Will the euro survive in 2012?

by michael roberts

The decision  of the American credit rating agency, S&P, to downgrade the bonds of eight Eurozone governments has reopened the euro crisis.  Credit ratings agencies are used by bond investors (banks, pension funds, insurance companies and hedge funds) to tell them what is the risk on a particular bond that borrower will default on repayment of the money invested.  If a credit agency gives a bond its top rate of 'Triple-A', it regards that bond as having a negligible risk.  So investors will pay the highest price for it and be willing to accept a low rate of interest as income. So when a bond is downgraded, the borrower will have to pay more interest on the bond and the price of the bond is likely to fall.

Usually, the bonds of governments in the major capitalist economies are regarded as ultra-safe and get a triple A rating.  But now French government bonds have been downgraded to a lower level than Triple A and Italian and Spanish bonds to one grade above what is called 'junk', a level which means you should not buy them if you are sane.  Only Germany, the Netherlands, Finland and tiny Luxembourg are now Triple-A.

The S&P is saying that it does not think the Eurozone governments' current policies of fiscal austerity are working to get the level of government debt down.  The S&P says that just imposing public spending cuts and raising taxes is not enough.  Indeed, it is making things worse, because it is contributing to driving many Eurozone economies into a new recession.  Indeed, if we look at the forecasts for economic growth in 2012 in the region, it makes dismal reading.  Greece is declining at a 7% rate: Italy and Spain are contracting at least at a 1% rate; while Portugal is falling faster.  Even Ireland of the three 'bailout states', which has been held up a success model for fiscal austerity policies, is being dragged down by the rest of region.  As a result, budget deficit targets set by the IMF and by governments are not being met in Greece, Portugal, Spain and Italy.  And without economic growth, the denominator in the debt to GDP ratio will just make the task of reducing public sector debt more difficult.  More fiscal austerity causes economic recession. Economic recession raises debt levels.  It's a Catch 22 situation.

What is the S&P's answer?: more policies to encourage economic growth.  And what are they?  According to the S&P, the IMF, the EU and the bankers who are now in the political leadership of government in Greece and Italy (see my post, Italy and Greece, rule by the bankers, 10 November 2011); and the right-wing leaders in Portugal, Spain and Ireland, it is 'liberalisation' of the economy to improve 'competitiveness'.  By that, they mean ending workers and trade union rights to protect jobs; ending 'restrictive practices' in various professions that apparently stop people getting into a sector; deregulation of 'red tape' and the privatisation of the remaining public sector assets to boost profits.  In other words, it is more of the same 'neo-liberal' policies that have been put in play by successive governments across the major economies for the last 30 years and got these economies into this mess in the first place!  The IMF, the S&P, various right-wing and social democratic governments and all the rest of the mainstream parrot on that you can't solve the debt problem by taking on more debt.  But they don't say also that you can't solve the problem of the lack of economic growth by more of the same neo-liberal policies that contributed to the Great Recession in 2008-9.  Moreover, if everybody is trying to raise their competitiveness and sell more exports, then nobody gets an edge!

So what is going to happen?  Well, the downgrading of the bonds also means the downgrading of the bonds of the EU's emergency fund, the EFSF.  That means it won't have enough money to fund anything more than the bailouts it is already committed to for Ireland, Portugal and Greece (twice).  But it didn't have enough money guaranteed by the likes of 'safe' Germany and France anyway.  The new permanent funding mechanism, the ESM, is due to take over in the summer, but that's six months away at least and even then it too won't have enough money.

So either the likes of Greece, Portugal, Italy and Spain will have to convince bond investors that they can finance what they need to borrow over the next year, or credit will dry up and the cost of borrowing will become prohibitive.  It is increasingly becoming clear that Greece cannot do this.  Its public debt to GDP level is already 160%.  So bad is this that the EU and the IMF agreed that private sector bond investors (mainly European banks and hedge funds) would have to accept a 50% 'haircut' on their holdings of Greek debt to get that debt level down.  The banks and hedge funds have been very reluctant to do this without huge 'sweeteners' in cash payouts and new Greek bonds guaranteed by the EFSF with a high rate of interest.

Even with a deal on this, the Greek public sector debt would still be at 120% of GDP in 2020, assuming that the Greek people is prepared to put up with crippling cuts in their living standards for the rest of the decade.  Given that most historical studies show that debt levels over 90% of GDP are not sustainable without default or an economic slump, Greece's debt maths just don't add up, even after the sacrifices of the people.  Default on its debt is the only way out for Greece, something I have advocated in this blog on many occasions.  But it won't be a default negotiated by a government looking to defend the living standards of the majority, but a 'disorderly default' that pushes Greek capitalism into a pit.  If Greece goes down, the focus will turn to Portugal and then Italy and Spain.  Bond investors will fear that they too will default and the cost of credit will rocket, pushing these economies further downwards.

Is there any way out of this?  Well, there is one entity that can provide the necessary funding to pick up the bonds of these distressed Eurozone governments: the European Central Bank (ECB).  As a central bank, the ECB can print as much money as it needs to fund anything it wants.  However, under the statutes of the ECB, it is not allowed to print money to fund government debt. That's because there was a fear such 'monetisation' of government debt would eventually lead to raging inflation.  The Germans are adamantly against monetisation, partly because it was the policy of Hitler in the 1930s and it caused hyperinflation in the 1920s.  Indeed, such monetisation can only meet the debt commitments of governments by cutting the real value of that credit for the investors.  It is in effect another haircut on the value of the debt.

So the ECB has not acted. Instead it has decided to provide unlimited funds to Europe's banks through unprecedented three-year loans on the grounds that it must support the stability of the financial sector.  And Eurozone banks are really squeezed of liquidity because no good bank wants to lend to a bad one.  The ECB loans will help keep the banks afloat but the banks won't use this 'free cash' to buy government bonds, especially if the likes of the S&P now considers them highly risky.  Instead the banks are cutting back on their lending both to governments and industry in order to make their balance sheets look better to regulators and shareholders.

In the meantime, the ECB plans to sit on its hands and expect that Eurozone governments can resolve the crisis by just imposing their policies of fiscal austerity.  That is why it welcomed the decision of last December's EU summit to sign up to a new treaty that committed governments to balance their budgets and reduce their debt levels under automatic threat of penalties and court action.  Now the ECB is worried that the final treaty terms, due to be agreed at the next EU summit at the end of this month, have been so watered down as to be useless in that task.

So we have an impasse. The ECB will not provide funds to bail out governments; and governments are refusing to introduce draconian fiscal penalties that might convince markets that the debt problem can be solved.  That's why the S&P has acted as it has.  If this impasse continues and European economies go deeper into recession, their fiscal targets won't be met and the risk of default will reach tipping point.  It is possible that the Eurozone leaders can engineer an 'orderly' default by Greece, perhaps with that country leaving the euro and yet convince markets that nobody else will follow.  But that will require more official funding.  If not, then Greece will default and perhaps be followed by others, leading to chaos and the eventual establishment of a euro just based on the stronger northern European economies.

There is an alternative to this.  Elections in Greece are planned for April. If the Greek people elected a government dedicated to negotiating a writing off of its debt with the bankers and hedge funds; and launched a programme for growth and jobs based on public sector investment, funded by proper taxation of the rich and public ownership of the major profitable industries, then there would be a possibility of turning things round in Greece.  Such a government could campaign for similar pan-European policies for growth aimed at cutting unilaterally the debt to the bankers and investing in public programmes for jobs and growth, rather than adopting neo-liberal measures of privatisation and deregulation.

According to recent polls, 56% of Greeks who were asked want radical change and 33% want a revolution.  There is a body of support for an alternative policy.  However, the leaders of the major parties in Greece are following the dictates of Greece's banker prime minister and the demands of the dreaded troika of the EU Commission, the IMF and the ECB.  That leads to a generation of misery and probable exit from the Eurozone.  The choice is stark.