January 09, 2011
As predicted, EU bailout euphoria is rapidly waning
Now, barely a week later, financial analysts seem to be reaching the same conclusion, with confusion about the exact nature of the EU's plans reigniting the crisis of confidence that has been haunting the continent for over a year. Once again, the sudden change of mood in global markets is aptly conveyed by a rapid turnaround in narratives in the mainstream media.
A Predictable Change in Mood
Consider the following headlines, for example, released in the wake of the EU emergency summit last week: "Eurozone leaders draw up radical plan to safeguard euro", "Greek bailout boosts global markets", "Eurozone crisis: Baby steps in the right direction", "Europe's debt crisis: The Counteroffensive".
The New York Times wrote that, "After years of resistance, European leaders agreed Thursday to reduce Greece's debt burden in a last-ditch effort to preserve the euro and stem a broader financial panic." A draft document of the agreement had spoken about a European 'Marshall Plan' for Greece, and this was part of the reason that markets galloped late last week.
But now compare last week's enthusiasm to some of the following headlines, released after the weekend: "Bailout rescue: euphoria wanes as doubts emerge", "Europe's "Marshall Plan" for Greece may disappoint", "Moody's warns Greek default almost certain", "The eurozone crisis is on pause, not over", "The shaky basis of the Greek rescue", "Contagion uncontained in eurozone", and "Greek rescue bizarrely increases its debts".
What explains this sudden shift in mood? Well, it seems that upon deeper inspection over the weekend many analysts discovered that last week's agreement is really just another instance of typical European window-dressing. As Wolfgang Munchau writes in the Financial Times:
You have to give it to the European Council. They are pretty good at stitching up impressive looking deals, having lowered expectation to a bare minimum beforehand. But the effectiveness of an agreement should not be gauged by the immediate market reaction, let alone by how the agreement compares with expectations.
For Munchau, the agreement fails to address two fundamental issues: first, it does not put Greece on a path towards sustainable debt reduction, and second, it fails to provide new rules for the European Financial Stability Facility (EFSF) that would make contagion less likely. As a result, Munchau warns that, "even before the ink on this second package is dry, a third Greek package beckons.
Sustainable Debt Reduction
The first issue is very serious for Greece - and for Europe - because as long as Greece is not put on a path of sustainable debt reduction, through either a resumption of economic growth or a sizeable debt default, the EU will be forced to keep propping up the Greek economy by pumping in extra loans. The latter will always remain a temporary solution, as it only increases Greece's actual debt.
As we observed in our analysis last week, the idea to bring Greece's debt of 150 percent of GDP down to the Italian level of 120 percent of GDP seems like wishful thinking at this point. The Greek economy contracted 5.5 percent in the last 12 months, and has been contracting for a third consecutive year this year. Facing such Depression-level declines in economic output, it will simply be impossible to balance the budget - let alone produce the type of surpluses required to service the national debt.
Rather than improving this bleak outlook, the second EU bailout is actually set to make matters worse for Greece. First of all, the term 'bailout' has an Orwellian quality to it. In fact, what the EU is giving Greece are loans - they may be issued at low interest rates, but they need to be paid back in full nonetheless. Reuters reports what the result of is of this second massive emergency loan:
Listen to the politicians and one might think that Greece's debts will fall as a result of last week's provisional rescue by euro zone leaders and private-sector creditors. In fact, they go up. Athens' borrowings will increase by 31 billion euros under the rescue scheme, according to an analysis by Reuters Breakingviews. This increase, equivalent to 14 percent of GDP, will push the country's estimated peak debt/GDP ratio next year to 179 percent.
One way Europe sought to address investor fear about protracted depression in Greece, was to call for a European 'Marshall Plan' in a leaked draft document. But, as Reuters reported, "that phrase was left out of the final version, perhaps in order to limit expectations." The EU investments will only see some effect on Greece's economic growth after two years or so, meaning the short-term debt issue remains. It also remains to be seen whether the EU will ever be willing to invest 5 percent of its total GDP in the continent's recovery, as the US did post-WWII.
All of this is slowly beginning to convince analysts that either "a Greek bailout is only a matter of time," or the "selective default" incorporated into the current agreement is the forebear of a looming disorderly default. Whichever of the two actually transpires, the bottom line is that Greece's debt levels remain unsustainable. At some point, someone is going to have to take additional losses.
Containing the Risk of Contagion
The question is, who will take those losses -- and when? Last week's summit was shrouded in uncertainty about the second Greek bailout. For a few days, there was a serious risk that this uncertainty would cause the crisis to spill over into Italy and Spain - the euro zone's third and fourth largest economies, respectively. As both countries are considered both too large to fail and too large to bail, this would have spelled catastrophe for Europe.
The seemingly radical expansion of the powers of the EFSF was meant to halt this contagion effect. Under the agreement, the EFSF would be allowed to buy back bonds of countries on secondary markets, even if they were not acutely in shortage of money - essentially taking over the task that the European Central Bank had been playing in the Greek debt crisis so far.
However, there are great worries that such a reform of the EFSF - which would virtually turn it into a European monetary fund, the first step towards a European economic government - would require an expansion of up to €1.5tn. As Larry Elliot of the Guardian pointed out, it is not obvious that Northern European parliaments and populations would be willing to bankroll this vast expansion.
The immediate effect of this realization, says financial analyst Nils Pratley, has been to make the "solution to the eurozone's woes look weaker by the day." Indeed, "in the fight against contagion, nothing has been achieved. The yield on 10-year Spanish bonds popped back above 6% yesterday and Italian 10-yields stand at 5.66%. Such rates, if sustained for long periods, are simply unaffordable."
There are other problems too. One of them is the paradoxical situation in which two countries under threat - Italy and Spain - are currently the third and fourth largest contributor to the bailout fund. How much longer can these debt-ridden countries continue to bankroll their neighbors without requiring similar aid themselves? And when we reach that stage, what will happen to France?
It is precisely this question that yesterday caused the early stirrings of a worrisome trend that could see France lose its triple-A rating - with catastrophic consequences for Europe and the world. After the US and Germany, France is the third-biggest issuer of triple-A rated bonds in the world and the second-biggest contributor to the EFSF.
Investors are starting to get worried that France's persistent budget deficits - it hasn't balanced a budget since the early 1970s - might soon become unsustainable, especially given the fact that France is acutely exposed to southern European debt, especially Greek and Italian debt. A default of Greece and/or contagion to Italy would rapidly drag down France as well.
Once Again, Banks Profit
Last week, Merkel presented the agreement as a victory, especially against European Central Bank president Jean-Claude Trichet, who had insisted that private lenders should not be forced to pay for Greece's debt troubles. Merkel, supported by the hard-line Dutch and Finnish governments, wanted to secure private sector participation in order to be able to get the package through Parliament.
But after a week, more and more people are beginning to realize that, for all the cosmopolitan European rhetoric about 'transnational solidarity' with the Greeks and the social justice masquerade of "securing private sector participation", the real beneficiaries of the bailout are neither Greeks nor average Germans. The real beneficiaries are French and German banks.
In a front-page article, the New York Times wrote that "Europe's latest plan to prop up Greece looks suspiciously like a plan to bolster European banks." In this respect, it is worth citing a Der Spiegel report at length, to highlight the impact that this indirect bailout of European banks has on the aforementioned sustainability of Greece's debts:
Deutsche Bank CEO Josef Ackermann's claim that "this hits us where it hurts" is all part of the show. In fact, Ackermann and Luxembourg Prime Minister Jean-Claude Juncker worked out the program together.
The financial institutions that participate voluntarily will be expected to write off 21 percent. In many cases, however, this number will be lower because of value adjustments that were already made. Calculations show that Deutsche Bank would face a write-down of about €100 million. "The private sector comes off pretty well," says Thomas Mayer, chief economist at Deutsche Bank. "This deal is a golden opportunity for banks and insurance companies. They should take advantage of it."
The effects on Greece, on the other hand, are modest. The country's debt ratio -- the ratio of debt to gross domestic product (GDP) -- will decline by only 12 percentage points in the first few years.
This means that, under the agreed measures, the debt level will remain at around 150 percent for some time to come. Greece cannot shoulder this burden alone. Deutsche Bank's calculations assume that, under the new conditions, Greece would have to generate budget surpluses over many years merely to arrive at the same, relatively high, debt ratio as Italy -- 120 percent of GDP -- by 2020.
So apart from the fact - highlighted in last week's analysis - that none of the elements in the EU agreement actually address the root causes of the crisis, the specifics that are mentioned in the agreement actually threaten to make the crisis worse in the short to medium term. No wonder, then, that the bailout euphoria is quickly waning. By pushing its problems down the road, Europe continues to lead itself to ruin.