Eurozone on a 'cliff edge', ready to fall
by Philip Booth
06 October 2011
Recession in the eurozone could trigger widespread sovereign defaults
The eurozone sovereign debt situation is on a cliff edge. This may sound like a statement of the obvious given the chaos within financial markets, but there is a very real sense in which this analogy holds. If sovereign debt default is limited to Greece, then it may be possible to contain the problem. There will be good ways and bad ways of dealing with the problem of Greek default, but Greece is relatively small compared with the total capacity of European financial markets so catastrophe should be avoided. If Spain, Italy, Ireland and Portugal do not default, we just stay on the land side of the cliff.
On the other hand, a debt default involving Spain and Italy – and possibly even Ireland and Portugal – would be a catastrophe. And this is much more likely to happen if there is further recession. Many journalists and financial market practitioners are just calling for political will to be exercised to resolve the crisis. If only the Germans had the courage, it is argued, we could resolve this problem. This is a delusion.
Already 30 per cent of the European Financial Stability Facility is being guaranteed by the countries that are in trouble. The European Central Bank stands behind the EFSF, but this also has its capital provided by the eurozone countries. This situation is like two people going to the bank and admitting that they are both insolvent, but asking the bank for more money on condition that they will guarantee each other's loans. If the eurozone governments in general recapitalise the banking sector in the event of a major sovereign debt write off, then other countries will run into trouble – France being the most obvious candidate. The whole of Europe will stand on Germany's increasing narrow shoulders.
We need to recognise the debt crisis for what it is. For more than a generation, too many European governments have spent money and imposed the burden on future generations through borrowing. This was a wealth transfer – for as long as it lasted – to the generation doing the spending. The process has become unsustainable. There is now a very real loss of wealth to the current generation as a result. We need solutions that recognise the reality and that lead to those who have invested in the banks that bought the securities losing their money. This will be a messy process; there will be an unavoidable wealth loss felt by many. But we cannot repackage debt in ever-more sophisticated ways and carry on brushing the problem under the carpet.
We can hope to alleviate this problem through a proper growth strategy. This means radical deregulation within the European Union. Unfortunately, this is very far from the minds of the politicians. When politicians talk about rekindling growth, they are normally talking about more government spending and yet more borrowing – or reducing the speed at which borrowing is reduced. This is the strategy that led us to where we are today. Deregulation, on the other hand, would help get people back to work and slowly nurture confidence within business that long-term investment is worthwhile. If we do not get radical action to bring about growth within the EU - then, sooner or later, the eurozone is likely to step off the cliff. The stakes are high.
Professor Philip Booth is editorial director of the Institute of Economic Affairs think-tank, in the UK
The eurozone sovereign debt situation is on a cliff edge. This may sound like a statement of the obvious given the chaos within financial markets, but there is a very real sense in which this analogy holds. If sovereign debt default is limited to Greece, then it may be possible to contain the problem. There will be good ways and bad ways of dealing with the problem of Greek default, but Greece is relatively small compared with the total capacity of European financial markets so catastrophe should be avoided. If Spain, Italy, Ireland and Portugal do not default, we just stay on the land side of the cliff.
On the other hand, a debt default involving Spain and Italy – and possibly even Ireland and Portugal – would be a catastrophe. And this is much more likely to happen if there is further recession. Many journalists and financial market practitioners are just calling for political will to be exercised to resolve the crisis. If only the Germans had the courage, it is argued, we could resolve this problem. This is a delusion.
Already 30 per cent of the European Financial Stability Facility is being guaranteed by the countries that are in trouble. The European Central Bank stands behind the EFSF, but this also has its capital provided by the eurozone countries. This situation is like two people going to the bank and admitting that they are both insolvent, but asking the bank for more money on condition that they will guarantee each other's loans. If the eurozone governments in general recapitalise the banking sector in the event of a major sovereign debt write off, then other countries will run into trouble – France being the most obvious candidate. The whole of Europe will stand on Germany's increasing narrow shoulders.
We need to recognise the debt crisis for what it is. For more than a generation, too many European governments have spent money and imposed the burden on future generations through borrowing. This was a wealth transfer – for as long as it lasted – to the generation doing the spending. The process has become unsustainable. There is now a very real loss of wealth to the current generation as a result. We need solutions that recognise the reality and that lead to those who have invested in the banks that bought the securities losing their money. This will be a messy process; there will be an unavoidable wealth loss felt by many. But we cannot repackage debt in ever-more sophisticated ways and carry on brushing the problem under the carpet.
We can hope to alleviate this problem through a proper growth strategy. This means radical deregulation within the European Union. Unfortunately, this is very far from the minds of the politicians. When politicians talk about rekindling growth, they are normally talking about more government spending and yet more borrowing – or reducing the speed at which borrowing is reduced. This is the strategy that led us to where we are today. Deregulation, on the other hand, would help get people back to work and slowly nurture confidence within business that long-term investment is worthwhile. If we do not get radical action to bring about growth within the EU - then, sooner or later, the eurozone is likely to step off the cliff. The stakes are high.
Professor Philip Booth is editorial director of the Institute of Economic Affairs think-tank, in the UK
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