Wednesday, September 29, 2010

European Fiscal Crisis

After weathering a crisis of subprime mortgages and collapsing banks, fifteen months on we are facing a different crisis - Government debt default. With a history of default, and little prospect of being able to tackle its debt, Greece has been hammered in the financial markets. It's debt has been downgraded to junk status (meaning default is likely). This has led to record interest rates on Greek bonds. Greece is now having to borrow at a staggering 18% interest rate on two year bond. This cost of repayment is crippling and makes it very difficult to make a dent in the actual debt. (out of interest UK pays approx £35bn on debt interest payments at 4%. If interest rates doubled the cost of debt repayments would be £75bn.)

Why Government Borrowing Has Become Such A Problem?
  • Before the Recession, many countries had a large structural deficit. There was an inability to meet responsible fiscal targets. e.g. political pressure against tax increases and spending cuts. In particular, Greece has been hampered by powerful unions which gained large public sector wage increases without corresponding increases in productivity. Greece has also struggled to raise taxes and check government spending (especially on defence and civil service)
  • The depth of the recession has worsened the government fiscal position much more quickly than expected. Tax receipts have fallen, spending on unemployment benefits have increased.
  • Euro Inflexibility.
    Size of current account deficit show decline in competitiveness and unbalanced nature of Euro.

    Being a member of the Euro, countries face limitations in Monetary policy.
  1. Can't devalue to restore Competitiveness. Greece, Portugal and Spain have very large current account deficits - indicative of their uncompetitiveness.
  2. Can't pursue a moderate inflation target through quantitative easing, independent monetary policy. The problem for the likes of Greece and Spain is that they are trying to impose 'austerity' problems against a backdrop of potential deflation. It is this deflation (or at least very low inflation which makes market more suspicious of European debt levels. It is one thing to have high levels of debt, but, this is compounded by the very weak prospect of economic growth.
In the post war period, many countries had much higher debt, but, strong economic growth and moderate inflation enabled a reduction in the debt burden; bond markets had more confidence in the government's strategy to repay. But, this is much harder to see in the current climate of Euro deflation.
  1. The ECB still pursues a false goal of worrying about inflation.
  2. Greek debt is financed by short term bonds. This means the debt needs refinancing more quickly and it is then harder to inflate the debt away. - short term investors would require a much higher interest rate to compensate for inflation. With long term debt it is somewhat easier to reduce debt burden through inflation.
  3. Greece can't leave Euro, even though everyone now agrees it was a mistake to let them in. (even when they joined their debt was over 100% of GDP)


EU debt as a % of GDP
  • Italy - 116%
  • EU average - 78.2%
  • Portugal - 77%
  • Spain - 54%
  • UK - 68%
  • Greece - 112%
  • Ireland - 65%
Annual Deficit
  • Ireland - 14.3%
  • Greece - 13.6%
  • UK - 11.5%
  • Spain - 11.2%
  • Portugal - 9.4%
  • EU - 6.8%
  • Italy - 5.3%

1 comment:

David said...

Does anyone want to comment on the extent to which so called Investment Banks helped PIIIGS acquire this debt in the first place - underwritten by Credit Default Swaps that only payed out when the reference asset (debt !) goes down in value ie shorted by hedge Funds ?