Events of the past few days have been dramatic – even by ‘eurozone crisis’ standards. In the wake of the European October 27 plan to solve the eurozone crisis, the shock proposal for a referendum in Greece on this latest plan and the subsequent abortion of this referendum proposal (following intense pressure from Germany and France) accelerated the demise of the Greek Prime Minister. This was followed by a sharp rise in Italian government bond yields to an unsustainable funding level (beyond the 7 % yield threshold) as Italy’s debt problems came under closer market scrutiny. The pressure on the Italian Prime Minister to resign immediately became irresistible.
Concerns about Italian debt (and the Italian bond market is the third largest in the world) began to ease a little as the ECB (European Central Bank) stepped in and bought Italy’s debt, thereby reducing Italian bond yields below the critical 7% threshold. At the same time, though, France’s borrowing costs began to surge. French banks hold £261bn of loans to the Italian economy, roughly six times the exposure of the UK.
Anxiety about contagion from sovereign (country debt ) risk is running high. At the same time, the European Commission has said that economic growth in the eurozone has ‘stalled’; it has also downgraded its economic growth forecasts for the UK economy. Just to complete the developing ‘scenario of gloom’, the IMF (International Monetary Fund) has warned that developing events in Europe could help produce a ‘lost decade’ of economic growth for the global economy.
The October 27 plan (the third one to date!) for the eurozone crisis had many positive aspects , but there were some major apparent problems. Two basic problems were the proposed size of the bail-out fund (too small to re-assure the markets) and the planned re-capitalisation of European banks (strung out over too long a time period and likely to involve banks shrinking their balance sheets and exacerbating economic growth prospects further via the resultant reduced bank lending). The German Chancellor warned in the same week that the latest plan was launched that it could be a decade before the present Eurozone crisis becomes history.
The most fundamental problem with the latest plan was that it simply failed to convince the markets that it would work. Events of the past few days have now raised the prospects of a country (or even a group) of countries, the so-called peripheral countries, exiting from the eurozone. Some are even talking about a possible break-up of the entire eurozone, although this is probably politically unacceptable at the present at least. In any event, the prospects of a Greek debt default (especially a disorderly one) might well spark off contagion effects as investor concern increases with other heavily indebted eurozone countries (like Italy).
The first financial firm casualties of the eurozone crisis have already appeared. Dexia, a Frenco-Belgian lender, was the first one. The first US financial firm has now hit the headlines. MF Global (an ambitious and high profile US broker-dealer) collapsed on October 31. This is the largest collapse of a financial firm since that of Lehman Brothers in 2008. MF Global was run by Jon Corzine, former chairman of Goldman Sachs.
What is clear is that vague promises and (vaguer) plans by politicians to save the euro and solve the eurozone crisis are not enough. But it is by no means ‘game over’ yet. There are still many big questions to address, including the possible future support role of the ECB and IMF. Other such questions include the available funds that may be leveraged out of China and other major countries (though this prospect is not looking quite so buoyant at present). The extent to which Greece, Italy and other indebted countries may be willing to accept greater intrusion into their national policies may also be critical. Another key question is how far Germany is willing to extend prolonged debt support.
A major issue is the extent to which Greece and other heavily indebted countries will accept the kind of national austerity policies that Germany especially demands. A glimmer of hope here is the developing experiences of Ireland with its national austerity programme. This has been severe by any standards, but the Irish have accepted what has to be done and got on with it. So far, the results are encouraging – for example the spread between Irish and German ten-year bonds has shrunk by close to 50% and the Irish fiscal position has also improved. There are certainly severe challenges and trials ahead for Ireland, and a larger than expected write down of Greek debt will surely exacerbate the improving, but still fragile Irish recovery. Nevertheless, the former ‘Celtic Tiger’ is beginning to inch its way moving slowly out of the infamous ‘Pigs’ group of indebted European countries. Contagion from the latest eurozone debacle could wreck these small, but hard won gains for Ireland.
Despite these glimmers of hope on what can be done, the preceding are just a selection of the ‘known unknowns’ for the developing eurozone crisis . In the weeks ahead, these and other related challenges (including the size of the proposed eurozone bail-out fund and the possible need to complement national austerity plans with structural reforms in order to improve economic competitiveness ) will have to be addressed . There is no denying the practical complexities involved and the inevitable interplay of economics and politics. Many critics believe that economic desirability has all too often been subjugated to political considerations within the various plans proposed for tackling the eurozone crisis. In the political domain, though, the very future and nature of the Eurozone are now very much ‘on the table’.
In the meantime, though it is the ‘unknown unknowns’ that are being nurtured with the present lack of a plan and the resultant market uncertainties. These ‘unknown unknowns’ cover possible market scenarios that might produce contagion effects and lead to system-wide risks and unpredictable consequences. Such events are usually rare and invariably unpredictable, since they are associated with market chaos and disorder. The problem is that these events become more possible and likely when continued uncertainty and fear stalk global financial markets.
A recent The Economist leader – entitled ‘That’s all, folks’ (The euro crisis after Berlusconi) – summarised their overall view of where we are now at……’
‘For the euro to survive, Italy must succeed. For Italy to succeed, its squabbling politicians must find unaccustomed reserves of unity and courage. That depends on ordinary Italians being willing to make sacrifices, the ECB backing Italy, and France and Germany standing resolutely behind the euro. It is a daunting long list of things to get right’.
They also comment:
‘At stake is not just the Italian economy but Spain, Portugal, Ireland, the euro, the European Union’s single market, the global banking system, the world economy, and pretty much anything else you can think of.’
An immediate priority must be to reassure global financial markets and reduce substantially and in a sustainable way the potential for contagion that has been exacerbated during the past two weeks.
Dangerous and challenging times indeed…
Professor Ted Gardener