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Defaults might be the only way to ensure the eurozone's survival

Eurozone crisis | Defaults might be the only way to ensure the eurozone's survival Ian Fraser

The response of the European Union to the unfolding eurozone sovereign debt crisis has, so far, been of the headless chicken variety. Or to put it more politely, it has revolved around treating the symptoms rather than the causes of Europe's closely interwoven sovereign debt and banking crises. Brussels has been sticking the equivalent of Band-Aids on limbs that in fact need much more radical surgery.

The understandable reluctance of the German people to keep bailing out their profligate neighbors hasn’t helped; the Olympian insouciance of the European Central Bank has only exacerbated the crisis; and the whole project of salvaging the eurozone may anyway be doomed thanks to the "zombie" nature of banks in busted countries like Ireland and Portugal (a problem recently highlighted by Professor Tyler Cowen in a superb article in the New York Times.)

The ECB’s decision to raise interest rates from 1% to 1.25% on April 7 may have been helpful to Germany, but it was supremely unhelpful for Greece, Ireland and Portugal. Indeed, it sends them a powerful signal that the Frankfurt-based institution has no intention of easing their pain via monetary softening. It’s going to make austerity programs more unbearable and limits their chances of restoring order to their finances in the foreseeable future.

The rate rise also boosts the chances that other troubled euro economies - Belgium and Spain spring to mind - will also need bailouts, which paradoxically won’t help Germany. The Germans have already contributed €52bn (20% of the total) to the bailout funds of the three troubled countries and this would rise dramatically if Spain were to join their ranks.

In a blog post (Euro crisis morphs into the sovereigns' subprime) published last May, I pointed to uncanny parallels between the European debt crisis and the US subprime crisis which manifested itself in March 2007. In a recent article in Real Clear Markets, Desmond Lachman picked up on this, saying a common theme is the pretence by the authorities that the crises are small and containable (in 2007 Fed chairman Ben Bernanke told us that since subprime only represented a tiny portion of the financial markets, its implosion didn't really matter - there have been similar claims about the already collapsed PIIGS). Lachman added:

"Another disturbing way in which the Eurozone debt crisis resembles the earlier US subprime crisis is the way in which European policymakers are engaging in self delusion. They do so by fooling themselves that the problems with which they are dealing are ones of liquidity rather than solvency..

"Despite record high interest on the sovereign bonds of Europe's periphery even after massive IMF and ECB support, European policymakers keep up the charade that Greece, Ireland, and Portugal do not need a debt restructuring. And despite Spain's serious problems of external over-indebtedness, a major housing bust, and a highly troubled savings and loan sector, European policymakers are asking markets to believe that Spain will not be the next domino to fall."

Policymakers' head-in-the-sand attitude towards the European banking sector, which is heavily exposed to the debt of peripheral nations, is one of the most disturbing aspects of the current crisis, said Lachman. He said policymakers should be requiring UK and continental banks to raise additional capital to cushion themselves from the inevitable large writedown in peripheral nations' debt.

Lachman is by no means alone in his pessimism about Europe. The Guardian’s economics editor Larry Elliott recently wrote that self-delusion still rules in Brussels and called for a different strategy.

"Financial markets are starting to send a clear message: the debt dynamics of certain eurozone countries are unsustainable. And the lesson from Britain on Black Wednesday in 1992 is that if a strategy is unsustainable, it is not sustained. Whatever policymakers might say or think."

Fathom Consulting believes the eurozone is already drinking in the last chance saloon. In its new global outlook, the London-based economic and financial market consultancy said:

"The euro area has catapulted itself to the top of the league of risks to the global recovery. It has a greater potential to derail the global recovery than either surging oil prices or the Japanese catastrophe. The tragedy is that to a great extent this is a self-inflicted wound. The combination of tighter monetary policy and a buyers’ strike for their debt leaves the peripheral euro area countries with no choice but to default."

In a well-argued piece, Portuguese-born Nuno Monteiro, assistant professor of political science at Yale University and Eduardo Sousa, senior analyst and manager at Bank Santander Totta in Portugal, claim that managed defaults are the only way out. Writing in Comment is Free, they said that

"defaults would dispel the specter of Weimar, with stagnant – or worse, contracting – economies leading to rising populist tendencies that could undermine democracy in member states and thus imperil European peace. A co-ordinated debt default would not endanger the stability of the euro and the EU. In fact, it might be the best way to preserve it."

They added that "by shifting some of the costs of the debt crisis away from the borrowers, a default would discipline lenders that have continuously supplied cheap money to troubled economies under the expectation that, if necessary, an EU or IMF bailout would guarantee their capital." Monteiro and Totta discount the risk that a stage-managed default along the lines they propose could have dire consequences.

Again, there are parallels with the subprime crisis, which took a distinct turn for the worse following the US decision to let Lehman Brothers go bust. We all know about the panic and mayhem that led to. In subprime 2.0, peripheral defaults, however carefully structured, could have similar knock-on effects for banks around the world, but particularly those in Europe.

The difference this time around is that governments would a lot less willing, and indeed a lot less able, to stump up the cash to rescue them from the consequences of their own folly.

Further reading on the crisis and the fate of the eurozone:

Tags: EU , European Central Bank , European Monetary Union , european sovereign debt , eurozone , Greece , Ireland , PIIGS , Portugal , sovereign debt crisis
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