Brother can you spare a Euro (Photo: Cathal McNaughton/REUTERS)
Let’s just be blunt: The Eurozone’s bailout program has failed. It’s not solving the underlying causes of the European debt crisis; it might even be making matters worse.
That’s become all too clear in the wake of Ireland’s decision to seek a rescue from the European Union and International Monetary Fund. The hope was that backing up Ireland would quell the contagion spreading to other weak Eurozone members, especially Portugal and Spain. But the opposite has happened. The fact that Ireland, considered a paragon of reform, was forced into a bailout has only solidified fears in financial markets that the others could be doomed as well. The sovereign bonds of both Portugal and Spain are taking a pounding. The spread between Spanish bonds and benchmark German bonds hit a new record on Tuesday, a sign that investors consider Spain’s debt riskier and riskier to own. The euro, after enjoying a strong rally in recent months, has also started slipping again.
How can Europe stop the bleeding? What we need is an entire rethink of how the Eurozone is approaching the problems of its weakest members.
The strategy so far has been simple: Put up rescue funds, demand reforms in the weak economies and hope those steps rebuild confidence in financial markets that the Eurozone’s struggling nations can pay back their giant debts. The process started with a $150 billion bailout of Greece in May; when that didn’t squash the contagion, the EU announced a fund of almost $1 trillion to rescue troubled Eurozone economies. Europe’s leaders hoped they’d never actually have to come up with this money. It was meant first and foremost as a confidence-building measure, so bondholders could be assured that enough cash was at hand to make them whole, no matter what happened in Ireland, Portugal and Spain.
This entire scheme has blown up in Europe’s face. The plan failed to save Ireland; now it is looking more and more likely that Portugal is next. With its high debt, meager growth and political disarray, Portugal has been in the investor spotlight for most of the year, and matters seem to be deteriorating. Unions are calling a general strike on Wednesday to protest a planned austerity budget, which faces a vote in the bickering parliament on Friday. I’m not sure that passing that budget will appease the markets. The government said on Monday that the budget deficit for the first 10 months of 2010 widened from a year ago. Investors seem to be assuming Portugal will inevitably require an Ireland-style rescue. In a Monday note to investors, Royal Bank of Canada Europe stated flatly that it expects Portugal to seek a bailout:
We think it is very likely that Portugal will need a bailout, too. Rates remain prohibitive and in the absence of a massive spread rally (which we do not expect), Portugal will be unable to fund at sensitive levels. Large cash needs will arise in April at the latest. Given the time lag, we think a program is likely by February at the latest.
Why has Europe’s bailout strategy failed? Because investors don’t believe it is viable. The strategy is predicated on the notion that the governments receiving bailouts can fix their finances sufficiently enough to restore confidence in their ability to pay their debts. That means Greece and Ireland have to implement steep budget cuts and other austerity measures. Those steps, however, will only further depress already depressed economies. Even if politicians in Greece and Ireland can muster the political will and authority to sustain those policies – and that’s a big if — there’s no guarantee they will work to turn these economies around. In fact, the bailout-mandated cuts, by suppressing growth, may make it even harder for Greece and Ireland to repair their financial position and pay their creditors. So investors don’t believe that the bailout programs are ensuring they’ll get their money back. That keeps the fear of eventual debt restructurings, in which bondholders share the losses, or even worse, defaults, very much alive.
The instinct of investors under these circumstances is to sell the bonds of weak sovereigns. That’s why Portuguese and Spanish bonds are getting pummeled. The response from the EU is to stress that the economic situation of each nation is different and investors should behave based on that fact. “Portugal does not need any help, it is in a very different situation to Ireland,” European Council President Herman Van Rompuy said Tuesday. That’s true, but it doesn’t matter. Ireland wasn’t supposed to be Greece, either. Once fear grips the minds of investors, they behave in ways that make those fears a reality. That’s how contagion works.
Stopping this cycle of fear and crisis won’t be easy. Investors have to be convinced that their money is safe in Irish, Portuguese and Spanish bonds. How can that be achieved? Europe has to address the problem with more than budget cuts and bailouts. Yes, Greece, Ireland and Portugal all have to get their fiscal deficits under control and stabilize debt levels. But blind slashing with a hatchet can’t be the sole method. Reform programs have to be designed to achieve financial stability while improving each nation’s opportunities to return to healthy growth. Such programs would bolster investor confidence that (1) they would be sustainable, politically and economically, and (2) that the governments implementing them would be better able to pay their debts over the long term.
I think Europe has to tackle its debt problem more proactively, not waiting until the edge of the abyss to step in, but getting ahead of the markets and putting in place reform-based bailouts now, at least for Portugal. I also believe these reform packages have to promise change in the Eurozone overall, not just within its weakest members. As part of the bailouts, the Eurozone has to show it is willing to take steps to help these debt-ridden weaklings out of their crises. That means countries like Germany and France can’t just put up some cash for a bailout and go about their business. They need to show a willingness to reform to support their fellow euro-users. Germany, for example, should show a stronger commitment to reducing its current account surplus by liberalizing its still highly regulated economy to spur more domestic demand and buy more from the rest of Europe.
If matters stay as they are, we’re potentially looking at the end of the monetary union. If Portugal goes, Spain is next to face the firing squad. And Spain is a game changer. Finding the cash to rescue Greece, Ireland and possibly Portugal, all small, peripheral economies, is not that much of a challenge, But if Spain, the world’s 9th-largest economy, gets into trouble, it would probably eat up much of what would be left in Europe’s $1 trillion rescue fund. And then what’s available to bailout the next victim? The more bailouts are needed, the more pressure that puts on the political leaders in the rest of Europe who have to put up the funds. This is politically dangerous stuff – asking voters to accept cuts to services and budget spending at home while directing taxpayer money to bailout the Greeks, Irish, and so on. We can’t expect Europe to keep the bailouts coming indefinitely.