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Forgive Us Our Debts

Europe runs out of money.

Nov 7, 2011, Vol. 17, No. 08 • By CHRISTOPHER CALDWELL
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London

Cartoon of a euro bill going down the drain

Gary Locke

As they do every few weeks, the leaders of the European Union met in Brussels on Wednesday, October 26, to solve their finance problems once and for all. As the sun rose on Thursday they emerged with a document that resembled an Obama budget—crystal-clear about its aims and aspirations, opaque about how it intends to achieve them. There is a reason for that. It is that these aims and aspirations are growing less and less realistic.

Back in 2010, when the crisis seemed confined to the Greek government’s inability to repay its lenders, the Europeans thought they could fix things by having its various neighbor countries chip in 45 billion euros ($65 billion) to throw at the problem. Eighteen months later, the crisis is as complicated as a Rube Goldberg machine and more dangerous. The particular corner of it they dealt with last week has three intertwined aspects, and to solve one of them is to exacerbate the other two:

(1) Greece is so totally bust that it required not only a fresh bailout totaling $185 billion but also a 50 percent “haircut” imposed on its creditors. In other words, if you lent the Greeks money by buying their government’s bonds, you lost half of it. (But don’t feel too bad—a lot of Greeks got to retire at 60 with pensions you paid for.) That “solves” the Greek solvency problem for a time, but it is a dangerous remedy.

(2) It is dangerous because it means that loss of confidence in Europe’s institutions moves from the periphery (Greece and Portugal, say) towards the core (France and Italy, say). If Greece can stiff its creditors and stay in the euro, might that not be a tempting option for other countries? Consider Italy, the third-largest economy in the eurozone, with a debt-to-GDP ratio over 100 percent. “Contagion” is the word for the presence of nervous thoughts like these in bondholders’ heads, and the only way to protect against its spread is to build a “wall of money” around the least reliable-looking debtors. Unfortunately, Europe is out of money. The only “wall of money” it can erect is a virtual wall of borrowed money.

(3) And that adds to a danger that is already present in the Greek bailouts. European banks hold a lot more sovereign debt (government bonds) than U.S. banks do. If some of that is going to get paid back at 50 centimes on the euro, then these banks are neither as wealthy nor as stable as they appear to be. That means banks are going to have to revise their business models. What European authorities insisted on this week was that they raise their capital ratios to 9 percent. There are two ways banks can do this. They can either hold more money or lend less. Europe’s leaders pretend they’re going to hold more. But since Europeans have already tapped every domestic source of capital, there is no place to get more. That means banks are going to lend less. Which in turn means the risk of recession has just risen significantly.

A lot about this deal makes it likely that Europe’s leaders will be back at the negotiating table before their seats have cooled.

For one, the debt of Greeks and others seems to be, as the Germans grumble, a “barrel without a bottom.” A European economist told me in the summer of 2010 that a Greek default was inevitable, and that the European bailout was designed to keep the country afloat until it could get back into “primary balance”—i.e., paying its bills except for its interest payments—in 2013. But this new bailout, haircuts and all, does not envision Greece reaching primary balance for a decade, and then only with the help of the most grinding austerity program enacted in our lifetime. At that point, in the 2020s, the country will be back to a situation where its debts are “only” 120 percent of GDP. Is that politically sustainable in a riot-prone democracy like Greece’s? One suspects not.

Another problem is that the deal is not having the desired effect in Italy, the primary candidate for contagion. Bond yields in most European countries fell in the immediate aftermath of the agreement, but not in Italy. Italy has the third-largest bond market in the world—almost $3 trillion—and over the summer the European Central Bank bought tens of billions’ worth of Italian bonds to keep Italy’s borrowing costs down.

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