‘Whatever It Takes’

By Fraser Cameron

While most of Europe goes on holiday or sits glued to the London Olympics, the euro sovereign debt crisis continues to preoccupy policymakers. In the last week of July, it appeared as if the crisis had reached Olympian proportions as the Spanish Government looked set to follow its banks and seek a bailout from the EU. Dealing with Greece is one problem. Dealing with Spain, and potentially Italy, are problems of a vastly different dimension. As rumors grew of a Spanish bailout request, markets fell and the euro dipped against the dollar.

Super Mario

But then Mario Draghi, President of the European Central Bank (ECB), spoke out and calmed the markets. In a speech in London, he said the ECB “is ready to do whatever it takes [within our mandate] to preserve the euro. And believe me, it will be enough.”

Investors were suitably impressed by“Super Mario.” Spanish and Italian sovereign bond yields, which had risen to a dangerous level, dropped back, and stock markets recovered as did the euro.

German Chancellor Angela Merkel and French President Francois Hollande also issued a joint statement emphasizing that they were “deeply committed to the integrity of the euro zone” and were determined to do everything to protect it.

So calm reigned again, at least for a few days. When the ECB held its monthly meeting on August 2, many commentators had assumed that Draghi would announce the ECB was going to start buying government bonds. But under pressure from Germany, Draghi was forced to soften his rhetoric and said that the ECB would only intervene once governments in trouble had availed themselves of the EUs rescue funds. Such steps by governments were “necessary conditions”for the ECB to begin its own bond purchases.

Draghis promise of further support but no immediate action led to a repeat fall of European and global stock markets and the euro. So are we to witness another summer of concern over the euro?

The problem is that markets do not believe that EU leaders are really getting a grip on the problem. There have been over 20 summits of EU leaders since the collapse of Lehmann Brothers in 2008. After each summit there is a brief market rally, and then the doubts set in again.

Some experts argue that the deal agreed at the June European Council to boost the euro bailout fund to 500 billion euros ($615 billion) already looks too little, too late. Greece, Ireland, Portugal and Cyprus have all drawn on the stability fund and there is mere 160 billion euros ($197 billion) left in the kitty. In July the Spanish banks were bailed out. Fears that the looming bankruptcy of several regional governments in Spain could force Madrid to seek a massive bailout from the EU led the Moodys ratings agency to downgrade even Germany to a negative rating, fearing that Europes largest economy will have to pick up most of the burden.

German concerns

In Germany there is a growing reaction against any more bailouts. The most strident opposition comes from within Chancellor Angela Merkels own governing coalition. German Economics Minister and Vice Chancellor Philipp Roesler publicly voiced his skepticism that Greece would be able to meet its obligations in order to access further bailout funds. He added that “the horror of such an event” had faded a long time ago.

The official EU line is that Greece should do everything possible to stay in the euro zone. Jose Manual Barroso, President of the European Commission, visited Greece at the end of July urging Greece to move ahead with the austerity program. He said actions were more significant than words and he wanted to see “results, results, results.” A group of officials from the EU, the IMF and the ECB also visited Athens to monitor progress.

After frantic last-ditch talks with his partners in government, Antonis Samaras, new Prime Minister of a fragile right-left coalition, was able to announce that Greece had accepted the need for a further 14.5 billion euros ($17.8 billion) of spending cuts over the coming two years. This was an essential deal; otherwise, the EU and IMF had indicated that the next 31.2-billioneuro ($38.3 billion) loan tranche would not be forthcoming. If this had happened, the Greek Government would have been unable to pay pensions and public-sector salaries. This could have led to a “Grexit” from the euro within weeks.

German concerns go beyond Greece. The parliament is waiting on a judgment from the Constitutional Court on the proposed fiscal compact agreed to by EU leaders in June. Once the fiscal compact is in place (it needs 12 out of 17 euro-zone members to ratify), governments will have to limit their total borrowing to 3 percent, with an additional 0.5 percent allowed in times of recession. These rules are supposed to stop them accumulating too much debt, and make sure there wont be another financial crisis. The new permanent fund, part of the fiscal compact, will have 500 billion euros ($615 billion), but there are doubts whether even this huge sum would be sufficient to deal with simultaneous bailouts in Spain and Italy.

No quick solution

The current crisis has little to do with government debt. Most of the debts in Spain and Italy are the result of private sector borrowing. When they joined the euro over a decade ago, interest rates fell to a historic low. This led to a debtfuelled boom with consumers buying more and more German cars and Chinese goods. As Germany built up its cash reserves, it lent substantial amounts to Spain, Italy and Greece.

But debts are only part of the problem in the Mediterranean countries. During the boom years, and unlike the situation in Germany, wages rose steadily leading to a loss of competitiveness in Spain, Italy and even France. All Mediterranean countries are now facing nasty recessions, because no one wants to spend. Companies and citizens are too busy repaying their debts to spend more. Governments are slashing public spending. But this is leading to even more unemployment(already over 20 percent in Spain), which makes the repayment of debts even more difficult.

Markets are simply reacting to these unpleasant facts and rising bond yields are a reflection of market uncertainty. Some experts argue that the crisis would be over at a stroke if the ECB were to authorize the issue of eurobonds. But such a move is strongly opposed by Merkel and other more fiscally conservative governments such as Finland and the Netherlands.

The ECB clearly has a key role to play. It has already lowered interest rates to a record 0.75 percent. It could re-launch bond purchases as a signal of support for the weaker economies. Such a move is currently blocked by the German Bundesbank, Germanys central bank, at least until governments show more resolve in implementing austerity programs. The ECB could also issue a banking license to the European Stability Mechanism, the monetary unions rescue fund as part of the fiscal compact. This would enable the mechanism to post the bonds it buys to obtain ECB liquidity and thus increase its firepower.

Meanwhile, the IMF has warned that the continuing euro-zone crisis poses a “key risk”to Chinas growth prospects. Most Chinese exports go to Europe and if the debt crisis continues it would affect consumer sentiment and demand, resulting in a cutback in exports. U.S. President Barack Obama is also pressing the EU to sort out its problems lest the crisis damage his re-election hopes for November.

The euro-zone crisis looks set to run and run. There is no quick solution in sight. Governments are all searching for the magic mantra that allows economic growth while keeping a tight rein on public expenditure. They may be searching for some time.