The whitened bones of the euro crisis poke out more starkly now from the arid sands of tedious and endless argument, iteration and reiteration. The bones are, firstly, that too much debt causes crises. It doesn’t matter who owes and owns it. ‘Too much’ starts somewhere around 80% of GDP, according to historical research. Then it starts to depress growth.
A few months ago, we were told Italy couldn’t have a crisis because it owed most of its debt to itself. As it didn’t have a substantial external deficit, it didn’t lack the savings to finance itself. Spain, it was said, had less sovereign debt as a proportion of GDP than Germany. It does, but its corporate balance sheet has much more, and much of that is foreign-owned. Debt matters and there’s too much of it.
The second bleached bone is that austerity alone cannot cure excessive sovereign debt. And deleveraging alone cannot cure excessive private-sector debt. Both can help, but you need growth too.
If growth slips below the fail-safe rate, austerity will simply decrease GDP faster than debt. Then debt sustainability is eroded because, ultimately, GDP must pay for it. Yet all policy measures in Europe are about austerity. The growth rate is falling and is well below the fail-safe rate. So the debt problem will get worse.
The third bone is that the European Central Bank policy to provide limitless three-year liquidity to prop up the liabilities of eurozone banks does not address their core problems: first, inadequate capital will cause deleveraging and credit contraction; and second, bank assets will deteriorate because the value of sovereign-debt holdings will decline.
Recession will see to that. And recession will also increase private-sector non-performing loans. That has the potential to at least double the €200 billion to €300 billion new capital that I estimate the banks need to cover losses on bank holdings of sovereign debt and hit a 9% core tier 1 ratio.
Forget any idea that banks will repeat the error of buying eurozone government long-term debt using cheap money from the ECB. This is the closet theory of the ECB helping the sovereigns by the back door. Excessive investment in sovereign debt is why the banks are in a pickle. It only makes sense for the banks to buy one-to-three-year sovereign notes using some of their ECB three-year funding after they have used it to pay down their own €800 billion-worth of debts that mature this year.
Bankers are not going to repeat the errors of the past or buy 10-year bonds with three-year funding. Such a duration mismatch would ultimately be suicide. So any buying of government paper with LTRO money will be at the short end of the curve, leaving long-bond yields untouched. By my calculations, the spare cash from the new LTRO funding will leave less than €200 billion at the very most to be put to other uses. That’s less than 20% of the funding needs of Italy and Spain.
In summary, the policy failures to deal with the euro crisis are: exclusive obsession with austerity; inadequate resources to raise growth in reforming economies with fiscal transfers; and monetary policy that refuses to reduce borrowing costs to levels consistent with debt sustainability for reformers.
| Corporate debt to GDP |
| 2011 |
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| Source: IMF |
This gaping eurozone policy shortfall will not lead to the demise of the euro, but it will take it to a precipice where these policies must be reversed. The ECB can finance reforming governments legally. The issues are merely about how and how much.
I’m not backing the mass monetisation of sovereign debt. That sort of moral hazard is unacceptable, but the ECB should help countries that are trying to help themselves. Financing reforming countries is fine because, without such backing, the deflationary impact of economic reforms will cause the reforms to fail.
ECB president Mario Draghi’s musings about the "spirit of the Treaty" as rendering such action illicit are the stuff of grand opera. But we are in the final scenes of Macbeth – an altogether bloodier tragedy. Draghi risks being a victim of the final scene: the king without a kingdom, a central banker without a currency.
Why is it that the key policymakers – politicians and central bankers – cannot decide together what needs to be done rather than reiterating the rules that prevent it being so?
David Roche is president of Independent Strategy Ltd, a London-based research firm.