To many today the question is not whether the Eurozone
would survive, but how long it would. A crisis that
started in the European periphery, transiting through
Ireland and Portugal, had gathered momentum when it
reached Spain and Greece. What Ireland and Portugal
had signalled was that sovereign debt, or the debt
owed by governments, was no longer seen as being safe
by definition. There were, of course, two features
characteristic of the debt owed by these countries.
The first was that it was not in a currency that was
only their own, but rather was that of a larger community
of nations. The second was that it was owed to large
financial institutions, banks and non-bank financial
companies, which had bought into these government
bonds on the expectation that they were completely
safe.
Government debt has conventionally been associated
with near-zero income and capital risk, since the
interest was always expected to be paid when due and
the capital was always expected to be returned wen
the loan reaches maturity. But this expectation was
partly based on two presumptions. The first was that
governments had not just the right but also the capability
to mobilise resources through taxation to meet their
commitments. The second was that when governments
were temporarily unable to mobilise the required tax
revenues they could borrow at will, if need be from
the ''lender of last resort'', the central bank, which
would turn to the mint to obtain the needed currency
if required.
Both of these are proving difficult to realize in
the Eurozone. A feature of recent global developments
has been a backlash against the state that has taken
the form of a tax revolt by the rich. Governments
have been under pressure to incentivise private savings
and investment, not by spending to create demand but
by reducing the taxes paid out of incomes and profits.
This obviously meant that governments have increasingly
lost their ability to manage their finances by adjustments
on the revenue side, and are more dependent on spending
cuts to rein in their budgetary deficits or generate
budgetary surpluses.
The second feature applicable to the Eurozone countries
is that individual countries have lost their ability
to print at will more of their currency, since the
euro is governed by rule of the monetary union and
is not subject to the discretionary policy of individual
central banks. This implies that as and when budgetary
deficits arise governments are forced to finance those
deficits by borrowing from the open market. And ''the
markets'' consisting of potential investors in government
bonds are neither required to buy into those bonds
nor accept the terms such as interest rates dictated
by governments.
These changed features of the financial environment
were not noticed till such time as the markets ''perceived''
the level of borrowing by individual governments as
being acceptable. In recent years, however, many governments
have seen a huge increase in the volume of their debt
relative to GDP. Not all of this is due to ''profligate
spending''. In fact, in many countries debt has ballooned
because of the expenditures made by these government
to ''bail-out'' a private financial system in crisis
as well as to stimulate economies experiencing recession
in the aftermath of the financial crisis. The resulting
budget deficits had to be financed with new borrowing.
Private investors whose wealth was being protected
from excessive erosion by the government bail-out
of banks and non-bank financial companies and who
were looking for new safe avenues for investment,
bought into the government bonds that were issued
to finance these expenditures. That increased their
exposure to public debt.
No objections were raised against deficit spending
so long as the purpose was to save private finance
and protect the wealth holders. But once such spending
had occurred, resulting in an accumulation of a large
volume of debt, attention was focused on how the repayment
commitments associated with such debt were to be met.
Governments, it was argued, must cut spending through
adoption of austerity measures in order to generate
the surpluses required for the purpose. If the evidence
was that governments were not doing this and increasing
their debt levels further, then the ''markets'' were
either unwilling to give them more credit or were
willing to do so only at exorbitant interest rates.
In countries such as Greece, the interest rate on
public debt rose to levels far above that paid on
German bonds, reflecting the risk perceived in lending
to those governments. When interest rates rise sharply,
the higher interest burden makes the spending cuts
needed to restore ''balance'' even greater. But spending
cuts affect growth and employment adversely, and therefore
the level of government revenues from taxation. This
makes ''adjustment'' even more difficult to ensure.
Thus, the actual outcome is a spiral of ever-increasing
austerity, which becomes politically difficult to
impose.
A good example of how this plays out is Greece. Given
the level of its revenues, Greece needs access to
credit to finance even unavoidable expenditures like
its salary and pension bills. But lenders are unwilling
to provide the needed credit unless the government
adopts new austerity measures that would adversely
affect a population already burdened with spending
cuts and income losses. Austerity becomes a requirement
for a third reason, other than the refusal to tax
and the inability to mint currency. This is the unwillingness
of big finance, which had merrily lent to governments,
to adequately share the ''adjustment costs'' in a crisis
substantially caused by them.
During the negotiations on burden sharing to resolve
the crisis in Greece, one stumbling block has been
the fixing of the haircut or loss banks must be required
to accept on the loans they made to Greece. According
to the official view the haircut agreed upon has risen
from nil, to 20 per cent to as much as 50 per cent
of loan value. But doubts have been expressed about
the veracity of the 50 per cent figure. According
to reports the offer made by the Institute of International
Finance, which represents the banking industry, involves
the issue of new bonds for which the current debt
would be swapped. Those bonds are to be lucrative,
carrying a high 8 per cent interest rate and conditions
regarding additional annual payments if and when the
Greek economy recovers. But the current value of the
future stream of incomes has been calculated using
a high ''discount rate'' of 12 per cent, making the
discounted value of the bonds about 50 per cent lower
than the debt being substituted.
If through these means finance manages to reduce its
burden substantially, the consequences would be extremely
damaging for those not culpable for the crisis in
the first place. According to the Financial Times,
the austerity package agree upon in Greece involves
spending cuts and tax increases that would reduce
the average post-tax income of Greek citizens by €5,600
from its current level of €41,400 or by 14 per cent-which
is almost double the cut imposed on citizens in Ireland
and Portugal after their crisis.
All this occurs because lenders have lost their confidence
in the ability of the Greek government to repay debt
under a business as usual scenario. It must be noted
that many countries were accumulating large volumes
of debt without any such loss of the confidence. The
degree to which public debt grew varied significantly
across countries in the Eurozone: Finland sports a
gross debt to GDP ratio of just above 50 per cent,
Germany and France of 83 and 87 per cent respectively,
Portugal and Ireland of 106 and 109 per cent and Italy
and Greece of 121 and 166 per cent respectively.
Countries with the highest debt-to-GDP ratios are
the ones saddled with austerity or experiencing a
loss of confidence among creditors. But it is not
always the level of debt that triggers the loss of
creditor-confidence. Spain, with a relatively low
67 per cent is facing more difficulties than many
others. Besides the sheer level of debt, another factor
that could possible be influencing the level of confidence
is the rate at which the public debt to GDP ratio
rises. More recently, ''confidence'' has been influenced
by the rating of pubic debt of individual countries
by leading credit rating agencies, the timing of whose
decisions is difficult to explain.
Once a decline in confidence is triggered, the process
described above begins necessitating governments to
adopt round after round of austerity, until it is
not politically sustainable. Consider Greece for example.
Realising that the severe austerity demanded by lenders
would be difficult to implement without popular support,
Socialist Prime Minister George Papandreou announced
a referendum to win social sanction to proceed. Since
the voters would not have sanctioned such austerity
the country would possibly have had to step out of
the Eurozone with unforeseen consequences. What followed
the announcement, therefore, was a furore that forced
a retraction of the referendum, the resignation of
the prime minister and the constitution of a national
''unity'' government involving all major parties (headed
by the ''technocrat'' Lucas Papademos), which promised
to implement the austerity measures. As of now it
is unclear how the government can implement the promised
measures and meet the fiscal targets it has been set.
On the other hand, with the difficulties faced by
the Greek government in meeting its payments commitments
becoming clear, attention has shifted to other countries
with similar problems. These countries are far more
important in the Eurozone. Italy, with a gross debt
to GDP ratio of 121 per cent (as compared with Greece's
166 per cent) has been the focus of attention. Though
the government chose to voluntarily adopt austerity
measures, lenders were not convinced that the measures
were adequate. Creditors are now less inclined to
provide additional credit to the Italian government
or are only willing to lend at very high interest
rates that the government could not bear. This is
disastrous for a country that is estimated to require
at least €650 billion in credit over the next three
years. Italy is now on a slippery slope to possible
default. That would be disastrous for the Eurozone,
since Italy accounts for close to 17 per cent of its
GDP.
What is needed is for the European central back to
print money to buy up government debt, for the Italian
government to tax its rich and for banks to be forced
to take a large and real haircut. But there is disagreement
on each of the possibilities. All that has happened
is a change of government in Italy as well. Since
Silvio Berlusconi was seen as incapable of delivering
the necessary austerity, he had to make way for a
government of technocrats. In sum, the crisis has
resulted in a series of changes in government in countries
with high debt levels, so as to facilitate the turn
to austerity. But that as noted is no solution to
the crisis in the Eurozone.
