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Monday 19 Feb 2018 | 05:33 | SYDNEY
Monday 19 Feb 2018 | 05:33 | SYDNEY

The EU's slow-motion avalanche



9 May 2011 12:23

Portugal has now joined Greece and Ireland in seeking assistance from the European Union, the European Central Bank and the International Monetary Fund. At €78 billion (around US$116 billion), the package compares with €110 billion for Greece and €67.5 billion for Ireland, and is a massive 45% of Portugal's GDP.

Each of these countries is unhappy in its own way.

Greece was unable to raise taxes to fund its bloated budget. Ireland saved its feckless banks but in doing so bankrupted the country. Now Portugal, after a decade of sclerotic growth (less than 1% per year), has a budget deficit close to 10% of GDP, a large external deficit (thus needing to continue borrowing from foreigners) and has lost competitiveness within the Euro zone. Politics makes austerity difficult, with Portugal's belt-tightening starting with unemployment already around 10%.

Meanwhile, it has become painfully clear that Greece is insolvent, not just illiquid, and needs a debt restructure to be viable. The IMF is busy denying rumours that it is now urging this course of action, which is usually a signal that the event is, in fact, imminent.

Certainly, it is clear that Greece can't return to the financial market to issue new bonds next year, as originally planned. The market now requires an interest rate of more than 20% to persuade it to hold current debt.

The hope was that these countries could hold out, with this level of assistance, until 2013, when Europe will have in place the European Financial Stability Facility, which would facilitate a more structured approach to sovereign debt. Such a delay would make sense if there was a real prospect that these countries could make substantial adjustment in the meantime. This fragile hope has now faded. Greece has already fallen behind its budget-reduction target, Ireland is asking for softer terms, and Portugal has an election in the middle of this year which makes serious austerity problematic.

The assistance gives breathing space by providing funding at normal interest rates. But it doesn't, in itself, alter the stark unsustainability of the debt levels.

Historically, countries eroded their debt burden by growing strongly (reducing debt as a percent of GDP) or by inflating the debt away. Neither of these paths is available for these three countries. Budget austerity crimps growth prospects. Inflation in the context of the fixed Euro link damages international competitiveness, widening the external deficit. The classic way of softening austerity is by boosting production through depreciation, but again the Euro link rules this out.

Some observers are pointing to Latvia as the model of how to recover while keeping a fixed exchange rate. Over the past two years, it has extricated itself from a similar bind, improving its international competitiveness by cutting labour costs by over 20% and implementing a fiscal contraction equal to 15% of GDP, which saw public sector wages fall by 26%.

This is bitter medicine. It is improbable that Greece has the political cohesion to pull off such a strategy.

While a debt restructuring might seem compellingly obvious, just about all the parties involved have a powerful motive for turning a blind eye to this option. Politicians in the debtor countries have every reason to delay acknowledging failure, if only because it is better for the ship to sink on a successor's watch.

The creditors (mainly banks in Germany and France) are holding the debt on their books at face value, and a restructure would involve bankruptcy-threatening write-offs. They would need help from their governments, so politicians would have to persuade taxpayers to pick up the residual bill. Giving more help to ailing bankers is not an election-winning strategy.

There is also the concern that a debt restructure would shift the spotlight onto the next domino. This is a big one: Spain.

Spain is in better shape: the government has addressed weaknesses and has already imposed about as much austerity as any country can take (unemployment is 20%). But it is exposed to Portugal's woes, with its lending to Portuguese banks amounting to 8% of Spain's GDP.

Thus the slow-motion avalanche continues.

Are there any lessons here for Australia?

On the surface, we are very far removed, riding the China-driven commodities boom. We have a floating exchange rate, so are not trapped in the strait-jacket of the Euro. Our budget is on the way to surplus. But the sobering aspect of the European experience is that each country found it so easy to live beyond its means and so extraordinarily painful (politically near-impossible) to correct this when it becomes unsustainable.

Our income has been boosted 12-15% by the commodity boom. We need the discipline of a sovereign wealth fund, funded by a substantial resources tax, to soften the transition when the good times end.

Photo by Flickr user schoeband.

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