Time to cut off Europe's club med
There's no solution on the table at Europe's summit that won't exacerbate the problems. Officials should stop the charade now and organise and orderly exit of 'club med' states, before their pain worsens.
Public debt now exceeds 150 per cent and 120 per cent of GDP in Greece and Italy respectively. Those ratios continue to rise, because austerity is causing their economies and tax bases to shrink. Longer term, accompanying economic reforms may instigate some growth, but not enough to permit Athens and Rome to pay interest and start retiring principal – simply, Greece and Italy are insolvent.
Spain’s debt is only about 75 per cent of GDP. However, its banks are heavily burdened by souring real estate loans totalling about €665 billion – more than 60 per cent of Spanish GDP. Banks don’t have the capital to cover those losses; however, with their survival essential to national economic recovery, bad real estate loans are an implicit liability of the Spanish government. Altogether, Madrid’s implicit sovereign debt is much closer to 100 per cent of GDP and rising rapidly.
Spain, like Italy, must pay more than 6 per cent on new 10-year government bonds – Greece, currently receiving EU bailout financing, is not in the private credit market, but when it returns, it will pay at least what Italy pays. Portugal, whose situation mirrors the others, is paying about 9.5 per cent.
Even in the unlikely event austerity and economic reforms instigate some modest growth in 2013, it would be inadequate
To keep the debt-to-GDP ratio from rising, nominal growth (real growth plus inflation) must exceed the interest rate paid on debt plus current government deficits as a percentage of GDP. Across the Mediterranean states, the latter sum is likely to be at least 9 per cent for the foreseeable future, and real growth plus inflation are simply not going to be that high.
Only the likelihood that Germany and other northern states will bail out the Club Med states keeps the interest rate on Italian and Spanish bonds from zooming past 10 per cent and instigating sovereign default.
For Mediterranean states public finances to be manageable, sovereign debt would have to be cut in half through restructuring, and private bondholders, and European banks, would take large losses.
Whether assisted by direct loans from EU bailout funds, or through new 'eurobonds' backed by the taxing authority of Germany and northern states, aid large enough is not possible, because it would make the sovereign debt of Germany as unworkable as the Mediterranean states.
For Spain, the proposed EU banking union could provide an alternative to direct debt relief. EU-wide deposit insurance, empowering the ECB to regulate banks and guarantee their solvency, and generous purchases of real estate loans by the ECB could recapitalise Spanish banks. However, purchases large enough to be effective would match in size what the Federal Reserve did for US financial institutions during the US mortgage crisis and leave the ECB with limited ammunition to assist banks elsewhere.
Eurobonds and banking unions will require treaty revisions to implement. However, even if Germany and the ECB claimed emergency powers – with the consent of other EU heads of governments and moved ahead quickly – the additional assistance Greece, Italy and Spain received won’t be enough to resolve their problems.
With each partial solution and halfway measure, Mediterranean governments fall deeper in debt. Private investors will eventually lose confidence and abandon Italy, Spain and others altogether, and their economies will collapse and hastily exit the euro.
In such a crisis, vexing issues such as the conversion of sovereign and private debt into domestic currencies and capital controls to avert capital flight and bank runs, simply won’t be addressed. Losses borne by private investors and the pain imposed on ordinary citizens will be much larger than imposed by an orderly restructuring now.
Germany and the others should recognise reality, and facilitate substantial debt writedowns and a sane and orderly withdrawal of the Mediterranean states from the eurozone.
Peter Morici is an economist and professor at the Smith School of Business, University of Maryland, and widely published columnist.
Follow Peter Morici on Twitter @pmorici1