Guillermo de la Dehesa
Chairman of CEPR, Member of the Group of Thirty, and author of “Europe at the Crossroads”.
The past year has plunged the Eurozone into crisis with many fearing for what 2011 has in store. In this column the CEPR Chairman argues that to prevent the Eurozone’s sovereign debt crisis from becoming a self-fulfilling contagion, the bailouts should not go beyond Ireland; they should not be extended to Portugal even less so to Spain. It outlines 10 reasons why.
To prevent the Eurozone’s sovereign debt crisis from becoming a self-fulfilling contagion, the bailouts should not go beyond Ireland; they should not be extended to Portugal even less so to Spain. There are at least 10 reasons why.
- Eurozone leaders are supposed to have learned from their previous mistakes in the handling of the present Eurozone sovereign debt crisis. Mistakes such as:
- Not leaving the IMF to do its job in a timely fashion in the case of Greece and then, months later, accepting its involvement after being forced to put up a €440 billion bail-out fund the European Financial Stability Facility).
- Announcing changes in the Lisbon Treaty that will introduce new sanctions in the Stability and Growth Pact that had a very low probability of being approved;
- Announcing, three years in advance and as a condition for making the Stability Fund permanent, that Eurozone sovereign debts issued after June 2013 could be restructured and should contain Collective Action Clauses, forgetting that financial markets discount any new future information in today’s price of the debt and that this ended up creating more confusion and accelerating the Irish bailout;
- Thinking about Eurozone sovereign debt restructuring or default, when no member country had defaulted since 1945 and believing that defaults would be similar to that of Argentina in 2001 when most of Argentina’s debt was held by foreigners, while most Eurozone debt is held by Eurozone citizens and financial institutions, and finally;
- Opposing the issue of Eurobonds, as proposed by Juncker and Tremonti, when the present the debt issues of the Stability Fund are already the equivalent or very similar to the proposed Eurobonds, given that they are guaranteed by their member countries according to their share in their paid in capital of the ECB.
- Neither Portugal nor Belgium and even less Spain have net debt levels as high as those of Greece. Nor do these countries have large banking solvency problems guaranteed in full by their government, as in the case of Ireland.
- The actual bail-outs are not well designed and tend to make solvency problems worse for the bailed-out member country. One problem is that the new Facility cannot buy the affected country’s debt for a period of 5 years, while the bailed-out country implements the very tough adjustment imposed by the Eurozone. The Facility is only allowed to give liquidity to the bailed-out country in the form of five year loans at high rates (5.8% in the case of Ireland). This ends up adding more debt on top of its already high debt burden. The bailout thus helps temporarily with liquidity, but worsens its solvency situation.
- These confusing signals have led many investors to sell the debt of Eurozone countries and even a minority of investors to sell them short with a high leverage making huge profits. This means that contagion goes on at the expense of the traditional long-term buyers of Eurozone sovereign debt, namely pension funds and insurance companies that use it to match their long term liabilities, or banks that use it for its liquidity properties (it does not require a capital provision and can be used to get ECB financing when markets are difficult to be tapped).
The short-sellers of sovereign debt have made huge profits and are ready to continue the practice as long as there is no clear response from Eurozone authorities. In this way, contagion may become self-fulfilling. The best way to address this issue should be to allow the Stability Fund to buy debt in the secondary market, joining forces with the ECB to stop contagion spreading further. The ECB cannot do it all, all the time, and alone.
- As a consequence of reason number 4, an increasing number of investors will start to believe that this debt crisis will end breaking-up the Eurozone, threatening the survival of the euro.
These beliefs are extremely dangerous because it is well known that debt sustainability is much longer when debt is denominated in the national currency of the issuer than when it is denominated in a foreign currency. If the Eurozone breaks up, member countries which are now solvent with their euro debt denominated, will become insolvent if they have to go back to their old, now devalued, currency while keeping their debt in euro. This is the reason why most Eurozone members cannot leave the euro, because they will be defaulting just by announcing it before even taking that kind of decision.
- Even Germany cannot exit the euro because, even though its exit would not lead it to default – on the contrary, its solvency would improve, it will stop growing or suffer another recession.
Given that exporting goods and services accounts for 50% of Germany’s GDP and the majority of this is exported to the Eurozone, German exports would suffer from an exit that would lead to an appreciation of between 30% and 80% compared with the devalued currencies of the rest of the Eurozone members and to an appreciation of up to 40% versus the dollar, the yen, and the pound.
- The Eurozone is almost in equilibrium versus the rest of the world, given that its current account shows a tiny surplus of 0.2% of GDP.
This means that the Eurozone can be considered as a closed economy from the global perspective. The current-account surpluses of Germany (6.1% of GDP) and the Netherlands (5.7% of GDP) are the counterparty of the current-account deficits of Spain (5.1% of GDP), Italy (2.9% of GDP), and France (1.8% of GDP) to mention only the largest Eurozone members. Moreover, there is a macroeconomic identity between external current account balances and national saving-investment balances, so that the surplus countries have an excess of savings over investments that need to invest externally and those in deficit have an excess of investment over savings that need to finance externally.
There is also another accounting identity showing that the sum of the current account and the capital account of the balance of payments of every country adds to zero, so that a country with a current account surplus needs to have a capital account deficit of the same quantity, and vice-versa. This means that Germany and the Netherlands have been financing the current-account deficits of Spain, Italy, and France by buying their debt or extending loans.
- Spain is too big to be bailed out.
Spain’s stock of private and public debt and loans in the hands of the citizens and banks of the rest of Eurozone members is almost €500 billion. A bailout of this size could provoke a banking crisis. This means that Spain’s bailout may become a “fire break” for the survival of the euro.
Nevertheless, in order to avoid a bailout, Spain needs to show to the rest of the Eurozone members that it is implementing what it has promised to do, that is, to