SERIOUS MONEY: TURBULENCE RIPPED through the world’s financial markets last week on a scale reminiscent of the chaos that accompanied the collapse of Lehman Brothers in autumn 2008.
It all began some months ago with localised fiscal difficulties in Greece, a relatively small part of the euro zone. But dithering, and a half-hearted response from EU officialdom, ensured the Greek problems morphed into something far more insidious – something that threatened to bring the global financial system to its knees once again.
EU institutions got the message and, on the 60th anniversary of the Schuman Declaration – the proposal by the former French foreign minister to create a supranational organisation of states in wartorn Europe – the EU unveiled a response that should prove sufficient to break the negative feedback loops that threatened to derail the global economy.
The “shock-and-awe” response includes a financial stabilisation package of up to €750 billion in EU and International Monetary Fund (IMF) funds that would be made available to recipient countries under IMF conditionality.
The sheer size of the package was far greater than anticipated, at an amount equivalent to 8 per cent of the euro zone’s gross domestic product (GDP) or the entire issuance of euro-zone bonds for the rest of the year. Additionally, IMF conditionality negates concerns that regional lending would be made at more generous rates than those offered by the IMF.
The announcement also revealed that both Spain and Portugal had agreed to “take significant additional consolidation measures in 2010 and 2011”, and to accelerate their paths towards fiscal rebalancing.
Meanwhile, the European Central Bank (ECB) announced that it would provide unlimited liquidity to European banks at its fixed 1 per cent official rate. It also said it would reactivate, in co-ordination with other central banks, the temporary liquidity swap lines with the US Federal Reserve to ensure sufficient dollar liquidity. Most symbolically, it committed to “conduct interventions in the euro area public and private debt securities markets to ensure depth and liquidity in those market segments which are dysfunctional”.
Bond purchases are to be sterilised to offset any impact on the monetary policy stance, and so do not constitute quantitative easing.
The measures are to be welcomed since they effectively insulate the European banking system and remove the threat of contagion spreading from Greece to other fiscally troubled euro-zone countries – notably Portugal, Spain and Ireland. However, investors need to recognise that these measures are short term and do not remove longer-term solvency risks.
This is not simply a euro-zone issue. It affects most of the world’s major developed economies including Japan, Britain and the US. Indeed, in an unprecedented peacetime development, total developed country public-sector debt, excluding off-balance sheet and contingent liabilities, should exceed 100 per cent of GDP next year.
A number of European countries have already exceeded the 100 per cent level or are likely to do so in the near future. Britain and the US are likely to approach this percentage soon after, while Japan’s public debt ratio is already north of 200 per cent and rising fast.
The predominant public policy concern behind the explosion in fiscal deficits and government debt ratios has been to act as a countervailing force to private-sector deleveraging and to prevent a repeat of the Great Depression. The unprecedented support operations have not only been successful in returning the global economy to a growth path, but have also been financed at historically low interest rates.
Deficit financing is unlikely to prove as painless once near-zero interest-rate policies are removed and bond market vigilantes focus their attention on the dangerous and ultimately unsustainable debt trajectories.
Significant fiscal adjustments are necessary simply to stabilise government debt ratios. The primary fiscal balances that would need to be generated to return debt ratios to pre-crisis levels are not achievable. If the so-called PIGS of Portugal, Ireland, Greece and Spain were required to reduce their public debt-to-GDP ratios back to 60 per cent by 2020, the improvement in the structural primary balance necessary using realistic assumptions would amount to 7, 12, 9 and 11 per cent of GDP respectively.
The US does not fare much better than Greece, while Japan and Britain face the biggest challenge of all with corrections worth 13 per cent of GDP required in both cases.
Current debt trajectories are unsustainable and are occurring at an inopportune moment given the coming rise in age-related spending. Adam Smith observed in 1776 that “when national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid”.
The structural bull market in government bonds that began in 1982 is over, and AAA-rated sovereigns will soon be a thing of the past.