if things took a turn for the worse. And they only need a whiff of bad news to go into panic mode: mere fears of contagion from Greece in July and August pushed Italian bonds to around 6% for the first time and required an emergency (and temporary) programme of ECB bond purchases to bring them back down. They are now close to 6% again. Another such jolt – say, if the set of measures currently being discussed by Euro leaders to combat the crisis fail to impress, and it would not be too far fetched to think the 7% threshold could be breached soon.
But then, if the crisis is caused by the failure to enact the measures needed to contain it, then we’re trapped in a circular argument and a logical fallacy because clearly there’s no damn crisis in the first place. You don’t need bailout money for countries that wouldn’t need a bailout unless markets were spooked about the fact there’s not enough bailout money. See the madness? “The only thing we have to fear is fear itself”. Roosevelt may have been talking about the Depresssion when he said that famous line, but it is equally applicable to the market hysteria which has engulfed Europe in this age of volatility.
Blame Brussels and Berlin
If Europe indeed melts down, the legions of euroskeptics rooting for its demise will say “I told you so”, the ultimate insult to injury. But to say that Europe’s leaders are blameless is naïve. First of all, if Europe is being extorted, it is being done so by the very same market forces that its politicians from both left and right have encouraged over the past three decades. These market forces were praised when Europe’s bubble-fuelled peripheral economies did well during the pre-crisis boom years, but can’t be taken as the sole culprits when things have gone sour. The sad reality is that the collective leadership of the Eurozone countries has been nothing short of deplorable, to the point that Jean Monet must surely be turning in his grave seeing how close the greatest attempt at multinational unity in human history is so close to unravelling. They failed to contain the Greek crisis while it was still an issue of illiquidity; they failed to prevent the contagion to Portugal and Ireland; and they seem increasingly incapable of bringing out the “big bazookas” and stopping the crisis in its tracks before it derails either Spain or Italy (or both). Lacking a strong and unifying leader doesn’t help. Germany’s Merkel, by far the continent’s most powerful head of state, doesn’t have the fiber of a continental savior. And although her sidekick, Sarkozy, might seem to better understand the bigger picture, France is in no position to lead the charge. That leaves the European Central Bank and its recently appointed new governor Mario Draghi. Being nominally independent (although Central Banks seldom are in practice), Draghi can do the one thing that could single-handedly stop the crisis from worsening: ordering the ECB to buy Spanish and Italian bonds on an extended basis. Not a long-term fix for Europe’s issues but enough to put a lid on the market pressure before it blows up.
Which leaves the confusing morass of fiscal options being floated around. The EFSF clearly lacks the punch without sufficient leverage, and the ESM (a permanent version of the EFSF) will only come into place in 2013 – too little and too late. Monday was the deadline for a definitive solution but as I write this on Wednesday, still no big bazookas have yet been deployed. Barely even a slingshot. Which is a shame since options (some quite creative) abound. For one thing, it seems even the lessons of recent history have not been learned in the halls of Brussels. In 2008, the US managed to starve off an even more massive meltdown though a series of interventions (such as the TARP, better known as the controversial bank bailout) which in the end were surprisingly cheap: of the $700 billion in allocated TARP funds, the government actually only lost about $19 billion as the rest has since been repaid. The intervention in the trillion-dollar commercial paper market (which basically helped avoid a swathe of corporate bankruptcies) also paid itself off. Further trillions may have been spent on guarantees which helped starve off self-fulfilling prophecies of their own. The fact is bailouts get paid back when a country starts making money rather than bleeding it. And guarantees are free when they avoid the losses you were guaranteeing in the first place. If markets are calling for a “big bazooka”, you don’t just bring a big bazooka, you nuke the goddamned market with all you’ve got and leave even the most ardent euroskeptic or short-seller without the remotest of doubts that Europe will be saved whatever the cost.
But all the grandiose plans get watered down into irrelevance when faced with an angry electorate – the Germans being by far the most vociferous – who don’t like the idea of spending money (even if it’s ultimately repaid) to bailout lazy and irresponsible Mediterranean countries so they can live to be lazy and irresponsible again. Stupid logic I say. It’s like saying the US should not have given Marshall Plan aid to Germany since it could use that money to rebuild and re-destroy Europe. This lethargic and prostrate response to crisis reminds me of the last time Europe was on the verge of self-destruction, in 1939. Replace Merkel with Chamberlain, Sarkozy with Daladier, turn Greece into Poland and put an armband with a swastika on the market and you have history repeating itself yet again. In the end, it is Jean-Claude Juncker who said it best:
Will the Eurozone crash and burn? I don’t know. I certainly do not wish it so. I hope that an eleventh-hour deal can be reached in which European leaders finally realize that their historical responsibility is to save the continent, rather than be re-elected. With the market crisis averted, Europe can then focus on its real problems: how to make its southern core competitive and how to sustain growth for the continent in the longer run in the face of increasing demographic pressures. These issues cannot be resolved when the priority is to avoid sovereign defaults any more than a ship cannot be steered in the right direction when it is sinking. But for the moment, one can only wait and see what comes out of these crisis meetings and hope that there really is some willingness left to keep Monet’s dream alive a little longer.
UPDATE (27/10/11): An eleventh-hour deal was reached in which Euro leaders pledged to force banks to write off 50% of Greek debt, boost the EFSF to €1 trillion and recapitalize banks, through bailouts if necessary. This is without a doubt the most far-reaching deal so far agreed and is a big step in containing the market crisis from spreading – at least for now. Not a big bazooka (I would have liked to see some ECB bond buying and/or guarantees as well as more details on the extra EFSF leverage) but far better than a slingshot. But only time will tell if markets buy it.