EUROPEAN UNION: by Colin TeeseNews Weekly
Still no end in sight for Europe's debt crisis
, August 20, 2011
Nobody can say how and when the European Union’s debt crisis will end.
Some commentators, however, are prepared to say more than others, for example, Robert Skidelsky, a member of Britain’s House of Lords and formerly professor of political economy at Warwick University. Professor Skidelsky is perhaps best known for having written the definitive (three-volume) biography of the 20th-century economist John Maynard Keynes.
On the basis of that work Skidelsky is rightly regarded as one of the greatest living authorities on Keynesian economics.
Of course, this does not automatically establish him as an expert on Europe’s debt problems — there probably is no such person. However, in the absence of any obviously identifiable authority, his views are at least worth careful examination, all the more so when, to the casual reader, they seem to make more sense than the opinions of many self-styled “experts”.
With refreshing and sweeping frankness Professor Skidelsky proclaims, “Everyone knows that Greece will default on its external debt. The only question concerns the best way to arrange it so that no one really understands that Greece is actually defaulting.” Cynical perhaps, but he’s probably right.
Two basic concerns seem to be worrying European lending institutions with critical debt exposure in vulnerable EU member-states, most notably the so-called PIIGS countries (Portugal, Ireland, Italy, Greece and Spain).
Above all, the total sum of money involved is indecently large. Depending on who is counting, it adds up to a figure in the high hundreds of billions. The second question relates to how lenders might get their money back.
And it is this second consideration, which gives such point to Skidelsky’s remarks.
Professor Skidelsky understands that so far as debt is concerned (whether it is government or private), the obligation to pay will be covered by contractual paper of some kind — usually called a bond. Quite simply, this means that the borrower commits to paying regular interest on the debt at an agreed rate. The principal is required to be repaid at some specified time: say, five, 10 or even 20 years. These longer terms (10 or 20 years) are usually associated with government rather than private borrowing.
In the case of Greece at least, the general feeling is that the Athens government is incapable of repaying its borrowings — either principal or interest. Once financial markets come to this view, the market value of the bonds, which are regularly traded in the bond markets, immediately falls below the bond’s face value. If the bonds are saleable at all, it will be at a much lower value. In the case of Greece the decrease in value will be substantial — in line with market assessments about the borrower’s capacity to repay.
Therein lies the difficulty in dealing with the problem.
When we hear talk of various possible solutions in terms of bond buy-backs or swaps or other fancy names, what is under consideration is a way of devaluing the debt in order to make it more palatable to the market. Lord Skidelsky’s point is that any process making the debt more market-friendly means decreasing its value to the disadvantage of the original lender.
There is a further difficulty. New paper will come with a higher interest rate (the greater the defined risk of default the higher the rate). The problem with all of these solutions is that, in the case of Greece, we know it can’t pay at the original interest rate, so how can it be expected to repay at the higher rate?
Some answered this point by insisting that Greece embark on an austerity program. To some extent it already has. Government jobs and spending have been cut. Promises (of dubious credibility) have been made to collect more tax and thus generate a budget surplus, and to keep this policy in place until the loans are repaid.
But nobody expects this strategy to work, for a number of different and obvious reasons. The most obvious is that cuts in spending and jobs mean slowing the growth in the economy, and that means a fall in tax revenue, with no change in the position of the better-off Greeks who evade tax obligations.
The next idea was so-called bond swaps; but any swap arrangement immediately increases the debt obligation and make the possibility of Greece paying its debts even less likely.
Another idea was to keep the interest and capital repayment of the debt constant, but significantly extend the repayment period (perhaps, say, to 30 or 40 years).
The question then arises: what about the interest? Effectively, this plan means Greece would go on paying, say, its 6 per cent interest on the debt whereas, given the status of the debt, the market might be demanding something of the order of 30 per cent.
Who would pay the new owners of the debt the additional 24 per cent interest? Certainly not the original lenders. The only alternative would be some form of government support or bailout.
But how? The European Union is precluded from bailing out member-states, as is the European Central Bank. Neither is the generality of member-states. Which leaves only the governments of individual member-states, whose financial institutions generated the original loans to Greece. So far as we know, these are mainly Germany, France and the Netherlands.
Taxpayers in those countries understandably reject the idea that they pay for what they regard as the imprudent borrowing of Greece — and, to that extent, the idea is difficult to sell politically, as German Chancellor Angela Merkel is finding out. The same is no doubt true for other exposed countries.
But unless there is a bailout, Greece will default. Why is that so difficult to contemplate? Well, the feeling is, if Greece defaults, then the other vulnerable economies will almost certainly follow.
The major European banks with exposure to this debt, helped by their governments, perhaps can manage Greece. But should the other precarious PIIGS economies follow suit, that would be far more serious. Such would be the financial burden on the EU financial system that Europe would almost certainly suffer a severe economic slump.
Once that is understood, the apparently cynical comments of Skidelsky begin to make sense. If Greece is the only domino to fall, that’s manageable. The trick is, how to allow Greece to fail and yet keep the others afloat.
The only hope is that the other weak economies are in better shape than Greece. For Ireland and Portugal, that seems unlikely. Perhaps, though, prospects are better for Spain and Italy.
In any case, a way out of this dilemma is far from clear.
Meanwhile, what can we say about the possible consequences? First, it seems unlikely that European monetary union and the euro currency can survive — at least in its present form. How it can or should change is not easy to say.
What can be said is that further expansion of the EU is probably impossible, and some of the integration that has gone on in the last 20 years will be have to be undone.
Quite possibly, the EU may slip back into something not much more than a customs union, with which it began its existence 55 years ago as the European Economic Community (EEC).
Professor Skidelsky’s recent writings seek to remind us that, although historically it was a matter of honour for governments not to borrow more than they collected in taxes, and likewise for businesses and individuals to live within their means, today that is no longer the case.
Skidelsky writes: “These historically embedded norms and practices were only slowly superseded. But, in the 20th century, with greater security of conditions and continuous economic growth, it became normal for individuals, companies and governments to borrow in anticipation of earnings — to spend money they did not have, but that they expected to have.”
What he did not add was that, while all this was happening, even the most imprudent lenders proceeded as if they had a moral right to have their loans repaid. They don’t.
Lending money on the basis of an interest charge and repayment of the principal over time is, or should be, done on the basis of a risk-analysis assessment of the borrower. If it turns out that the loan cannot be repaid, then that is part of the risk of lending money for profit. Lending should be a business with the possibility of loss sitting alongside the possibility of gain, according to how well the game is played.
Of course we all know, as does Skidelsky, that imprudent lending by financial institutions has been a characteristic of Western institutions in recent decades, and it has been tolerated if not encouraged by governments.
It has led to disasters in both Britain and the United States where tax money has had to be used to bail out financial institutions whose collapse threatened to wreck economies. The cost thus far of those financial follies to the British and U.S. economies, and indeed to the wider world, is still being worked through.
It may be that, because of them, the world cannot escape another economic slump.
If, indeed, Europe’s financial institutions are in the process of falling victim to the same follies, then the question to be answered is this: how much additional stress will this place on a world economy still not yet recovered from the after-effects of the global financial crisis which pushed it into deep recession only three years ago?
What can be said for certain is that no country, least of all Australia, can expect to avoid the consequences of what seems likely to happen in Europe.
Colin Teese if a former deputy secretary of the Department of Trade.