Satyajit Das: The European Debt Crisis Is Not Over
Despite statements by European leaders and policy makers, here's why it's premature to claim victory in the European debt wars.
The real economy, already in recession, is likely to remain weak, with low growth and high and rising unemployment.
Eurozone members remain committed to avoiding the unknown risks of a default and departure of countries from the euro. This means that assistance will be forthcoming, although the exact form and attached conditions remains uncertain.
Peripheral countries will be forced to rely on the ESM and ECB to provide funding. Unless the size of the ESM is increased, the ECB will be forced to provide financing directly and indirectly. Central banks in stronger countries will continue to use the TARGET2 (“Trans-European Automated Real-time Gross Settlement Express Transfer System”), a payment system to settle cross border funds flows within the eurozone, to finance peripheral countries without access to money markets to fund trade deficits and capital flight.
Over time, financing will become concentrated in official Euro-Zone agencies, the ECB and the TARGET2 system. Risk will shift from the peripheral countries to the core of the eurozone, especially Germany and France.
The ESM relies primarily on the support of four countries: Germany (27.1%), France (20.4%), Italy (17.9%) and Spain (11.9%). Market analyst Grant Williams prosaically described the other countries backing the ESM as Greece, irrelevant, doesn’t matter, don’t bother, makes no difference, who cares, somewhere near Poland, pointless, up the top, former something-or-the-other, tax shelter, pretty much a non-country and somewhere with mountains. If Spain or Italy needs assistance, then the contingent commitment of the remaining countries, especially France and Germany, would increase.
Germany provides an indication of the magnitude of the task. German guarantees supporting the EFSF are Euro 211 billion. The ESM will require a capital contribution from Germany. If the ESM lends its full commitment of Euro 500 billion and the recipients default, Germany’s liability could be as high as Euro 280 billion. There is also the indirect exposure via the ECB and the TARGET2 claims.
The size of these exposures (potential losses of Euro 1 trillion or more) is large, both in relation to Germany’s GDP of around Euro 2.5 trillion and German private household assets which are estimated at Euro 4.7 trillion. Germany also has substantial levels of its own debt (around 81% of GDP). The increase in commitments or debt levels will absorb German savings, crippling the economy. Germany demographics, with an aging population, compound its problems.
Over time, the shift of risk will mean de facto debt mutualization and financial transfers by stealth. This is precisely the outcome that Germany and its allies have sought to avoid.
Stealth integration will have substantial costs. For the peripheral nations, financing assistance will be available, albeit in doses which will keep the recipient barely alive and prolong its suffering. It will require adherence to strict austerity policies, which may mire the economies in recession.
Living standards will be reduced by internal devaluation. In the period since the introduction of the euro, German unit-labor costs rose by 7-8%, compared to 30% in Italy, 35% in Spain and 42% in Greece. These rises have to be reversed to increase competitiveness. Employment conditions, pension benefits, and social benefits provided by the state will become less generous. Taxes will rise, reducing after tax income.
In the stronger nations, savers will see the value of their savings fall. They too will suffer losses of social amenities as income and savings are directed to support weaker eurozone members. Europe will find itself locked in a period of subdued economic activity and high unemployment. Unemployment rates, which in some countries approach 30% and 50% for people under 25 years, will feed increasing social and political instability.
While de facto integration is the likely outcome, a smooth transition is not guaranteed. Outflows of actual cash to beleaguered nations, the first claims on the German budget, significant rating downgrades for core eurozone members or a rise in inflation and consumer prices may alter the dynamic quickly. If voters in Germany and other stronger states become aware of the reality of debt pooling and institutionalized structural wealth transfers, then the outcome might be different. Continued deterioration in economic activity requiring further bailouts as well as unsustainable unemployment and social breakdown may still trigger repudiation of debts, defaults, or a breakdown of the euro and the eurozone. Whatever the outcome, ordinary Germans will discover the reality of an old proverb: “If you stay the beast will eat you, if you run the beast will catch you.”
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