Even rival theorists agree that fate of euro hangs in balance


ANALYSIS: Whether you advocate debt default or gradual resolve, the common currency is bleeding

THOSE WHO observe and comment on economic affairs, in Europe and internationally, take very different views on what needs to be done to deal with the latest phase in the crisis of finance that has convulsed the rich world since 2008. But there is one issue on which a consensus exists – the euro’s future. Few believe that its existence is not in question.

How has it come to this?

The origins of the crisis, as with other previous phases, lie in an international financial system that has failed. That system became blind to risk over an extended period. Among many other things, it channelled too much cheap money to ballooning banks (including those in Ireland, Iceland and the Baltic trio) and to debt-laden governments (those of Greece, Portugal, Italy and Hungary, among others).

The collapse of Lehman Brothers 27 months ago exposed the structural flaws in the financial system. Its participants went from being blind to risk to panicking blindly. A realisation dawned that debt levels previously thought to be sustainable were, in fact, unsustainable.

The panic this year has focused on euro area countries, with faith draining away in the ability of some governments to repay their debts. As this happens, the cost of new borrowing rises for those countries whose creditworthiness is questioned. This very quickly becomes a vicious and self-fulfilling cycle.

The cycle in Europe is widening. From Greece to Ireland; from Portugal to Spain; from Italy to Belgium. It risks spinning out of control and, ultimately, blowing the euro apart. On dealing with the underlying problem of over-indebtedness, there are two broad schools of thought: the impatient purgists and the cautious gradualists.

Those in the first school have come to the conclusion that the amount of debt some countries have run up – in either their public or private sectors, and sometimes both – simply cannot be repaid because there is too much of it. They believe Ireland and Greece are two such countries.

The only answer to excessive debt is to purge it from the system by not repaying it and writing it off. This is known variously as default, debt restructuring and debt rescheduling.

They also say that the lending tango takes two. Both parties are culpable if it all goes wrong. Currently, lenders in Europe are getting away scot free and the losses are being heaped on taxpayers. This is outrageously unfair. They have to suffer the consequences of their miscalculations.

Purgists also say that those who have made bad lending decisions will take the hit and then move on. Best to get it over with, so that everyone can focus on new beginnings, rather than the constant fear that worse is to come.

Argentina’s default a decade ago is often cited as an example. It was the largest sovereign default in history. In late 2001, the South American country gave up trying to repay bonds worth $81 billion (at yesterday’s exchange rate that was €62 billion). Although it caused chaos, once it was done Argentina was able to start recovering, albeit after strife and deaths. International investors took their pain and learnt a lesson about risky lending.

The second school of thought on handling the underlying crisis – the cautious gradualists – baulks at making the blind pay now for their folly because the entire financial system is so weak and the amounts involved so huge. Crystallising gargantuan losses now would bring the system down. There can be no orderly default, only meltdown given the amounts involved and fragility of the system.

According to the ECB, euro zone banks took losses of €515 billion between the onset of the crisis and mid-2010. These losses have blown a hole in the foundations of the European financial system.

It remains so fragile that yesterday, Jean-Claude Trichet, the head of the ECB, was obliged to extend, yet again, the extraordinary support his institution has been providing the system since the crisis erupted. For the system now to take losses potentially far greater than those already written down would be insanity.

Consider the sums involved. In the euro zone, banks have €5,000 billion in outstanding debt (the ECB does not break the figures down further, so how much of this is accounted for by senior bonds is not published).

There is almost as much weak country sovereign debt out there. The Greek and Irish governments combined currently have almost €500 billion in bonds outstanding. The Portuguese government owes approximately €150 billion. Spain owes about €700 billion – more than all three peripheral minnows combined. Italy owes close to €2,000 billion.

Put the Piigs public debts together and the sum arrived at is greater than the wealth 90 million Germans generate in a year.

Gradualists say that pointing to past examples of sovereign default – such as that of Argentina – is meaningless because a euro zone default would dwarf anything that has ever happened before.

They point, too, to Lehman Brothers. When it crashed, it defaulted on less than $400 billion (€303 billion). No one needs reminding of what happened.

The cautious gradualists also retain some hope. They do not share the grim inevitability of the impatient purgists. National economies can grow out of trouble. Financial institutions can trade their way to stronger capital bases, given time. As long as there is any hope of crawling out of the hole, better to keep going than risk bringing the roof down.

The gradualists are also more concerned about risk than fairness. It is outrageous that anyone can pocket their gains and push losses on to taxpayers, but that inequity is to be dealt with in the future, not now. This is about survival.

It is clear that the cautious gradualists hold sway now, as the conditions of Ireland’s bailout proved – any form of default on any form of debt was categorically ruled out.

But will the cautious if unfair approach succeed in saving the euro?

It is clear, having bailed out two of the 16 euro zone countries to prevent their default, that rescuing the weak will not be enough now that the currency is in contagion’s iron grip.

A more radical step is needed. Yesterday it would appear as if the ECB acted radically. Although Trichet did not say so explicitly at his monthly press conference in Frankfurt, the big decline in weak euro countries’ bond yields over the course of the day would suggest that he used a variant of money printing to buy these bonds.

This carries its own risks and is far from uncontroversial, in Germany most of all. But it increasingly looks like the only way to halt the slide towards disintegration.