How will the sovereign debt crisis in the eurozone play out? Last week the EU bought time by pledging vague support for Greece while threatening to demand further austerity measures in mid-March. They hope Greece will turn out like Ireland, says The Economist. “Brutal spending cuts restored market confidence without aid from its European neighbours.” But even if Greece can avoid a bail-out or a default, which is a big if, “there are plenty of other trouble spots that threaten confidence” in Europe’s Economic and Monetary Union (EMU), says Morgan Stanley.
The pain in Spain
While the eurozone can probably muddle through a Greek meltdown, it can’t bail out Spain, which comprises 12% of the bloc’s GDP. Its overall public debt load should still be under the eurozone average this year at 68% of GDP, but it is rising “dizzyingly fast”, says Wirtschaftswoche. Last year’s budget deficit hit 11.4% and GDP is still falling.
Domestic demand has plummeted and high relative wages and prices (due to the boom years) make exports uncompetitive. As devaluation is not an option, Spain seems “doomed to suffer years of grinding deflation and high unemployment” in order to restore competitiveness, says Paul Krugman in The New York Times. It hardly helps overall confidence that Spain’s private sector is also highly indebted. The private and public sectors together have piled up external debt of 80% of GDP following years of high current-account deficits, say Bridgewater Associates. There is also no sign that the government is capable of pushing through tough spending cuts. So there is “a high risk that Spain won’t be able to sell the debt it needs to fund its deficits”.
Italy’s no better
Italy, which has around a quarter of the eurozone’s debt, isn’t looking too good either, according to Nobel Prize-winning economist Robert Mundell. If Italy came under speculative attack, “it would be a big problem” for the single currency. Its budget deficit was only 5% last year, but the overall debt load is approaching 120% of GDP. In short, “Italy can ill afford to service its debt”. Worse, soaring Italian yields, due to contagion from another scare in Greece or the Iberian peninsula, would quickly make the debt load “untenable”. And a weak government is unlikely to push through spending cuts.
The euro makes it all worse So the euro is likely to “face bigger tests than Greece”, says George Soros in the FT. It’s becoming clear that the whole project is “flawed”. EMU has a one-size-fits-all monetary policy. But it has no central fiscal authority to transfer EU money to parts of the zone in trouble as, say, the US Treasury could for an American state.
So there is nobody to enforce fiscal discipline. Member states in trouble may well baulk at the prolonged deflation required to restore competitiveness and growth. “Europe has an unfortunate tendency towards civil unrest when subjected to extreme economic pain,” says Albert Edwards of Société Générale. The political will to remain in the eurozone could well crumble. And Roger Bootle of Capital Economics points out that no currency union has ever endured without a political union.
Not only is the eurozone looking set for an existential crisis, but its recovery is distinctly lacklustre. Growth was just 0.1% in the fourth quarter after 0.4% in the third. America, for now at least, is growing faster and looks set to raise rates sooner. An overall rise in risk aversion this year has also been good for the dollar. Given all this, further falls for the euro are on the cards. Morgan Stanley sees it sliding to $1.28, from around $1.35 now, over the next few months.