European Debt Crisis

No doubt the biggest issue of 2012 will be the European Debt crisis. The New Year is likely to see a worsening of the current crisis, but is also likely to signal an end to it as well. The European debt crisis started off with Greece and later spread to Ireland and Portugal. The crisis has now begun to affect the likes of Spain and Italy who have seen a dramatic increase in the cost their governments pay to borrow money. Over recent months, almost all Eurozone countries have seen the cost of borrowing increase. Even Germany has been affected, with German borrowing rates exceeding the rate that the UK has to pay on its borrowings.

While there remains significant downside potential in the Eurozone, we may be beginning to see an end to the crisis. Europe has - and has always had - the ability to solve this crisis on its own. What it lacks is the political will to do so. Germany in particular has made every effort to block long term solutions to the debt crisis, preferring instead that countries turn to ever greater levels of austerity. While governments must cut back, the German position does not really take into account the unique set of circumstances that many Eurozone nations are facing. While Greece clearly broke EU rules and covered it up, both Ireland and Spain had some of the lowest debt to GDP ratios in the developed world. Both nations had fiscal surpluses running into the crisis in 2008. However, their economies which were heavily reliant on finance, collapsed so far so fast the governments had little choice but to take on a huge debt burden to pay social security and rescue their banks.

Italy will find it hard to cut back with greater levels of austerity. The Italian budget deficit is actually rather low at 4.6%. That’s half the level of the USA and only 1% higher than the German deficit. Italy’s major issue is that it has a historically high level of debt which has been exacerbated by the fact that the country has experienced little in the way of growth since it joined the Euro in 1999. With concerns spreading through the Eurozone, Italy began to look vulnerable and the cost of its borrowings on a 10 year basis has now risen above 7%. This is the level at which Greece, Ireland and Portugal where all forced to seek a rescue from the EU.

There are two major concerns presently driving the European debt problem. Firstly, with all the austerity being undertaken across Europe at the same time there is a major concern that the Eurozone will re-enter recession in the first half of 2012. Indeed it’s likely that Europe is already in recession now. This makes it harder for governments to keep borrowing down as tax receipts fall and social security bills rise. In severe cases like Greece, the government can enter a debt spiral where government’s cutbacks lead to greater unemployment which in turns reduces tax revenue and increases benefit costs, leading the government to have to further cut spending leading to more unemployment.

The second concern is the ability of countries, particularly Italy and Spain, to roll over existing debt. Italy alone will require EUR 350 billion this year just to keep its debt levels where they are today. With yields of 7% plus, this is likely to be unaffordable in the medium term. The European Rescue fund is likely to be increased up to EUR 500 billion however almost half of that has already been used to rescue the likes of Greece and Ireland.

However, it should not all be seen as doom and gloom and we may actually be beginning to turn the corner in the crisis once and for all. Europe has the ability to solve this problem, it simply lacks the will. However, as the crisis deepens, European leaders can find themselves with a greater mandate to take the necessary action to fix the problem. The Eurozone as a whole is the largest economy in the world. Its debt to GDP ratio is 80% and its fiscal deficit is 6.4%. However, compared to the next two largest industrialized economies, Europe’s position does not look so bad. The USA has a debt to GDP ratio of 100% and a fiscal deficit of 8.9%. Japan has 225% debt to GDP and a budget deficit of 6.4%. Both Japan and the USA pay significantly less to borrow than even Germany, the Eurozone’s strongest single member.

There are two options available to the Eurozone to bring down their borrowing cost significantly allowing them to sustain the types of fiscal balance sheets that both Japan and the USA do. Firstly, they could make the ECB a lender of last resort. Countries like the USA will not default on their own debt for the simple reason that their Central Bank will always lend money to them as a last resort to cover debt repayment. The Central Bank can essentially print the money to do this. This means there is virtually zero chance of a domestic default. The ECB is prohibited from doing this largely based on a German resistance over inflationary pressure.

The second option available to Europe would be to issue common Euro bonds. These would be backed up by the ECB. Nations would be allowed to issue up to 60% of their GDP as blue Euro Bonds backed by the ECB and the rest of their debt would be held in unsecured red bonds. This would significantly reduce the borrowing cost for countries like Spain and Italy. Given the levels of austerity measures these countries have already embarked on, they may actually be able to go into surplus with new lower government borrowing costs. Again, Germany has been the major country that has blocked any move towards Euro bonds.

However, there are signs that the German position may change. German borrowing costs have risen to levels above that which comparable non-Eurozone countries like the UK pay. It may actually work in Germany’s favour to accept the Euro bond system. Secondly, Angela Merkel has experienced a large jump in popularity at home giving her more political "wiggle room" to pass strong measures.

These factors may well combine in the next 6 months to signal the end of the European debt crisis once and for all. However, in the short term the crisis is likely to get worse before it gets better. 

 

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