Monday, July 28, 2014
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The Eurozone’s Narrowing Window

PRINCETON – Portuguese authorities recently made a preemptive offer to their country’s creditors: Instead of redeeming bonds maturing in September 2013, the government would stretch its repayment commitment out to October 2015. The deal was concluded on October 3, and has been interpreted as a successful market test for Portugal. Ireland’s authorities have conducted similar recent operations, exchanging short-maturity paper for longer-term debt.

These transactions highlight the broader strategy of buying time. Both countries are seeking to create a longer, more manageable repayment profile for their privately-held debt as they begin weaning themselves from dependence on official “bailout” funds provided by the “troika” (the European Commission, the European Central Bank, and the International Monetary Fund). Private investors are acknowledging the reality that repayments will likely be drawn out, because insisting on existing terms could cause an untenable bunching of debt-service payments, with possibly unpleasant consequences.

This strategy’s success presupposes that, in the interim, economic growth will strengthen the capacity to repay debt down the line. The debt ratios for both Ireland and Portugal are expected to peak at about 120% of GDP in 2013, after which they are projected to fall. The peak ratio and the subsequent downward trajectory depend crucially on the assumed pace of economic growth.

But growth prospects remain grim. The Portuguese economy is now expected to contract by 1% in 2013. In late June, the IMF projected modest growth, and, at the time of the “bailout” agreement in May 2011, GDP in 2013 was expected to grow by 1.25%.

Such successive downward forecast revisions have become commonplace. The latest estimates for Italy and Spain project a deeper contraction, prolonged into next year. Ireland is doing better, although its growth forecast has also been revised downward, to just under 0.5% in 2012 and 1.4% next year. Moreover, Irish GNP (the income accruing to its nationals, as distinct from foreign firms operating in Ireland) continues to shrink. Each downward revision implies postponement of the date on which the debt/GDP ratio will peak.

Beyond 2013, growth must depend on either the elixir of structural reforms, or a strong revival of the global economy. But a revival of economic growth in the short term is unlikely. Crucially for Europe, world trade has been virtually stagnant in recent months. Global trade and economic performance in the eurozone appear to be dragging each other down.

The potential consequences are serious. While the IMF’s primary scenario is that Irish and Portuguese debt levels will soon stop rising, it comes with a chilling litany of downside risks. The likelihood that budget deficit and debt targets will be missed is rising.

Thus, the eurozone faces three choices: even more austerity for the heavily-indebted countries, socialization of the debt across Europe, or a creative re-profiling of debt, with investors forced to accept losses sooner or later.

Austerity alone cannot do it. Some countries face the growing risk of near-perpetual belt-tightening, which would further dampen growth and thus keep debt ratios high. After all, if a country’s debt/GDP ratio is to decline without austerity, the interest rate that it pays on its debt must be lower than its GDP growth rate. If the interest rate is higher than the growth rate, austerity is required; the wider the gap, the more austerity is needed.

Acknowledging the limits of austerity, several initiatives attempt a European resolution. Special European facilities, along with the IMF, lend money at below-market interest rates, which reduces the extent of austerity required. But the facilities’ resources are dwindling, and they certainly would not be sufficient if Spain and Italy were to seek support. The ECB’s announcement of a new program to purchase sovereign bonds has lowered market interest rates. But, even with that decline, many countries’ long-term interest rates will most likely remain higher than their growth rates for the next several years.

More ambitious pan-European efforts are embodied in various Eurobond proposals. These schemes imply socialization of debt – taxpayers elsewhere in Europe would share a country’s debt burden. These proposals, once in great vogue, have receded. Not surprisingly, the political opposition to such debt mutualization was intense.

Given that perpetual austerity is untenable and others in Europe can only do so much, without robust growth the options will narrow quickly. As a result, much now hangs on the ECB’s actions – and how long they will be sufficient to maintain a truce with financial markets.

Perhaps the Portuguese time-buying strategy points the way ahead. But time eventually does run out. If buying time is not enough, will there finally be a greater call on bondholders to share the pain?

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  1. CommentedMarten Klein

    The important thing is not "austerity" but order, compliance, discipline. Who ever talks about "growth" means lack of discipline and asks for more money without concessions. You can solve the crisis in no time with eurobonds provided discipline and compliance are there. The North can prolong the crisis satifiying demands while the power position of the growth romanticists quickly decreases the longer they resist.

  2. Portrait of Christopher T. Mahoney

    CommentedChristopher T. Mahoney

    The eurozone is doomed without 4-5% nominal growth. Since that would violate the ECB's price stability mandate, either the PIIGS must hijack the ECB, or Europe is doomed. The decision to hijack the ECB must be made by Hollande, Monti and Rajoy. Present Merkel with a fait accompli.

  3. CommentedZsolt Hermann

    While based on the article's argument the window is narrowing, and we are gradually running out of options, it is a still leading to a solution, to our next step.
    It seems we have to close all the windows, we have to try and fail in everything we presently know and want to use, before we understand we have to fundamentally change the whole system.
    As long as people still have other "options", "solutions" they think they haven't tried yet, yet another bailout, yet another kind of austerity, some more "easing" or "injection" they will continue their futile attempts until we become so desperate, falling on our knees, that we have no other option but change the only thing we can change: ourselves, the way we look at the world, the way we want to live, grabbing everything for ourselves, expansively growing where it is impossible to grow, exploiting everything like a cancer until we are on the brink of "death".
    This is the story of our evolution, history so far, we made the next step, a jump when the present state became intolerable. Then came a revolution, war or some other violent change, pushing humanity to the next level.
    So as we stand today we have to wait until the whole system collapses after the futile "stimulus vs austerity" attempts dry everything out, countries brake away from each other or brake apart themselves...leading to unpredictable and scary scenarios in a long, crisis filled transitional period,
    Of course there could be another way, if humanity finally started understanding through the daily examples of the crisis and the countless scientific publications coming out each day that we evolved into an unprecedented state, in a global, totally interconnected network with each other, within the closed, finite natural environment, where only a completely new, mutual and equal human socio-economic system, based on necessity and available resources could prosper.
    With each day there is less time to choose the better option.

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