Eurozone's end game
25-11-2011 | Economic news
The world’s been watching the unfolding Eurozone debt crisis with an increasing degree of anxiety. Jan Lambregts, Global Head of Financial Markets Research, presents his latest comments.
Eurozone debt markets are in full-scale meltdown. Predictably, October’s fudged summit outcome saw a fast expanding buyers’ strike. Traditional buyers of government bonds are the risk-averse type. They can deal with inflation or the wiley ways of central banks. They cannot take default risk, however. As long as there is even a sliver of perceived default risk in Eurozone debt, these investors will not return.
A slow motion car crash
We have been comparing the Eurozone debt crisis to a slow motion car crash. We are now fast arriving at the end of the road. The wall is in sight, but the passengers haven’t escaped yet. Can the Eurozone still be rescued? To answer that question, we need to agree on the anatomy of the crisis first, for only then can we think of the solution and see how close we are to it.
At the heart of the Eurozone crisis is a negative feedback loop, in which peripheral debt woes cast doubts on the health of the financial sector. This subsequently translates into economic weakness that outstrips austerity measures and results in deteriorating debt-to-GDP ratios, completing the circle. Dangerously, the more often we pass through the feedback loop, the thinner the popular political support in both the peripheral and core countries, as austerity and bail-out fatigue respectively set in.
The systemic nature of the crisis
We also continue to argue the crisis is systemic, rather than fundamental. It started out with a focus on the individual fundamental weaknesses in Greece, Portugal and Ireland, but these simply masked the systemic nature of the crisis. Once the market began to question Italy, Spain and France, it revealed its doubts were about the very heart and structure of the Euro project. Austerity measures taken in isolation are both irrelevant and self-defeating, as they exacerbate the negative feedback loop and threaten to drive these economies into the ground. Hopes of technocratic governments in Greece and Italy solving the crisis through new austerity measures are therefore in vain. Moreover, they ignore the systemic nature of the crisis: one monetary policy and 17 different fiscal policies.
So how do we create a circuit breaker to the feedback loop? We argue it’s threefold:
1. A sufficient haircut on peripheral debt that brings about a sustainable debt outlook.
2. A ring fencing of the Eurozone financial system from the fall-out from such a haircut.
3. A greater degree of fiscal and political union.
In a half-hearted fashion the October summit touched upon the first two points, but they completely ignored the third because it’s proven politically toxic material for the home constituencies of key politicians. Which brings us back to the central tenet throughout this crisis. It’s not whether things have to get worse. They must get worse before they can get better. This is because only through a series of crises will the necessary pressure build up on politicians to fix the system and agree on a greater degree of fiscal and political union.
Rabbits caught in the headlights
Unfortunately, things are spinning so fast out of control now that politicians appear like rabbits caught in the headlights. As we approach the abyss and stare down into it, it looks as if the ECB will be the only party in the Eurozone that can act swiftly enough by going nuclear and acting as a lender of last resort. This would be a covert way of achieving a greater degree of fiscal and political union. Firstly, because the ECB is backed up by the tax-raising powers of its member state and secondly, because Germany would even in dire circumstances only agree to this in exchange for increased pan-European budgetary oversight.
So let’s hope the ECB goes to the printing press at the same time as this column.
