As European leaders are frantically discussing whether the European Union’s bailout fund should be increased from its current size of $585 billion, it’s clear that the debt crisis in the eurozone is entering a new stage – one in which events can unravel quickly. At this stage, the European sovereign debt crisis has become a systemic problem for the European periphery as a whole – and not just a series of mishaps in its individual countries. As a result, it also has become a systemic problem for the European banking system, as much of the periphery’s debt sits on balance sheets of major German banks.
Given the magnitude of the problem, it is striking to observe the utter inadequacy of European policymakers’ response. Many in the Brussels political elite are in a state of denial. Earlier this month, in a private and therefore supposedly frank discussion with a high-level official at the European Commission, I was told debt restructuring in the periphery was «completely off the table.»
This state of denial should not be surprising. After all, from its inception, the common European currency has been a political project and not one justified by economic considerations. Recognizing that the project has been a failure – or even recognizing a need for a change in the current arrangement – will be extremely hurtful for those who have invested a lot of political capital in the status quo.
What is paradoxical, however, is that the denial is not accompanied by a credible commitment to keeping the project alive, no matter what. The current size of the EU bailout fund – the European Financial Stability Fund (EFSF) – is just too small to keep the periphery afloat. If there is a need to rescue Portugal, the fund will run dry quickly, without leaving anything to aid Spain. Yet, given the degree of economic and financial integration of the two countries, it is likely that if Portugal faces a liquidity problem, so will Spain.
It is true that the recent Portuguese bond auction went rather well and Portugal was able to sell $1.7 billion worth of government bonds, with a reasonable risk premium. However, this addresses just a small fraction of Portugal’s immediate financing needs. In the course of this year, it will need to raise more than $33 billion in the financial markets. The idea that one successful bond auction means that the periphery’s financing problems have disappeared – as some European politicians seem to imply – is simply fanciful.
Sooner or later, Portugal will need assistance from the EFSF. It is difficult to predict what will happen then. German Chancellor Angela Merkel has signaled that the German government is tired of the permanent streams of proposals to enlarge the lending facility. Moreover, back in Berlin, Mrs. Merkel’s coalition partners – the Free Democrats – have rejected the idea that the fund should be increased. In May 2010, German voters expressed their outrage at the Greek bailout in the Westphalia election, and a permanent policy of fiscal transfers to the European periphery is likely to prove political suicide.
Moreover, this policy is likely to be met with a backlash in the periphery itself. The ailing countries are being asked to implement substantial fiscal cuts, quickly and without the benefit of being able to devalue their currencies and make their exports competitive. Unless voters acquiesce to sinking their countries deeper into an already grave recession, the austerity measures imposed on the periphery will come to an end. We already have seen the popular backlash against the cuts in Greece and in Ireland, where Sinn Fein is now stronger than ever. The most likely scenario in the periphery is thus one in which one – or several – of the governments default unilaterally on their debt.
As Desmond Lachman, economist at the American Enterprise Institute, notes, markets already are weighing in a substantial probability for the default of some of the peripheral countries. At this stage, bowing to the inevitable and restructuring the periphery’s debt in an orderly fashion is the best option left to both European policymakers and the European banking sector.
To be effective at addressing the underlying predicaments of the eurozone’s periphery, its countries also should be allowed to exit the eurozone – in a permanent or temporary way – and reduce their external imbalances through currency depreciation. How exactly this monetary transition should be orchestrated remains an open question. Nonetheless, facing the reality – instead of pretending the euro can survive its present stresses and that no plan B is necessary – would be a useful starting point. Nothing can harm an already enfeebled European economy more than a wave of chaotic defaults on the periphery’s $2 trillion in sovereign debt.
Dalibor Rohac, a research fellow at the Legatum Institute.