The eurozone survived 2010. My prediction is that it will survive in 2011. The question is, in what condition?
Quite probably we will see more funding crises, as some eurozone governments and banks seek to refinance their debts. We must also be prepared for a public backlash against what in several countries are the most extreme austerity programmes since the 1930s. The euro, even if it survives the year, will remain a source of political, economic and financial instability for the eurozone itself and the world as a whole.
One can look at the future of the euro from a political or historical perspective, as is so often done, or from a macroeconomic one. However, to understand what is likely to happen in the next year or so, I find it more instructive to look at it from a risk-management perspective. The foreign owner of a Greek, Irish or Portuguese bond, for example, faces two specific dangers that result directly from the present crisis. One is the risk of a eurozone break-up. The other is a default risk – in which case the debtor defaults but stays inside the eurozone.
That risk is not calculable. But you can make a useful distinction between risks that are positive, but too small to bother about, and those that are small, but non-trivial. Three years ago I would have described the risk of a eurozone break-up as trivial. Now I still think it is small, but non-trivial.
Risk awareness is something that shifts suddenly. For a long time you may see no risk; when you do, it is time to seek insurance. For the first 10 years of the eurozone, investors considered the risks trivial and sought no insurance whatsoever. They treated the bonds of eurozone member states almost identically. But once this changed, sovereign bond yields began to diverge rapidly.
What we saw last year was not a speculative attack on the euro, as continental European politicians would have us believe, but a perfectly normal response to a change in risk perception. Smart investors understand that the combination of high indebtedness, high interest rates and low growth raises dramatically the risk of default at some point in the future. Normally, a higher interest rate would compensate for such risk, but this does not work when the rate become so high that it triggers the default you want to insure against. This is why the rational response has simply been to get out – especially given the abundance of far less risky high-yield alternatives. Ten-year Turkish government bonds were yielding just under 9 per cent last week. Ten-year Polish bonds were at 6 per cent. Neither country is going to default or adopt an inflationary monetary policy.
What about growth? In the case of the eurozone periphery, it is hard to claim that this will come to the rescue. Most of the countries in the periphery suffer from a competitiveness problem – which is what makes this crisis so toxic. If you reform your labour markets and deflate your wages to become more competitive, inflation falls, and so may house prices. The real value of your debt explodes and you might end up insolvent. Combined debt and competitiveness problems are very hard to resolve without devaluation or inflation. It is not a matter of discipline. Infinite discipline could still make you insolvent.
So what about the European Union’s bail-out umbrella? The European financial stability facility (EFSF) is lending money to Ireland at an interest rate of about 6 per cent, which is higher than the country’s nominal growth rate is likely to be for many years. While the loan solves Ireland’s funding problems, it actually exacerbates the country’s underlying solvency problem. The Irish situation reminds me of one of these loan shark advertisements: “Need money fast? No questions asked.”
So how is the toxic interaction of high interest rates, high debts, and low competitiveness going to play out from 2011? I would expect Portugal to be the next country to fall under the umbrella of the EFSF. The European Central Bank has been the only large buyer of periphery bonds in the secondary markets, and is now putting pressure on the countries concerned to accept loans from the EFSF.
What about Spain, Italy and Belgium? Spain should be solvent, but of course there always exists an interest rate/growth rate combination at which the solvency assumption breaks down. With 10-year yields no higher than 5.5 per cent, the approximate current level, I would expect Spain to go through a severe and long recession, possibly with further asset price falls. Productivity will probably remain low and unemployment high for the foreseeable future. But the country should remain solvent – miserable but solvent. If interest rates were to rise to over 6 or 7 per cent, perceptions of Spanish solvency may change.
The main risk for both Italy and Belgium is political. Italy’s banking system is relatively stable but a combination of high interest rates and continued low productivity growth could lead to a debt explosion. Without a stable government that can deliver reforms to boost productivity, it is hard to see how Italy can prosper in the eurozone in the long run. Italy is not a victim of the financial crisis and has so far managed well to stay off the radar screens of international investors. There is no guarantee that this will continue.
Belgium is sinking deeper and deeper into political chaos – and, unlike Italy, it also has a vulnerable banking sector. Belgium is not going to split, but that may not stop investors from panicking about the status of a federal debt that, like Italy’s, exceeds 100 per cent of annual gross domestic product. The underlying problem is that Belgium may not end up with a sufficiently strong central government to take the measures necessary to raise growth and consolidate public finances.
To cope with any crisis beyond Portugal, the EU may need to increase both the size and remit of the EFSF. I predict that the European Council would take such a step if pressed – maybe after some dithering by Germany.
The EFSF will expire in 2013, at which point a new, tougher crisis regime will kick in. The EU has chosen this particular two-step construction for mainly political reasons, but from a funding perspective it is a nightmare. All existing bondholders will be protected until 2013. All government bonds issued from 2013 onwards will have collective action clauses. This means that if a government cannot service the debt, it can agree a haircut with a majority of investors – with legal force for all investors, including those who disagree with the majority vote. Looking at it from a risk-management perspective, this means that the entire default risk of the eurozone periphery will be concentrated on post-2013 bond issues. No one in their right mind would buy such junk bonds.
The way the new crisis mechanism is constructed ensures that the market for European periphery bonds is going to remain thin. What is now being conceived as a new crisis mechanism may end up as the eurozone’s principal funding agency if no one else will provide the funds. It would issue its own bonds – eurozone bonds – underwritten by the few remaining triple A-rated sovereigns, most importantly Germany and France. It is hard to see how such a construction could be sustainable. Should there ever be a default, Berlin and Paris would have to pay up – or default themselves.
This year, Europe’s political leaders pledged to do “whatever it takes” to save the euro. They never answered the question of what that meant. My central prediction for 2011 and beyond is that we will find out.