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Greece, Thanks. And Estonia, Welcome!
Robert S. Tipp, CFA
Managing Director and
Chief Investment Strategist
Prudential Fixed Income
March 2010
May 2010
It's been ugly in Europe as of late. Fiscal profligacy, a market crisis, then a
massive bailout, with lamenting by both those being bailed out as well as by those
doing the bailing. Is it really all so bad? Of course it is, at least for the near-tointermediate term: those on both sides have to pay more and get by with less.
Looking further out, however, there may be some important silver linings for
investors. This brief paper covers the origins of the recent crisis and then looks at
the potential upside for the Eurozone going forward. After all, plenty of ink has
already been spilled discussing the negatives.
One Decade of Hard Work
During the 1990s, potential Eurozone candidate countries worked hard to meet the
European Union’s Maastricht criteria for adopting the euro. Arguably the most
challenging task for most countries was reducing their budget deficit below the
specified limit of less than 3% of GDP. In the early 1990s, for example, both Italy
and Greece were running steady budget deficits in the area of 10% of GDP.
In the late 1990s, however, these and other countries across Europe engineered
massive fiscal consolidation in pursuit of their goal, and 11 countries entered the
European Union and adopted the common euro currency in 1999. While Greece
was not quite prepared to enter in 1999, by 2001, they had met the criteria and
thus were permitted to enter the Eurozone as well.
One Decade Squandered
In contrast with the tremendous budget improvements European countries
generated in the 1990s to gain entry into the monetary union, the decade of the
2000s that followed was characterized by fiscal slippage for many of those
countries. French, German and Italian budget performance was barely passable,
running deficits averaging around 3% of GDP, while Portugal and Greece saw
their budget deficits widen significantly.
Were Government Deficits Really the Only Cause of the Crisis?
Economic
Perspectives
Excessive government spending was not the only problem during the “squandered
decade.” Spain experienced a housing boom of American proportions, while Irish
banks literally grew to be far larger than the Irish economy. In both cases, the
excesses were funded with foreign capital.
For more information contact:
Miguel Thames
Prudential Investment Management
2 Gateway Center, 4th Floor
Newark, NJ 07102-5096
973.367.9203
[email protected]
While the causes varied, by 2009, Greece, Ireland, Spain, Portugal and Italy were
all reliant on foreign capital, and all were running large current account deficits
(Figure 1, next page). As 2010 began, these countries entered the new decade
vulnerable to capital flight.
Figure 1
Current Accounts of Select Eurozone Countries
(Balances as % of GDP)
1990-2009
Thanks to its strong net export
performance, Germany had
capital to spare, shown by its
rising current account surplus.
% 10
5
0
-5
-10
-15
-20
On the other hand, the increasing
reliance on foreign capital by
other European countries was
seen in their burgeoning current
account deficits.
Germany
Greece
Ireland
Portugal
Spain
Source: International Monetary Fund (IMF). As of April 2010.
Capital Strike
This vulnerability was publicly tested following Greece’s October 2009 elections, when government accounting
irregularities came to the fore, revealing a massive upward revision to an already excessive Greek budget deficit.
That was the straw that broke the camel’s back.
Despite Greek measures in late 2009 and early 2010 to rein in its deficit, Greece’s debt markets continued to
deteriorate. Perhaps worse, the Greek problem had become contagious. Other troubled countries, the so-called
peripheral countries of Spain, Portugal, Italy, and Ireland, saw their borrowing costs rise as well. Investors,
concerned about the exposures large European banks had to these governments’ bonds, began to shy away from
bank debt, causing interbank rates to rise.
Solution #1: The Band-Aid
Attempting to calm the markets, the European Union and the International Monetary Fund (IMF) announced, on
Sunday, May 2nd, a 110 billion euro rescue package for Greece. Supported by the IMF and bilateral loans from
European countries, this was intended to provide more than two years of liquidity relief to Greece, and thereby
stanch the crisis. While the markets managed to calm down on Monday, May 3rd, the rest of the week was a rout.
Borrowing rates for the peripheral European countries began to soar. Finance Ministers, Central Bankers, and
IMF officials saw a liquidity crisis of 2008 proportions in the offing.
Solution #2: The Bazooka
They acted quickly. Early on the morning of May 10th, European Union leaders, the European Central Bank, and
IMF officials unveiled a more comprehensive support package intended to contain, once and for all, the European
sovereign crisis. It included 90 billion euros available from the European Union and the International Monetary
Fund, plans for another 660 billion euros to be made available by the IMF and through a special purpose vehicle
supported by European countries, and a European Central Bank commitment to execute liquidity measures and a
bond buying program. The joint program approached 1 trillion US dollars in size, excluding the European Central
Bank measures.
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Is This Good or Bad?
In the week that followed the May 10th announcement, global bond market tensions subsided. Yields on stressed
European sovereign debt fell, and European bank money market rates showed some signs of stabilizing. In all
likelihood, the near-term liquidity squeeze for the European sovereigns and their banks has probably crested.
Whether the credit problems of these sovereigns are solved over the longer-term will depend on their ability to
trim their budget deficits and reduce reliance on foreign capital.
In the broader scheme, however, this crisis has helped to define the Eurozone. For example, it was assumed that
the European Central Bank’s staunch independence and monetarist roots would preclude it from buying the bonds
of member countries. On May 10th, that question was answered: the European Central Bank entered the market
and bought the foundering bonds of Greece, Portugal, and Ireland.
Another question lurking from the beginning days of the European Union was “Would the larger, more
creditworthy countries in the Eurozone ever financially rescue the smaller weaker countries, even if the troubled
country’s problems were of its own making?” That question, too, has now been answered: Whether through the
European Union, jointly with the IMF, or bilaterally, aid was there, with the size increasing as the potential need
grew.
In the end, all European Union member states, even German lawmakers in the face of elections, put the stability
of the Union ahead of their local interests and supported the financial lifeline extended to Greece and the other
troubled countries. The European Central Bank and the European Union proved they are not as vulnerable as their
weakest link. In fact, they demonstrated they have tools and firepower on par with any nation, commensurate with
the size of the Eurozone itself.
And the Benefit of Discipline?
Greece will receive support, but at a huge cost. Cutting public salaries and pensions, extending retirement ages,
and raising taxes in a recession (yes, the Greek economy is still contracting) is like salting a wound. It is a procyclical policy that will hurt Greece’s economy in the short run. It is the hard way. The lesson: countries that don't
clean house when times are good will risk having to impale themselves on a spit of fiscal austerity at an
inauspicious time.
Perhaps more important still, a consensus is emerging at the European Union level for strengthening enforcement
of the Eurozone’s existing budget control mechanism, the so-called “Growth and Stability Pact.” Leading the
charge is Germany, pushing for all Eurozone countries to adopt a balanced budget law. While that degree of
reform seems unlikely, the fact that Europe just witnessed a handful of fiscally profligate countries threaten the
stability of the entire Union suggests that, at a minimum, stronger enforcement of the existing rules seems quite
likely.
Thanks, and You're Welcome!
In the near-term, budget cuts, tax hikes, later retirement ages, and digging deep to help one’s neighbor are all
going to cause pain. Looking further out, however, there are a number of positive outcomes from the crisis:
1. Grumbling and political circus aside, the Eurozone countries have shown they can act as a single unit to
contain a crisis, putting the stability of the whole ahead of the needs of any one country. The rich will
support the poor, and the large will support the small.
2. The European Central Bank has demonstrated it is not hamstrung by its mandate. It will even go so far as
to buy the government bonds of member countries if circumstances dictate. In sum, it has the same
powerful tools at its disposal as does the US Federal Reserve, the Bank of Japan, or the Bank of England.
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3. Fiscal discipline in Europe is being reinvigorated. Spain and Portugal have taken further budget measures
on top of previous cuts. The IMF will try to keep Greece on course. And, European Union-wide efforts to
improve enforcement of the Eurozone’s existing mechanism for keeping fiscal rectitude, the “Growth and
Stability Pact,” are clearly afoot.
To the extent that the Eurozone can get through the short-run, in the long-run it may very well emerge with a
stricter fiscal framework than most countries.
Will this crisis damage European officials’ confidence in the future of the Eurozone? Apparently not. On
Wednesday, May 12th, Estonia was recommended by the European Commission to enter monetary union and
adopt the euro. The Estonian government is enthused to enter.
So, to the extent that the European Union is stronger and better positioned as a result of the crisis, Greece, thank
you! And, here’s to the future, Estonia, and welcome!
May 18, 2010
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NOTES
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