A month ago we posted on the dynamics of the sovereign debt crisis in Europe. The BBC has published a handy flowchart with graphs that explains the origins of the problem. It all goes back to the decision of countries (originally 11 nations in 1999, now 17) in continental Europe to share a single currency. This removed the prior “safety valve” ability of economically weaker countries (e.g. Greece or Italy) to let their currency devalue until it reached some appropriate parity with stronger currencies such as the German mark.
The currency union allowed individuals and corporations in southern European countries to borrow money at the low interest rates usually reserved for the historically stable German mark. This led to a binge of borrowing and building, resulting in a huge real estate boom and bust.
A parallel factor was the loss in competitiveness in southern Europe versus northern Europe. Workers in southern Europe demanded and received raises, paid in expensive euros. Meanwhile, in an impressive display of far-sightedness and social cohesion, Germany around 2003 implemented a set of reforms to reduce welfare spending and to strengthen key export industries like machinery and chemicals. The government helped with vocational training, and unions agreed to low wage hikes even when their companies were prospering. (To American ears this sounds like fantasy, since our labor unions typically agree to concessions only after it is too late and the company is already going bankrupt; then again, the German workers know that their bosses are not walking off with multi-million dollar compensation like U.S. CEOs).
This plot (courtesy The Pragmatic Capitalist) shows unit labor costs for key eurozone countries, relative to Germany:
High-quality goods could be manufactured at lower cost in Germany than in southern Europe, which led to epic trade imbalances as the people in the peripheral countries borrowed (mainly from German and French lenders) on the cheap, and bought (for instance) BMWs.
The BBC graphs show that, apart from Greece, profligate borrowing and spending by the national governments was not a key initiator for crisis. Spain, for instance, kept a very low ratio of public debt to GDP, at least prior to the 2008 financial crisis. But Spain is in recession due to the debt-fuelled boom/bust. Italy is also in slow or negative economic growth. This makes it hard for them to service what might be otherwise manageable sovereign debts. There is a big psychological factor at work here – if the markets become sufficiently fearful of a potential Italian or Spanish default, the markets will demand very high interest rates on Italian or Spanish bonds, which would then precipitate an actual national default.
Stock markets around the world have been rising and falling lately on the news out of Europe. The markets want to see a money-printing “bazooka” unleashed that would dilute away Europe’s debt woes. The European Central Bank (ECB) has the capability to create euros out of thin air and buy Italian and Spanish bonds, in order to keep the interest rates on these bonds at manageable levels. The ECB has made sizeable bond purchases, though it publically maintains (correctly) that that is not its mandate. As we noted earlier, Germany is preventing the ECB from formally committing to stabilize Italian and Spanish bond interest levels via direct purchases.
The ECB has found a way to indirectly subsidize the purchase of government bonds. This week, the ECB’s Long Term Refinancing Operation (LTRO) offered European banks money on excellent terms (1% interest, for 3 years) against collateral such as their country’s sovereign debt. Thus, a bank can effectively borrow money at 1%, use that to buy Italian or Spanish bill yielding perhaps 4%, and pocket the 3% spread. This would normally be a luscious carry trade, and it was hoped that this would stimulate the banks to buy a lot of their governments’ securities. This would be a sort of stealth Quantitative Easing, in which the ECB indirectly financed the purchase of government bonds, as opposed to buying them outright.
Stock markets soared on Wednesday’s LTRO exercise, with a higher-than-expected 437 billion euros borrowed by the banks. This had the appearance of the longed-for bazooka. However, banks used most of that money to swap out existing, higher-interest debt. Banks have in general been paring down their exposure to sovereign debt in order to reduce their risk exposure, so they are unlikely to load up with a lot of new peripheral bonds.
All that said, there seem to be general agreement that the LTRO has helped bring euro bond rates down, and has improved the financial conditions of Europe’s banks, easing a liquidity squeeze and being generally a positive factor for financial stability and business transactions. So at a minimum, this lend-fest should help to kick the euro can yet further down the road.
A long-term solution remains to be found for the structural imbalances in the eurozone. Within a nation, it is common for wealthier regions to subsidize poorer regions on an ongoing basis. In the U.S., for instance, federal taxes and transfer payments tend to net transfer wealth from the coasts to the interior. The north of Italy has subsidized the south for over a hundred years. There seems less willingness among the Germans, Finns, and Dutch to subsidize “la dolce vita” in the Mediterranean countries.
Unless the southern countries leave the euro, their wage scales (in euros) must be beaten down in order to become more competitive and thus have a chance at paying down their debts. It seems like Spain and Italy are doing this the hard way, with government austerity provoking deeper recession and sufficient unemployment that workers may be willing to accept lower wages in return for having a job. Wages are “sticky downward,” so this will be a contentious process. Also, lower wages and low employment may make create a downward spiral of GDP contraction, which may make it all the more difficult for these countries, and individuals within these countries, to service their debts.
Time will tell whether the citizens of these countries continue to believe that the benefits of the euro are worth the costs, and (separate question) whether Europe is still democratic enough that the wishes of its citizens still matter.
[Followup Dec 29: per Zerohedge , we learn that almost NONE of the 437 billion euros borrowed by the banks has gone to purchase net government bonds. As noted above, a bit over half of that sum was put to refinancing existing loans. The remaining $210 billion was mainly just parked by the banks in their accounts in the ECB, presumably to have on hand in case of further financial crisis. So the whole LTRO exercise has been a (needed) windfall for the banks, but an epic fail as far as providing additional funding for European sovereign debt. ]
See here for an overview of the modern monetary system.