The end of Europe? C.P. Chandrasekhar

To many today the question is not whether the Eurozone would survive, but how long it would. A crisis that started in the European periphery, transiting through Ireland and Portugal, had gathered momentum when it reached Spain and Greece. What Ireland and Portugal had signalled was that sovereign debt, or the debt owed by governments, was no longer seen as being safe by definition. There were, of course, two features characteristic of the debt owed by these countries. The first was that it was not in a currency that was only their own, but rather was that of a larger community of nations. The second was that it was owed to large financial institutions, banks and non-bank financial companies, which had bought into these government bonds on the expectation that they were completely safe.

Government debt has conventionally been associated with near-zero income and capital risk, since the interest was always expected to be paid when due and the capital was always expected to be returned wen the loan reaches maturity. But this expectation was partly based on two presumptions. The first was that governments had not just the right but also the capability to mobilise resources through taxation to meet their commitments.  The second was that when governments were temporarily unable to mobilise the required tax revenues they could borrow at will, if need be from the “lender of last resort”, the central bank, which would turn to the mint to obtain the needed currency if required.

Both of these are proving difficult to realize in the Eurozone. A feature of recent global developments has been a backlash against the state that has taken the form of a tax revolt by the rich. Governments have been under pressure to incentivise private savings and investment, not by spending to create demand but by reducing the taxes paid out of incomes and profits. This obviously meant that governments have increasingly lost their ability to manage their finances by adjustments on the revenue side, and are more dependent on spending cuts to rein in their budgetary deficits or generate budgetary surpluses.

The second feature applicable to the Eurozone countries is that individual countries have lost their ability to print at will more of their currency, since the euro is governed by rule of the monetary union and is not subject to the discretionary policy of individual central banks. This implies that as and when budgetary deficits arise governments are forced to finance those deficits by borrowing from the open market. And “the markets” consisting of potential investors in government bonds are neither required to buy into those bonds nor accept the terms such as interest rates dictated by governments.

These changed features of the financial environment were not noticed till such time as the markets “perceived” the level of borrowing by individual governments as being acceptable. In recent years, however, many governments have seen a huge increase in the volume of their debt relative to GDP. Not all of this is due to “profligate spending”. In fact, in many countries debt has ballooned because of the expenditures made by these government to “bail-out” a private financial system in crisis as well as to stimulate economies experiencing recession in the aftermath of the financial crisis. The resulting budget deficits had to be financed with new borrowing. Private investors whose wealth was being protected from excessive erosion by the government bail-out of banks and non-bank financial companies and who were looking for new safe avenues for investment, bought into the government bonds that were issued to finance these expenditures. That increased their exposure to public debt.

No objections were raised against deficit spending so long as the purpose was to save private finance and protect the wealth holders. But once such spending had occurred, resulting in an accumulation of a large volume of debt, attention was focused on how the repayment commitments associated with such debt were to be met. Governments, it was argued, must cut spending through adoption of austerity measures in order to generate the surpluses required for the purpose. If the evidence was that governments were not doing this and increasing their debt levels further, then the “markets” were either unwilling to give them more credit or were willing to do so only at exorbitant interest rates. In countries such as Greece, the interest rate on public debt rose to levels far above that paid on German bonds, reflecting the risk perceived in lending to those governments. When interest rates rise sharply, the higher interest burden makes the spending cuts needed to restore “balance” even greater. But spending cuts affect growth and employment adversely, and therefore the level of government revenues from taxation. This makes “adjustment” even more difficult to ensure. Thus, the actual outcome is a spiral of ever-increasing austerity, which becomes politically difficult to impose.

A good example of how this plays out is Greece. Given the level of its revenues, Greece needs access to credit to finance even unavoidable expenditures like its salary and pension bills. But lenders are unwilling to provide the needed credit unless the government adopts new austerity measures that would adversely affect a population already burdened with spending cuts and income losses. Austerity becomes a requirement for a third reason, other than the refusal to tax and the inability to mint currency. This is the unwillingness of big finance, which had merrily lent to governments, to adequately share the “adjustment costs” in a crisis substantially caused by them.

During the negotiations on burden sharing to resolve the crisis in Greece, one stumbling block has been the fixing of the haircut or loss banks must be required to accept on the loans they made to Greece. According to the official view the haircut agreed upon has risen from nil, to 20 per cent to as much as 50 per cent of loan value. But doubts have been expressed about the veracity of the 50 per cent figure. According to reports the offer made by the Institute of International Finance, which represents the banking industry, involves the issue of new bonds for which the current debt would be swapped. Those bonds are to be lucrative, carrying a high 8 per cent interest rate and conditions regarding additional annual payments if and when the Greek economy recovers. But the current value of the future stream of incomes has been calculated using a high “discount rate” of 12 per cent, making the discounted value of the bonds about 50 per cent lower than the debt being substituted.

If through these means finance manages to reduce its burden substantially, the consequences would be extremely damaging for those not culpable for the crisis in the first place. According to the Financial Times, the austerity package agree upon in Greece involves spending cuts and tax increases that would reduce the average post-tax income of Greek citizens by €5,600 from its current level of €41,400 or by 14 per cent—which is almost double the cut imposed on citizens in Ireland and Portugal after their crisis.

All this occurs because lenders have lost their confidence in the ability of the Greek government to repay debt under a business as usual scenario. It must be noted that many countries were accumulating large volumes of debt without any such loss of the confidence. The degree to which public debt grew varied significantly across countries in the Eurozone: Finland sports a gross debt to GDP ratio of just above 50 per cent, Germany and France of 83 and 87 per cent respectively, Portugal and Ireland of 106 and 109 per cent and Italy and Greece of 121 and 166 per cent respectively.

Countries with the highest debt-to-GDP ratios are the ones saddled with austerity or experiencing a loss of confidence among creditors. But it is not always the level of debt that triggers the loss of creditor-confidence. Spain, with a relatively low 67 per cent is facing more difficulties than many others. Besides the sheer level of debt, another factor that could possible be influencing the level of confidence is the rate at which the public debt to GDP ratio rises. More recently, “confidence” has been influenced by the rating of pubic debt of individual countries by leading credit rating agencies, the timing of whose decisions is difficult to explain.

Once a decline in confidence is triggered, the process described above begins necessitating governments to adopt round after round of austerity, until it is not politically sustainable. Consider Greece for example. Realising that the severe austerity demanded by lenders would be difficult to implement without popular support, Socialist Prime Minister George Papandreou announced a referendum to win social sanction to proceed. Since the voters would not have sanctioned such austerity the country would possibly have had to step out of the Eurozone with unforeseen consequences. What followed the announcement, therefore, was a furore that forced a retraction of the referendum, the resignation of the prime minister and the constitution of a national “unity” government involving all major parties (headed by the “technocrat” Lucas Papademos), which promised to implement the austerity measures. As of now it is unclear how the government can implement the promised measures and meet the fiscal targets it has been set.

On the other hand, with the difficulties faced by the Greek government in meeting its payments commitments becoming clear, attention has shifted to other countries with similar problems. These countries are far more important in the Eurozone. Italy, with a gross debt to GDP ratio of 121 per cent (as compared with Greece’s 166 per cent) has been the focus of attention. Though the government chose to voluntarily adopt austerity measures, lenders were not convinced that the measures were adequate. Creditors are now less inclined to provide additional credit to the Italian government or are only willing to lend at very high interest rates that the government could not bear. This is disastrous for a country that is estimated to require at least €650 billion in credit over the next three years. Italy is now on a slippery slope to possible default. That would be disastrous for the Eurozone, since Italy accounts for close to 17 per cent of its GDP.

What is needed is for the European central back to print money to buy up government debt, for the Italian government to tax its rich and for banks to be forced to take a large and real haircut. But there is disagreement on each of the possibilities. All that has happened is a change of government in Italy as well. Since Silvio Berlusconi was seen as incapable of delivering the necessary austerity, he had to make way for a government of technocrats. In sum, the crisis has resulted in a series of changes in government in countries with high debt levels, so as to facilitate the turn to austerity. But that as noted is no solution to the crisis in the Eurozone.

(This article was originally published in the Frontline, Vol. 28, No. 25, December 03-16, 2011.)