I should have known what would happen when you post a question at the end of a column. Last week I asked how it could be, that somebody who was pessimistic about the eurozone six months ago could be optimistic today? If you always thought it was just a liquidity crisis, you should not have been worried then, and you would be right to be optimistic now. If you thought of it as a solvency crisis, as I did, you should still be worried now.
Several readers pointed out to me, quite rightly, that I offered only an extreme choice. What about a solvency crisis that is not inherent but caused by a liquidity squeeze – a self-perpetuating insolvency crisis? Solvency is, after all, an analytic concept. It depends on the level of debt, future growth, ability to tap private sector wealth through taxation, ability to raise funds through privatisation and, of course, future market interest rates. Reasonable people could disagree on all of these. Even Germany could be considered insolvent if you assumed a sufficiently high interest rate.
Distinguishing pure sovereign risk (minus the contingent liabilities for the financial and non-financial private sectors) from risks that have arisen purely in those sectors, my judgment on the solvency of various entities in the eurozone has been the following. In the first category, I consider Greece to be unconditionally insolvent; Italy and Portugal to be solvent – but conditional upon a return to sustained growth. I consider the sovereigns of Spain, Ireland and the rest to be fundamentally solvent – minus the banks, of course. In the second category, I consider the private and financial sectors in Spain, Portugal and Ireland to be insolvent.
Once you conflate sovereign and financial sector risk, the situation becomes more complicated. My bottom line is that the national backstops have not removed, and have possibly increased, the total solvency risk in the system.
Even worse, I believe the outlook for solvency has deteriorated over the past six months due to the effects of austerity on growth at a time when interest rates have hit their lower limit. The economists Dawn Holland and Jonathan Portes have pointed out one other reason why the fiscal multiplier is unusually high at the moment: everyone is pursuing austerity at the same time. We may well have crossed the line where austerity not only raised debt ratios in the short run, which is to be expected, but may end up increasing them even in the long run – so that it becomes self-defeating.
So if you started from where I did, you cannot be optimistic. But then again, as an Irish saying goes, you might not start from here.
John McHale, economics professor at the National University of Ireland, Galway, has argued that official policy can restore financial health in a self-perpetuating solvency crisis, provided a number of conditions are met. He lists four. First, the liquidity support given through the European Central Bank’s Outright Monetary Transactions programme and other mechanisms must be reliable. Second, the conditions must be reasonable. Third, the conditionality must be flexible - unanticipated shocks should not trigger fiscal adjustments in future. Fourth, the link between banking sector losses and state debt must be broken.
I concede that these conditions, especially the fourth, could restore solvency everywhere except in Greece. The problem is that they stand in contrast to official policy. The ECB has only announced the OMT programme. So far, nobody has made an application. The Spanish prime minister is still playing hard to get and I doubt he will make an application this year. The OMT may end up as a phantom. As in Hans Christian Andersen’s fairy tale – I am writing this column from Denmark – it may not be very long until some child in the bond markets points out that Mario Draghi has no clothes.
Second, it has been, and continues to be, official policy that countries must heap one austerity program on top of another if they miss nominal deficit targets – which they do because they keep underestimating the fiscal multiplier. Finally, even though I assume that eurozone leaders want to set up a meaningful banking union, I see no chance that this will lead to a separation of banking and sovereign risks. Angela Merkel stated clearly that this was not going to happen.
The main significance of the OMT, should it ever become a reality, would be to prevent a contagious spiral between bank debt and sovereign debt for approximately two to three years. This would be important in its own right, but does not in itself improve the underlying solvency of the various entities, given current policy choices.
You have to make some brave assumptions about the future – continued rollover, separation of banking and sovereign risks, readiness for fiscal transfers, readiness to abandon austerity - all of which stand in complete contrast to officially announced policies. Solvency thus depends on the assumption that official policy is a lie. One could make that assumption, of course. I have not, and would not.
Copyright the Financial Times 2012.