Whilst amusing, the theatre of Greek and Italian politics is irrelevant to the financial disaster that now looms for Europe. An inability to diagnose and deal with the problem means that the European debt problems may have reached a point of no return, which a change of leadership and technocratic governments cannot arrest. With the problems having now reached Italy (which has ?1.9tn in debt, more than five times Greece?s ?370bn), the policy options and political will to deal with the issues are now limited.
The escalation in the crisis was driven by the most recent EU plan, which was too little, too late and involved too much wishful thinking.
Everybody recognises that countries like Greece need to restructure their debt to reduce the amount owed?a euphemism for default. On October 27, 2011, banks and investors holding Greek bonds agreed to a ?50%? haircut. Unfortunately, it was a trim, not the required crew cut. In reality, the reduction of ?100bn was less than 30% of outstanding debt, as only private investors were covered. The haircut also only reduced debt to 120% of GDP and funding requirements to ?114bn through 2020, leaving Greece with an unsustainable residual debt burden.
Inevitably, the Greek write-downs created speculation for Ireland and Portugal to follow suit, especially if economic conditions deteriorate. The precedent of bank and investors shouldering part of the burden for Greece meant that the supply of money to beleaguered countries dried up.
The EU plans called for ?106bn in recapitalisation of European banks, primarily to cover losses on holdings of sovereign debt such as Greece by June 2012. The amount was at the low end of what is required. Taking into account possible losses on Irish, Portuguese, Spanish and Italians bonds, the required recapitalisation is around ?200-250bn. In addition, the recapitalisation did not take into account the fact that the general reduction in debt and austerity programmes are likely to reduce economic growth, resulting in increased general credit losses.
It was also not clear where the additional capital was coming from. Recapitalisation funded via a loan from the EFSF, the European bailout fund, was classified as the last resort.
An enhanced EFSF was also the cornerstone of efforts to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the further spread of the debt crisis. The EFSF would provide loans to or purchase bonds in order to support market states faced with market pressures to ensure that their cost of borrowing does not rise to levels that threaten solvency.
The EU steadfastly refused to recognise that the EFSF does not have adequate resources to perform its functions?fund bailouts, recapitalise banks and avoid contagion. After accounting for existing commitments to Greece, Ireland and Portugal, the fund?s available capacity is around ?200-250bn. The amount available can be compared to the financing requirements of beleaguered European countries. Over the next 3 years, Spain and Italy will need to find around ?1tn to meet their financing requirements. Italy alone has to find over ?300bn in 2012.
The schemes to enhance the capacity of the EFSF?borrowing to leverage the fund or partial guarantees or seeking Chinese funding?were far fetched. Support for the idea amongst potential investors, such as China, has been lukewarm. More worryingly, the EFSF?s attempts to raise money to meet existing commitments has run into problems, meeting lacklustre support and a sharp increase in costs.
The failure of the plan to mollify investors and markets has made contagion a reality with the crisis now engulfing Italy, Spain and now re-infecting Ireland and Portugal. Debt costs for Spain and Italy have risen sharply to the unsustainable level of over 7% as investors become reluctant to finance the country.
Stronger countries like France (at risk of losing its AAA credit rating) and Germany are at serious risk, as evidenced by rising pressure on ratings, increasing cost of borrowing and on their ability to raise funds.
The European debt crisis is nearing its endgame. The options remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies); debt monetisation (the ECB prints money); or sovereign defaults.
The key element of the October 27 plan was the unwillingness or the inability of Germany and France to increase the size of their commitments. Restricted by the German Constitutional Court?s decision, for the moment, Germany cannot or will not go above ?211bn in guarantees for the bailout funds already committed?about 7% of its GDP. Fiscal integration would have a higher cost than Germany is willing to pay or can sustain without affecting the country?s creditworthiness. Germany?s GDP is around $3.2tn and its debt-to-GDP ratio is around 75%. Supporting the financial needs of weaker countries would stretch its financial abilities.
France is at the limit of its financial capacity. France?s GDP is around $2tn and its debt-to-GDP ratio is around 82%. Following the assumption of the liabilities of the failed Franco-Belgium financier Dexia, the rating agencies have indicated that France faces a rating downgrade.
The Netherlands, Finland and Luxembourg are too small to make much difference. Fragile coalition governments in the Netherlands and Finland are increasingly reluctant to increase their commitments to the bailout process. These constraints make fiscal union difficult.
The ECB is not allowed to print money. Germany?s Bundesbank opposes debt monetisation. There would be deep-seated unease about printing money in Germany, which is still haunted by the memory of hyperinflation in the Weimar period.
The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow the printing of money. This assumes that a cost-benefit analysis indicates that this would be less costly than a disorderly break up of the eurozone. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their own history, Germans believe that this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetisation.
Unless restructuring of the euro, fiscal union and debt monetisation is available, sovereign defaults may be the only option available.
The author has published ?Extreme Money: The Masters of the Universe and the Cult of Risk?