In 1992, the thirteen nations of the European Communities met in Maastricht, Netherlands to sign the Maastricht Treaty. By doing so, these nations, which included Italy, France, West Germany, the United Kingdom, and Greece, bound themselves in an association known as the European Union, now comprised of 17 nations. In the process they created a unified currency—the euro—which forever linked the fortunes of these economies, whether good or bad, in an essentially unbreakable chain.
Douglas J. Elliot, a Senior Fellow at the Brookings Institute, wrote on CNN Money that “the road into the Eurozone ran only one way.” What he meant was that the Eurozone countries made it almost impossible to dump the euro without leaving the European Union; there is no mechanism in place for such an act. The fear was that if a country like Greece were to dump the euro as its currency, they would set a weaker exchange rate leading to a run on their banks and a domino effect rushing through the Eurozone.
At this moment, however, the very foundations of the European Union are buckling under the weight of debt and instability. The governments of Greece and Italy have both been ousted after promising substantial austerity packages. The euro itself is in danger of folding and the nations of the Eurozone watch as each domino continues to fall. How bad is it? Simon Wolfson, the CEO of European retailer NEXT is offering a $400,000 prize for a plan to break up the euro peacefully.
The root cause of this crisis is essentially government debt, a prescient warning for American technocrats. The Maastricht Treaty mandated that annual government deficits not exceed 3% of GDP while government debt not exceed 60% of GDP. Most European nations, however—particularly Greece and Italy—used complex currency and credit derivatives to mask the realities of their debt situation.
Currently all the major Eurozone nations have debt to GDP ratios over 60%: the United Kingdom (77.8%), Germany (75.7%), France (83%), Italy (118.9%), and Greece (140.2%). These staggering ratios—particularly those of Italy and Greece—have strained the relationships between banks and clients, investors and business, government and business, and government and citizens. As a quick aside (and a story for another day), the American debt to GDP ratio is 99.6% for the year and ironically crossed the 100% plateau on Halloween according to projections by the International Monetary Fund.
German Chancellor Angela Merkel and French President Nicolas Sarkozy have led the efforts by the more structurally sound European nations to maintain stability and find a long-term solution. But experts worry that they are playing a losing hand. The fiscal monstrosity that is the Greek and Italian bond market, combined with their astounding levels of government debt, has led some to fear the “doomsday scenario.”
On Tuesday, the yield on 10-year Italian government bonds reached 7.039%, a rate at which economists believe the refinancing of Italy’s debt becomes unsustainable. Were Italy and Greece unable to refinance their debt and default, economists and heads of state alike worry that the domino effect will spread through Europe and beyond—quickly. Spain and Portugal would fall, followed by Ireland, and eventually the cancer would reach France.
While France may not be a dominant geo-political power, they do dominate the banking sector of the Eurozone. Germany, the most reliable of the bunch, houses almost all of its capital in French banks. France also holds approximately $1 trillion in American money. Meanwhile, the French banks have overleveraged themselves in the unpredictable Eurozone market resulting in France’s rocky fiscal infrastructure and dim economic outlook. As rating agency Standard & Poor’s stated in downgrading the French banking sector, “we see weaker economic prospects for Europe, including the peripheral countries to which some French banks are significantly exposed.”
Eurozone leaders have taken action. At a summit in October, they decided to write down—essentially reduce in value—the Greek debt held by the private sector by 50%. Meanwhile, Lucas Papademos has replaced George Papandreo as interim Prime Minister of Greece and promised a strong effort to pass a significant austerity package.
Last week in Italy, the Parliament voted to approve an austerity package—which includes cutting 300,000 public sector jobs, increasing the retirement age for government benefits, simplifying the tax code, creating incentives for venture capital investment, and reintroducing the property tax—paving the way for Silvio Berlusconi to resign as Prime Minister.
But there are flaws to these measures. The write down of Greek debt makes very idyllic assumptions. An article in The Economist after the deal was struck commented that the Eurozone’s main rescue fund, the European Financial Stability Facility, “does not have enough money to withstand a run on Italy and Spain” while other sources of liquidity—Germany and the central bank—have ruled out further bailouts. The Italian austerity package is vague—such as when it outlaws deficit spending “except in the case of exceptional events” and fails to define “exceptional events”—and the country itself currently lacks a government.
As the dominos continue to fall, the worry shifts from the collapse of the European bond market and banking sector to the impact on American markets. The universality of the worldwide financial system means that the economic domino effect does not stop at the water’s edge.
No comments:
Post a Comment