By Jamal Harwood
In the last week of October the heads of the Eurozone countries announced their long awaited plan for solving the debt crisis ravaging the region. With Greece seemingly on the brink of a sovereign debt default and Portugal, Ireland, Spain – and even Italy also tottering with very high debt levels coupled with rising debt repayment levels – something was sorely needed. Not only to quieten the markets but also to show confidence that the politicians have a workable plan to save the region from a possible Euro meltdown.
Earlier in October the governor of the Bank of England Mervyn King said: “This is the most serious financial crisis we have seen at least since the 1930s, if not ever”. Angela Merkel, German Chancellor, highlighted to the Bundestag that the European union has meant unprecedented stability and “peace” for the region. So, when leaders of this calibre talk of the ‘biggest crisis ever’ and evoking the spectre of war we know the situation is serious.
The solution proposed has 3 pillars:
1. Debt forgiveness for 50% of Greece’s debt held with banks and other private institutions. This would be debt classified as forgiven, and not as a default – an important distinction.
2. Expanding the European Financial Stability Facility (EFSF) to a possible €1 Trillion+ to meet the potential needs for further bank or sovereign bailouts.
3. The requirement for European banks to recapitalize – to find an additional €108 Billion – over the next 12 months.
But examine the fine print in the light of reality and it is doubtful that the crisis will be solved through these tentative measures, which have been thrown into question after the shock proposal to take the Greek bailout proposals to a referendum and the subsequent resignation of the Greek Prime Minister.
Reviewing the solutions point by point reveals serious flaws.
1. The Greek Bailout
Greece owes €364 Billion, 170% of its GDP, with its Government debt amounting to €329 Billion. The 50% “haircut” (debt forgiveness) proposed does not affect the one third of Greek debt owed to the IMF, EU and ECB (European Central Bank) and is projected to reduce the debt load to 120% of GDP by 2020 IF (and it is a big ‘IF’) all other measures are accepted by the Greeks and all projections for growth and austerity cuts are successfully implemented. (100% of Debt to GDP is often put forward as the absolute limit beyond which governments should not go.)
Many are sceptical about whether the “haircut” plan will solve the Greek debt crisis and foresee a Greek default. Default and leaving the Euro seemed to be the option that former Greek PM Papandreou proposed with the referendum on acceptance of the bailout, which is planned for early December. But EU officials have made it clear that Greece cannot simply leave the Euro without leaving the European Union itself – and some commentators have argued that there is no process in place that adequately allows for one country to leave the Eurozone without the currency itself collapsing.
In the fine print to the bailout are many unpleasant surprises for the Greeks including forced privatisation of assets to the tune of €65 Billion, further severe public sector wage and benefit cuts and deep spending cuts. To many the prospect of default and a fresh start again outside of the straightjacket of the Euro will be seen as preferable – Iceland stood up to the Banks and defaulted. Hence, Papandreou’s crafty idea to put this difficult decision into the hands of his public. Faced with two very difficult options (to stay or go) he hoped to direct any flak from whatever is decided his unpopular ruling party towards public opinion. Liana Kanelli of the Greek Communist Party said the referendum question was: “Do you want to die or do you want to be killed?”
It doesn’t end here as even if the Greeks decide to accept the bailout and austerity package, what is to stop the rest of the heavily indebted country from calling for the same. Why should Ireland, Portugal, Spain and even Italy continue to pay interest on high debts and impose severe austerity on their voting populations when Greece shows an easier way? The temptation to default or threaten default is very real and Ireland and Spain this week have already highlighted lower than expected growth rates, hence greater difficulty in paying existing debts, and, “hey buddy can you help me like you plan to help Greece”.
The third unintended consequence of stopping Greece’s default (or attempting to stop it) can be seen in the murky world of derivatives. It was pivotal that the bailout included words to the effect that Banks were accepting the haircut, so as to avoid the “default” word. The default word is important because default triggers Credit Default Swaps (CDS) credit events, which are forms of insurance against default that banks, hedge funds and others write to offset the risk of default. Take a look at this linked diagram of European debt. It highlights the serious interrelationships and risks of debt default upon respective European partners.
What it doesn’t show are the equally serious interrelationships of those institutions insuring these bonds via CDS. The CDS market is over $60 Trillion – much larger than the bonds to which it purports to cover. Those gambling on defaults can expect no sympathy from the public or politicians but those using CDS to hedge against sovereign debt defaults could fail as the politicians are manipulating the “default” market (by labelling technical defaults as non-defaults). Take a 50% loss, but you are not covered, as your CDS isn’t triggered. Who will collapse next in this arena? American and British banks are big in this market.
2. European Financial Stability Facility
Political chicanery is also apparent in this “stability” facility. First we were told that the EFSF would be boosted from €440 Billion to €1 or even €2 Trillion to provide the needed comfort against potential sovereign defaults. But as the following table highlights, the levels of debt throughout Europe are enormous and getting larger.
Furthermore official interest rates are tiny (ECB official rate is 0.75%) yet the PIIGS are facing steeply rising interest on their debts. Italy is now paying more than 6%, and that is unsustainable with its increasing budget deficits. The Euro was supposed to provide low rates of interest to all its members and even France with rumours of French bank failures looming is now seeing the spread between French and German bonds rise alarmingly.
The bigger question is whether the stability fund can cope and how €440 Billion becomes €1 or €2 Trillion? And is €2 Trillion even enough? Talk has been of leveraging the €440 Billion, via a form of insurance so that the ECB effectively guarantee the first 20% of European sovereign bonds. Yet this is hardly likely to bring confidence to a market, which is now expecting a 100% Greek default and accelerating problems for its PIIGS compatriots. The Germans know this and refused to increase their €210 Billion contribution to the stability fund. Where else will the money come from – China was approached and appears to be reluctant given that it is the prime funder of America’s vast deficit. This only leaves money printing as a solution with the attendant inflation it brings – something the Germans are particularly sensitive to having suffered through the Weimar hyperinflation.
3. Bank Recapitalisations
The third pillar of the plan dictates that European banks should have at least 9% of tier one capital to offset any potential risks they are facing. If only it were that simple. The latest enormous bank to collapse and get bailed out – Dexia – (the 10th largest Eurozone bank) sailed successfully through its capital stress test of last year with a reported 12% of tier one capital. Off balance sheet “gambling” derivatives money is seldom reported and even official liabilities of these “you wouldn’t dare let us fail” banks are at obscene levels:
Banking Liabilities (% of respective country GDP)
- France 409%
- Spain 338%
- Germany 331%
- Italy 250%
- Greece 213%
With French banks holding approximately half of Italy’s debt it is little wonder that the French credit rating is under pressure for a downgrade.
The damning indictment inherent in the above figures is that since the dawn of this crisis in 2008 the Banks have failed to deleverage their bloated balance sheets and despite public bailout backing have not brought their houses in order. The European bank loan to deposit ratio is 1.2, which is the same as the Japanese banks in the early 1990’s as Japan went into a prolonged recession – its lost decade. Japan has now managed to reduce this ratio to 0.7 but Europe shows no signs of being able to emulate this. We are no closer to stability than any time in the past 4 years. Governments are dreaming if they think that these toxic bank positions will lead to any stability without serious restructuring of the banks and banking.
“The provision of additional liquidity support to countries or institutions in trouble can buy valuable time” Bank of England governor Mervyn King said on in late October, going on to say that lenders in Europe remain inadequately capitalized and governments must do more to tackle the underlying debt problem”. The debt problem is effectively one of solvency with banks and governments alike insolvent.
Some concluding thoughts
Growth across the region is anaemic and the OECD is projecting it to be 0.3% in 2012 down from an earlier projection of 2%. Without substantial growth these economies will struggle to repay debt. As debt continues to climb and government-spending deficits widen, the market increases interest rates for the riskiest economies. One of the key objectives of Euroland was to enable widespread low, stable interest rates. This is failing and the second division of Euroland, the PIIGS, are taking the brunt of this.
On the other hand Germany has benefited greatly from a low and stable Euro exchange rate, consistently lower than the old Deutschmark, and hence an opportunity for strong trade growth – an opportunity the efficient Germans have taken full advantage of and are very loath to give up. They have benefited greatly but domestic public opinion weighs heavily on their politicians and is against credit easing which could lead to high levels of inflation and further bailouts of spendthrift Eurozone neighbours. So it is rather short-sighted to put all of the blame on the PIIGS countries.
It is more surprising that the real core of the problem is seldom raised.
If a society is going to hand responsibility for control of money (creation) and its flow (lending) to Banks, then we can expect debt bubbles as we have seen grow in the last 10 years – and extreme profiteering by those Banks.
When money is paper and not backed by anything tangible (gold/silver for example) the growth of such paper “assets” is inevitable, as is inflation – the “elected” politicians just cannot control themselves.
When interest is allowed on that debt then eventually interest rates will consume growth and the weak will be devoured by that debt and interest.
When a large region (Europe) decides to launch a paper currency without a strong and fair political union (and associated fiscal and economic policies) then inevitably that union will struggle to maintain its unity – and the strong will still dominate the weak.
The unwinding of all of this will be very slow and painful.
Luxembourg’s long-serving prime minister, Jean-Claude Juncker recently said: “We all know what to do, but we don’t know how to get re-elected once we have done it”.
A rare moment of honesty, perhaps, but still limited in terms of real solutions.
Jamal Harwood is a regular contributor to New Civilisation. He is a lecturer in Finance, and a member of the UK Executive Committee of Hizb ut-Tahrir Britain.