Europe's Turn Again
Europe has been pretty quiet lately. But apparently that was an illusion. The Eurozone's slide down the slippery slope continues, but because the current stage involves colorless bureaucrats debating the terms of debt swaps rather than street riots and air strikes, it has been overshadowed by the chaos in the Middle East.
That's about to change, as the flaws in the design of the common currency system really start to bite. As the Telegraph's Ambrose Evans-Pritchard reports:
Portugal edged closer to the brink yesterday, having to pay almost 6pc to raise two-year debt. The yield on 10-year bonds briefly surged to 7.8pc after the Chinese rating agency Dagong downgraded the country's debt to BBB+.
"These levels of interest rates are not sustainable over time," said Carlos Costa Pina, secretary of the Portuguese Treasury, blaming the latest upset on the lack of a coherent EU debt strategy rather any failing by Portugal to deliver on austerity.
Mr Costa Pina rebuffed calls by leading economists in Portugal for an EU-IMF bail-out rather than drawing out the agony. "It is not justified. Portugal doesn't need external help, it needs urgent measures by the EU to restore market confidence."
David Owen from Jefferies Fixed Income said last week's shock move by the ECB to pre-announce rate rises had tightened credit and effectively doomed the country. "The ECB by its actions has made it inevitable that Portugal will need a bail-out. There are parallels with the actions of the Bundesbank during the ERM crisis in 1992," he said.
Mr Owen said the ECB is playing brinkmanship with EU leaders, pressuring them to come up with a grand solution to the debt crisis at summits this month. It is a dangerous game. "Spain is not yet safe. It has €2.5 trillion of combined household and company debt. That is an awful lot," he said
There is no sign yet that Germany, Holland, and Finland will agree to expand the remit of the bail-out fund (EFSF), letting it buy the bonds of debtor states pre-emptively, or lend to these countries so that they can buy back their own debt in a "soft-restructuring".
If anything, the mood is hardening in Germany. The regional Länder have begun to demand a say over any EFSF deal. Hesse's justice minister Jörg-Uwe Hahn said he "categorically rejects" all moves to an EU 'Transferunion', debt pool, or fiscal fusion.
The three blocs of Chancellor Angela Merkel's Bundestag coalition have written a paper instructing her to resist any concessions on a debt union. She has little leeway anyway since the long-awaited ruling of Germany's constitutional court on the legality of the EU rescue machinery hangs like a Sword of Damocles.
"The EU will do too little, too late: the markets will dictate the solution," said Louis Gargour from LNG Capital, speaking at a Euromoney bond forum. He said Greece is already in the grip of an unstoppable debt spiral, spending 14.3pc of tax revenue on interest costs. He expects 50pc 'haircuts' on the debt, perhaps along the lines of the Brady Plan following Latin America's debt crisis.
The Greek crisis is going to from bad to worse. Ten-year yields spiked to 12.78pc yesterday and unemployment jumped sharply to 14.8pc in December, a reminder that the social trauma of austerity has yet to hit.
Greece is undergoing the harshest fiscal squeeze ever tried by a modern Western economy, yet public debt will end above 150pc of GDP by 2013 even if it complies with EU-IMF terms. "We should default and return to the Drachma to punish foreign loan sharks who have bled us dry," said Avriani, a paper linked to the ruling PASOK party.
There was similar anger in Ireland yesterday where Socialist MP Joe Higgins denounced "the poisonous cocktail of austerity concocted by the witchdoctors in Brussels and in Frankfurt".
Premier Enda Kenny said Ireland was at "the darkest hour before the dawn." He has so far played down talk of a clash with Germany over the terms if Ireland's bail-out, but Irish politics may force him to default on senior bank debt if the EU refuses to yield.
George Magnus from UBS said EU leaders are living in a "parallel universe", unable see that the festering EU debt crisis cannot be resolved without going to the root cause and recapitalising the banks.
Peripheral EMU will remain trapped in deep slump without debt forgiveness but the EU cannot do this until lenders are strong enough to absorb the losses. "The sequencing of this has to start with the banks, otherwise there will be fears of another Lehman. The EU and IMF are in denial about everything we have learned over history."
"The US banks raised $200bn of common equity in six weeks and that proved to be a turning point. If the EU does that, the crisis goes away," he said.
Olli Rehn, the EU economics commissioner, has been pleading for a policy shift to lessen the burden on debt-stricken states, including a cut in the punitive interest cost imposed on Ireland.
However, EU leaders have the final say on the terms of the rescue machinery, and they are answering to their own angry electorates. The eurozone remains a collection of sovereign states. That is the nub of the matter.
It looks like the Eurozone made a huge mistake in not kicking Greece out of the system the minute it failed to meet the zone's debt and deficit targets. This would have established that the rules matter. If a country wants the benefits of a strong common currency, it has to manage its finances responsibly. In the same way that expelling a disruptive student from a classroom changes the behavior of the remaining kids, the other PIIGS countries would have immediately begun making the hard cultural and financial choices necessary to live in a (relatively) sound money world.
But by bailing out Greece, Europe instead sent the message that soaring government spending and double-digit deficits will be rewarded with massive loans. This allowed the other weak economies (Ireland being the notable, admirable exception) to put off the hard adjustments -- which soured German voters on further bailouts, making help on an effective scale a tough, if not impossible sale.
Now, with inflation rising, the European Central Bank has been forced to promise to raise interest rates, which traps the PIIGS countries between two destructive forces: rising interest rates (prospective from the ECB and immediate in the bond markets) and the inability of German leadership to deliver a trillion-euro bailout.
The result is a feedback loop of deteriorating finances leading to credit downgrades leading to higher bond yields leading to further deteriorating finances, until at some point everything falls apart.
We may not be far from that point, when the bond markets demand unmanageably high rates on new Portuguese or Spanish bonds, one or both threaten to default, and German voters call their bluff. What happens then is anybody's guess.