Eurozone facing potential dislocation.


Barely three weeks after the announcement of the second bailout package for Greece events point to an uncontrolled unravelling of the situation.

Over the first six months of 2011 the Greek budget deficit jumped by almost 30% on an annual basis. Without further drastic measures to reduce spending this year’s deficit could reach 13.5% of GDP, compared with a target of 7.5% (The Economist, August 13th 2011).
With the recession worsening in Athens and GDP likely to fall by 7.5% this year any reasonable hope that Greece can even approach the targets for deficit reduction look vain.
In order to stick to its objectives the Irish Government will need to cut spending or raise taxes by at least € 4 billion in 2012. One month into its tenure the new Portuguese Government acknowledged that a further 1% of GDP in reduced spending or new tax income needs to be raised this year to secure compliance with the objectives set for 2011. Meanwhile the recession is deepening further complicating the task for 2012.

While the ECB’s recent initiative to intervene in the purchasing of Spanish and Italian sovereign bonds met with considerable success, temporarily lowering 10 year yields to 5%, it is unlikely that this offers anything but a limited time window for the Italian and Spanish Governments to impress the market with credible additional measures of fiscal restraint.
Spain however is heading for climatic parliamentary elections in late November, potentially delaying the emergence of an enhanced effort to deal with its problems (unemployment well above 20% and a worsening economic contraction is threatening to disrupt the strained social and political fabric of society).
Prodded by the ECB, Italy’s remarkable speed to present a further €45 billion set of fiscal austerity measures will be assessed by the market in the next couple of weeks.
In the meantime France could to be pried away from the core group of the Eurozone by the widening of the spread of its sovereign OAT’s over Bunds. At the very least this may serve as a warning that France is potentially reaching the limits of its commitment to continue underwriting additional funds to cope with the European debt crisis, leaving Germany to face the bill basically isolated.

In Berlin, The Government must be actively considering the limits of the growing cost of its commitment against the (considerable) advantages of the Eurozone for Germany and Europe.
Mrs Merkel’s room for manoeuvre, never unlimited, is visibly shrinking. Her electorate, never enthusiastic about the ever growing commitment of German resources to the widening European crisis needs to be convinced, at least, that German funds are committed to a context of perceived conditionality where the recipients are seen complying with their engagements to adhere strictly to their objectives of fiscal consolidation. Greece will again, soon, prove such a prospect as futile while the question, not quite so hopeless, remains open for the other recipients.

If, as it appears likely, the present bailout strategy proves unable to elicit compliance from the recipients and fails to arrest ‘contagion’ ever closer to the core, Europe is faced with stark and increasingly urgent choices.

One potentially powerful initiative would be to accept that the EFSF needs to be dramatically expanded to perhaps € 1 trillion in order to potentially have the resources to cope with the needs of Spain and Italy. The issue here is not only Germany’s reluctance but, more deeply, France’s ability to commit to such an effort without jeopardising its already shaken AAA rating.
An even more ambitious initiative would be to accept the creation of Eurobonds, underwritten jointly by the Eurozone governments. Such an initiative, which would theoretically dispel the limits that beset the diminishing number of countries that qualify for funding the EFSF, would nevertheless imply a further weakening of conditionality for recipients to comply with their commitments and would be the equivalent of a potentially unrestricted mechanism of transfer from higher savings and fiscally responsible countries to failing ones.
While recent bailouts have already rendered fiscal sovereignty a feature of the past for the recipient countries, the key and fundamental implication of Eurobonds would be a substantial relinquishing of fiscal sovereignty for those countries, Germany in the forefront, which will be called to guarantee them.

Nothing at this stage could ensure that EFSF, Eurobonds, or ultimately German Bunds (if subordinated to a new supranational debt) could reasonably aspire to a stable AAA rating in the future. In the absence of an effective compliance by beneficiaries, or because of a larger than foreseen future need for funds, the quality of the debt in those countries that are so far shown some degree of control over their national fiscal issues can be damagingly diluted by institutional amalgamation.

Whether the high stakes involved in the adoption of such a transfer mechanism would ultimately be effective would crucially depend upon fundamental changes in European governance that would mandate further supranational authority upon all participants to enact structurally needed reforms as well as a further dilution of their sovereign status.

Even without entering a discussion of the merits and pitfalls of such an historical set of changes it is clear that they would raise difficult and potentially paralysing constitutional issues in Germany.

No amount of bailouts can secure that the beneficiaries comply with their fiscal targets and failure to do so will simply waste resources and raise the cost. Any extension of the role of the ECB whether by reversing its ill advised recent attempt to ‘normalize’ monetary conditions or by buying debt in faltering countries will eventually affect its balance sheet and may raise the need in the not too distant future to recapitalize it.

What needs to be considered at this stage is that the European debt crisis has grown already beyond the periphery and that the strategy to cope with it so far has failed to contain it, even less to resolve it. In the absence of a new set of choices and a credible strategy for their implementation the Eurozone, as we know it, is heading towards dislocation.

14th August 2011