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As the eurozone dominos line up and Chancellor Angela Merkel of Germany seeks to "maintain the primacy of politics over markets," leaders and policymakers in the region are confronting an increasingly urgent question: how to deal with the speculative forces creating turmoil in European financial markets.
As the contagion shifts from Ireland to Portugal and Spain, the market attacks are looking increasingly speculative. Europe's financial woes started with Greece, where economic fundamentals remain problematic even after the May 2010 International Monetary Fund/Europe Union (IMF/EU) rescue program. As a result, markets remain doubtful about the country's future solvency and the credit-worthiness of its debt. A restructuring of that debt still looks like the most likely outcome. So far, so good.
Ireland, by contrast, got most of its structural economic policies right. The sole issue is one of the ultimate size of the hole in the banking system and the Irish sovereign government's capacity and political willingness to cover for the recklessness of that sector. The latest problems were precipitated by the refusal of the European Central Bank (ECB) to continue to fund the Irish banking system amid this continued uncertainty and a lack of political will in Dublin to address the solvency issue of the Irish banking system.
We will have to wait for the report from the IMF/ECB/EU inspection team to see just how big the expected banking losses ultimately are, and then whether they can credibly be covered by the Irish government. It seems certain that all shareholders in all Irish banks will be wiped out. Even the healthiest of the big banks, Bank of Ireland, trades at just a few cents on the euro now. Judging from the voluntary exchange offer of subordinate debt in the Anglo-Irish Bank recently, in which creditors overwhelmingly accepted 20 cents on the euro (i.e. a roughly 80 percent haircut), markets are also already pricing in a rout of this creditor segment.
The core issue is whether the losses are so big that the associated refinancing burdens placed on the Irish government, combined with broader budgetary effects of the recession, would saddle Ireland with an unsustainable debt stock at the end of the crisis. The new 4-year budget from the Irish government unsurprisingly suggests not. That budget foresees debt peaking at "just" 102 percent of GDP in 2013 . There remains concern, however, over the issue of whether mortgage losses in Ireland will grow to the scale experienced by the United States as a whole, or even Las Vegas. If that happens, the recapitalization costs of the banks could force the Irish government to impose haircuts on senior bank creditors as well. Such a move could destabilize the entire eurozone banking system.
It is unfortunate that Ireland and in particular the Republican Party (Fianna Fail) government, which oversaw the country's 20-year boom, failed to deal forcefully with its banking sector and now must turn to the nation's partners in the ECB and European Union and undergo the harsh regime dictated by the latest example of "coercive eurozone policy coordination."
Portugal, on the other hand, faces circumstances different from Greece and Ireland. Portugal failed to grow following the introduction of the euro, a trend that was clear even before the latest economic crisis. Accordingly, concerns over its longer-term potential, combined with the Portuguese government's complacency, raise questions about its ability to sustain its current debt stock. These questions come even though this stock (76.1 percent of GDP in 2009) is quite a lot lower than that of Greece or Italy1 and even slightly lower than the eurozone average (79.2 percent of GDP in 2009). So far in Portugal, the policy response has been underwhelming, though not irreversibly so. Lisbon could still turn things around, but it would require a new level of policy commitment.
For all these dangers, the potential fall of this next domino does not constitute a particularly large problem for the broader eurozone. Existing policy tools in the form of the European Financial Stability Facility (EFSF) and the European Financial Stabilization Mechanism (EFSM) have sufficient capital to assist on short notice.
Because different causes are at work in Greece, Ireland, and potentially even Portugal, the eurozone and the IMF have been able to deal with these issues.
That leads us to the next alleged domino—Spain. Here the case that economic fundamentals are behind the turmoil is missing. Instead, market concerns seem overwhelmingly speculative.
Certainly, Spain faces serious economic growth and labor market challenges as it works its way through a devastating real estate collapse. But it has neither the debt stock of Greece, the bust banks of Ireland, or the complacent government of Portugal.
General government debt was 53 percent of GDP in 2009. This debt, moreover, has a high degree of domestic financing. More importantly, the contingent liabilities associated with the Spanish government's support for its banking system (large banks and the savings banks known as cajas) is less than 5 percent of GDP (in Ireland it was 176 percent of GDP). If you factor in the reliance of the large Spanish banks BBVA and Santander on large emerging market operations, which could be sold off in an emergency, it is hard to see how Spain is in serious trouble on a consolidated "sovereign + private banks" basis.
Certainly, Spain has seen a dramatic real estate collapse that has weakened the broader economy and the banking sector. But because of Spain's tough "recourse" mortgage debt laws, which give a lender the right to seek repayment of a mortgage loan from the borrower's (and/or guarantor's) personal assets, it is not clear that the immediate cost of the residential real estate collapse will be as high as it was in the United States. In addition, debt-burdened Spaniards seem less likely than the Irish to migrate out of their native country, weakening its economic base still further. Many people point to the high Spanish unemployment rate of about 20 percent and infer that the country might be on the verge of a "social revolution." But as sad as Spain's difficulties are, joblessness is now back at levels seen in the mid-1990s, before declines in real Spanish interest rates led to the real estate boom associated with the country's entry into the euro. History suggests that even a 20 percent unemployment rate is not associated with large scale social unrest.
There is also another side to the Spanish story on jobs, if one focuses on employment rates rather than unemployment. Here Spain has suffered a dramatic drop in employment from 66 to 58 percent in the 16-to-64 year age group. The 58 percent employment, however, is still the rate experienced as recently as 2003. It is also more than 15 percent higher than in the mid-1990s. Not all the labor market gains of the boom have been lost in the subsequent bust.
Then there is the issue of private sector debt held by foreign institutions—just over 100 percent of GDP in 2010. This level is much higher than it is for the Spanish government, but the real issue is not so much the scale but the type of liabilities and maturities in foreign private sector hands. Fortunately for Spain, two-thirds of the private sector foreign debt is in long-term bonds, notes, or loans. The actual immediate short-term private sector funding risk in Spain is consequently limited.
Most important, though, the Spanish government has embarked on a constructive policy trajectory since the Greek crisis peaked in May. It forced publication of the EU banking stress tests over the summer and for its own part went considerably beyond what other EU members did in terms of the stress test assumptions and transparency. The socialist government cut spending and public wages, committing political hara-kiri in the process. It has also finally begun liberalizing the Spanish labor market.
Moreover, for 2011, the government has announced further austerity measures, more labor market liberalization of collective bargaining, and a pension reform raising the retirement age from 65 to 67. In sum—Prime Minister José Luis Rodríguez Zapatero "gets it," and Spain is taking its medicine preemptively.
What we are seeing, therefore, is a largely speculative attack by the markets on the inability of current EU policy tools (EFSF/EFSM) to address Spain in the same way as Greece, Ireland, and Portugal. This does not mean that the European Union lacks the will or capacity to assist Spain. The European Union functions best in crisis, and the political will to preserve the eurozone should not be underestimated.
Or to put in another way, one of the implications of Angela Merkel's fight to "preserve the primacy of politics over markets" is that EU politicians can throw out the rulebook again to fight off markets' speculative attacks on Spain. In extremis, the ECB—with German political acceptance—could simply print money before seeing Spain forced into a disorderly default scenario by irrational market contagion and associated excessive interest rates.
Despite the temporary market volatility, as long as the underlying health of the European economies are being aggressively addressed through the austerity and reform measures politically enabled by the economic crisis, speculative attacks cannot break the eurozone apart.
Notes
1. Simplified, the standard debt sustainability condition ratio, which must be kept stable, has in the numerator the current debt stock, plus the expected future creation of debt (new flow), and in the denominator the expected cost of the debt (interest rates paid) over the growth rate of the economy. Portuguese concerns center around the growth rate of the economy.
