For Britain a day of calm, a pause before the seismic changes to come; for Europe a day of mounting concern about not just the financial plight of one of its member states, Greece, but of concerns about the viability of the euro and the future shape of the European political adventure.
These have been days of high drama, indeed tragedy, in Greece and in the other weaker eurozone members. This saga will continue for many months yet. When politicians start saying that their economies are sound and that the financial markets are behaving disgracefully, you know it is time to head for the hills. Anyone with any experience of financial markets can see the danger signs. Once trust is lost that debts will be met when they fall due, it takes an age to rebuild. That lost of trust has now extended far beyond Greece itself and is spreading further across southern Europe every day.
But what I had not appreciated until a couple of days ago is that Greece will almost certainly default on its debts. I could see the numbers looked dreadful but I assumed that given political will the country could dig its way out. Besides, it would be so much in the self-interest of its eurozone partners to avert default that they would do so. Greece would probably be forced out of the eurozone, though not until the next global downswing seven to 10 years from now. But debts would be paid.
The more I look at the numbers, though, the more I think a formal default is inevitable, with the country having to do some sort of deal with its creditors that pays them less than 100 cents in the euro. There are two reasons for this.
First, and most simply, even on favourable assumptions that Greece's debt will rise to something like 150 per cent of GDP over the next three years. Assume a real rate of interest (ie allowing for inflation) of 5 per cent. So 7.5 per cent of GDP has to be set aside each year to service the debt (at the moment it is 5 per cent). Assume tax revenues are around 40 per cent of GDP. So something between 15 and 20 per cent of tax will simply be paying interest, year in, year out, without any prospect of relief. That surely cannot be politically sustainable. It is all the tougher given that Greece faces the worst growth outlook in the eurozone, both this year and next.
The second reason for expecting default is what might be termed, inelegantly, the cock-up factor. Great wodges of debt are falling due that have to be refinanced in the coming months. That is before Greece has to raise new money to finance the growing deficit. Much the same situation applies to other Club Med countries. So there is a very high probability of something going wrong. Most eurozone sovereign debt is held abroad (see second chart), and international investors are unlikely to make fine differentiation between the different borrowers. This is not just about Greece. If one country misses a redemption, others will be hit too.
If this line of argument is right, what does it mean? It is not possible to see the detail of how a sovereign debt crisis might unfold, any more than it was possible the detail of how the banking crisis would develop. But there are several general points to be made.
The first is that the experience of previous debt crises is that there is invariably some contagion. The slightly more sound borrowers get lumped in with the least sound. That is now evident, with Portugal and Spain already in the line of fire. Italy will, I expect, be in trouble in the months ahead.
From the perspective of the eurozone, this is deeply worrying. As a rule of thumb, most eurozone countries have somewhat higher overall public debt-to-GDP ratios than other developed economies. They frequently have lower personal debt-to-GDP ratios but the concern here is sovereign risk, not personal risk. In any case, personal risk is carried largely by domestic institutions whereas sovereign risk is carried largely by foreign ones.
That leads to an inevitable, if disagreeable, further matter: will the fears spread to the UK? The new government will be cut a little slack by the markets – the markets being shorthand to mean the global saving community – but not much. The key point is the one so often made: that the deficit reduction has to be credible. This is sometimes seen as lenders exacting their pound of flesh, with all the associations that encourages. We have heard some pretty nasty comments in Greece about the German role in the rescue package.
Actually, the markets tend to be more realistic. "Credible" means that the numbers have to be acceptable in social terms as well as economic ones. It is not in anyone's interest to cut spending in a disorderly way or to make the economy less competitive by hiking taxes too quickly.
There is, however, a further point to be made. It is that as countries, all countries, start to bring in fiscal measures, they will be compared with each other. The mood will be to get budget deficits to a sustainable level as quickly as reasonably possible. Any country perceived to have sub-standard policies will run the risk of being forced to change direction.
The central point here is that fiscal consolidation will be the next global game. Every country will be doing it. Some will do it better than others. All will be scrutinised. The parallel is with the monetary consolidation of the 1980s and 1990s, when all countries struggled to cut inflation, using different monetary templates to discipline and guide their actions. Those that underperformed, including the UK, were punished by having to borrow at higher rates.
The UK eventually was dealt its get-out-of-jail card when sterling was kicked out of the exchange rate mechanism and the country was able to devalue. But, it has been pointed out, that option has not been available to the eurozone members.
Well, there is one gleam of light amid the dark clouds, which is that one of the side effects of these continuing ructions over its weaker members will probably be a devaluation of the euro. Capital Economics expects this to happen. It has already come down quite a bit but if it were to fall by a further 20 per cent, then the export outlook for the entire eurozone would improve vastly. Until the recession struck, eurozone exports closely followed the level of the currency. Now it is plausible, if the euro does indeed fall sharply, that the region will experience another export boom.
It will certainly need it. Domestic demand will continue to be depressed, and unemployment (now 20 per cent in Spain) will continue to remain high. Indeed, the only obvious way of relieving the social pressures will be to boost growth via export demand. But a weaker euro is not what the Germans signed up to, so political tensions of another sort will mount.
As you can see, there are no easy answers. Greece yesterday got its austerity package through parliament. But the social glue binding together the eurozone is weak. The strains on it will increase. And it is hard to see a happy outcome.Reuse content