As the strains in the Eurozone intensify, the world is holding its collective breath to see if the steps being taken to address the crisis will pull the largest trading bloc out of its travails. A healthy Europe is critical for a healthy globe – including Guyana, since it is the destination for so large a chunk of exports. But the diagnosis of the crisis is crucial for a successful intervention: while misdiagnosis is not, in itself, malpractice – a continuation with measures based on such misdiagnosis stand the chance of hurting the patient further.
The problem with the European intervention is that it is based primarily on the diagnosis of Germany (and many other institution’s such as the European Central Bank that follow its lead) that the PIGS in theperiphery have been too profligate in their spending. “It is an indisputable fact”, pronounced Germany’s finance minister, Wolfgang Schäuble recently that “excessive state spending has led to unsustainable levels of debt and deficits that now threaten our economic welfare.” From this diagnosis the cure appears indisputable: austerity by the erstwhile profligate governments.
As such, the leaders of the euro’s core countries such as Germany and the Netherlands demanded draconian budget cuts as the price of rescue loans to troubled economies. They pressed the Italian and Spanish governments to tighten more and faster. And they plan more deficit reduction themselves. The ECB has supported these moves. In August it demanded a toughening of Italy’s austerity budget before it would step in to buy Italian bonds.
This harsh medicine is reminiscent of that imposed on Latin America back in the 1980’s. Not surprisingly, to observers of that scene, output has plunged precipitously in “rescued” countries such as Greece and Portugal. With growth prospects weakening, this drives the costs of debt up further. But it has not solved the problem. Confidence in the Italian and Spanish economies has evaporated even as their governments accelerated the cuts. The rot is spreading. Fears have risen about Belgium, even France. The crisis is clearly getting worse rather than better.
This is because the profligacy diagnosis is incomplete, and thus misleading. While it may be true of Greece, other economies such as Spain, Italy and Ireland had different fundamentals for their troubles. An alternative diagnosis explains the continuing chaos by pointing out that an implicit assumption behind Europe’s financial integration—that sovereign debt was risk-free—has been overturned. But no one knows what to assume instead.
While the euro project was founded on a rule that there would be “no bail-outs” of governments’ debt the reality was that its functioning regime presumed otherwise. Initially the ECB treated all sovereign bonds equally. Even when it decided to take credit ratings into account, the ECB’s practices discouraged banks from clear distinctions between sovereign bonds. The fact that banks could turn government bonds from across the euro zone into cash at the ECB encouraged governments to borrow, and banks to rely on short-term funding to an extent now proving parlous.
Over the past 18 months the possibility of national defaults has shattered the idea that all euro-area debt is equally risk-free in a particularly damaging way. Now no one knows how far the landscape had changed: which euro-zone countries would be allowed to go bust? Which debt remained risk-free? Europe’s financial structure thus became suddenly and alarmingly fragile. The excessive “convergence” of bond yields over the decade reversed as investors factored in the risk of sovereign default. Europe’s banks, which need to raise some €1.7 trillion ($2.3 trillion) of funds in the next three years, are weighed down by their huge exposure to the region’s governments. The result has been a classic panic.
The ECB has responded as a lender of last resort to the banking system, expanding and extending its liquidity lines for banks. But there has been no similarly comprehensive fallback for sovereign debt. The dynamic is similar to the “sudden stop” of foreign capital that lies behind many emerging-market financial crises. Will G20 and the IMF backstop the sovereign debt or will they cast the government to the wolves?
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