EuroZone All In
By Peter Boone and Simon Johnson, Baseline Scenario, 10 May 2010
The eurozone self-rescue plan announced last night has three main elements:
At first pass this package might seem to be in with what we recommended
But the European central banks have come in very early – with government bond prices still high – and there is no sign yet of credible fiscal adjustment for Spain and Portugal. The eurozone apparently did not even discuss the situation in Ireland, which seems increasingly troubling.
This is a whole new level of global moral hazard – the result of an alliance of convenience between troubled governments in the south of Europe and the north European banks (and implicitly, north American banks) who enabled their debt habit. The Europeans promise to unveil a mechanism this week that will “prevent abuse” by borrowing countries, but it is hard to see how this would really work in Europe today.
Overall, this is our assessment:
The underlying problem in the euro zone is that Portugal, Ireland, Italy, Greece, and Spain are locked into a currency which means they are uncompetitive in trade terms while they are also running large budget deficits. To get out of this they need large wage and price cuts to restore competitiveness, and they need to make fiscal cuts to get budget balances back at sustainable levels.
Markets decided these adjustments were going to be difficult, so spreads on those countries’ debts widened (i.e., interest rates relative to German government bonds). As the rates go up, this causes local asset prices to fall, concerns over bank balance sheets increase, etc. This combination was causing an incipient run on banks. Any country with its own currency could reasonably devalue in such a situation, but this is not an option within the euro bloc.
All these problems were exacerbated by the appearance that the Germans were going to be unwilling to bail out troubled nations – and would eventually chose to bail out their own banks instead. It is this risk which is now resolved. The Germans have shown willingness to provide very large amounts of money (the 750bn euro support is probably just enough for Spain and Portugal if they got packages in line with that received by Greece) and they would obviously provide more if needed (e.g., for Italy). (Here again is the ready reckoning chart for
However, the solvency issue remains. The Spanish and Portuguese have said they will now cut their budgets further, but already their forecasts were optimistic, and neither has seemed willing to admit they have severe budget problems, so we will need to watch how they implement in the near term. Greece
750bn euros in a fiscal support program, with 1/3 coming from the IMF (although this was apparently news to the IMF).The European Central Bank promises to buy bonds in dysfunctional markets.Swap lines with the Federal Reserve, to provide dollars.a week ago and again on Thursday.interlinkages between indebted Europeans.)remains simply far too indebted.