Satyajit Das: Europe's problem is not one of liquidity but rather solvency


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The Independent Online

Outlook: This month's summit was billed as the last chance for European leaders and Eurocrats to avoid a financial disaster.

European leaders succumbed to their long-standing commonsense deficit, which is as intractable as any budget and trade deficit. The European plan's failure or success is bad for Britain.

The most recent summit made no attempt to tackle the real issues – the level of debt, how to reduce it, how to meet funding requirements or how to restore growth. Most importantly there were no new funds.

The new Fiscal Treaty will not work. Austerity – draconian budget cuts and tax increases – to bring budget deficits and public debt under control cannot deal with the problem, the deflation of the debt-fuelled bubble. The attempt to bring budget deficits under control will slow growth and make controlling debt even more difficult. Automatic, court-enforced sanctions on countries that exceed 3 per cent of GDP on budget deficits and 60 per cent of GDP on debt are laughable. Even if the treaty changes can and are implemented, the bulk of eurozone countries do not and cannot meet these limits now or in the foreseeable future. As for the fines, they would have to borrow to pay them.

Greater integration of finances where Germany and the stronger economies subsidise the weaker economies combined with jointly and severally guaranteed eurozone bonds was explicitly rejected. The European Central Bank remains reluctant to embrace debt monetisation (the ECB prints money and uses it to buy bonds). In reality, neither option was really feasible, economically or politically.

The European Financial Stability Fund (EFSF), the European bailout fund, to be replaced by the European Stability Mechanism (ESM) in 2012, is largely irrelevant. Schemes to increase the capacity of the EFSF – borrowing to leverage the fund or partial guarantees or seeking Chinese funding – are simply far fetched or incomprehensible. With only a maximum of €500bn (£416bn), some of it already ear-marked for existing bailouts, it lacks the resources to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from contagion.

European central banks will provide money (€200bn) to the IMF to provide money to beleaguered nations mainly to circumvent existing rules. Even if other countries agree – and that is not assured – the IMF might only be able to muster €300bn-€450bn, which will be insufficient. Spain and Italy alone need €1 trillion to meet their financing requirements over the next few years.

Europe doesn't have a "liquidity" problem. European countries have a "solvency" problem – they have debt that they can never seriously expect to pay back. Stronger nations cannot save the peripheral nations without destroying their own credit.

There has to be realistic writedowns of the debt of countries such as Greece, Portugal and Ireland and a preparedness to do the same for Italy and Spain quickly, if necessary. An aggressive plan to recapitalise European banks and the ECB is needed. None of this was tackled.

Weaker nations have to leave the euro. The devaluation of the new currency in conjunction with structural reforms would provide some chance of regaining competitiveness. Within the euro, the only option – internal devaluation entailing a sharp fall of incomes and living standards – cannot work. European leaders predictably re-affirmed their commitment to the euro.

The solution now may be beyond Europe's financial ability – the €2.5trillion to €3.0trillion required. Europe is rich, but a lot of this wealth in invested in government bonds which are increasingly risky.

Germany and France are unwilling and unable to increase the size of their commitments. Chancellor Angela Merkel's spokesman Steffen Seibert put the matter plainly stating that Germany doesn't have "unlimited financial strength." France is at the limit of its financial capacity and at risk of losing its AAA credit rating. Fragile coalition governments in Netherlands and Finland are increasingly reluctant to commit more to the bailout process.

Time is running short. European sovereigns and banks need to find €1.9trillion to refinance maturing debt in 2012. Italy alone needs €113bn in the first quarter and around €300bn over the full year. European banks need €500bn in the first half of 2012 and €275bn in the second half. Yet since June 2011, European banks have been only able to raise €17bn compared with €120bn for the same period in 2010.

The ECB has reduced euro interest rates and lengthened the term of emergency funding of banks to three years with easier rules (a lottery ticket is now acceptable as surety for borrowing). This alleviates funding pressure on banks without dealing with the fundamental problems.

For Britain, if the plan fails, then its already weak economic position will worsen. Europe is the UK's largest trading partner. UK banks are heavily exposed to European banks and borrowers. UK savings are invested in part in Europe. The earnings of British companies active in Europe will be affected.

Irrespective of whether the plan works or fails, the friction with the eurozone means that London role as the de facto financial centre for Europe is now under threat. It is difficult to see Europeans accepting the City as the primary trading centre for "their currency".

What happens in Europe will not stay in Europe. The shock will be rapidly transmitted through trade, investment and inter-relationships to the UK and rest of the world.

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (November 2011)