Spectre of default raises its ugly head

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The Independent Online
It is fitting that on the same day the European Union should lecture its members for their budget deficits, it should find that Italy is blocking approval of the EU budget. Italy's refusal seems to be motivated by political irritation (it has recently been fined for producing too much milk) rather than any long-seated tradition of fiscal responsibility. Still, it draws attention to the mess into which fiscal policy in Europe has fallen.

Given the record of the EU itself on its own budgetary control, it might seem odd that its chief civil servant, Jacques Delors, should seek to lecture members about their budget policies. But of course political pressure from the Commission to cut budget deficits is driven by the need to make the plans for a single currency credible - to get as many countries as possible to observe the Maastricht criteria - rather than any ideological or practical opposition to public spending.

Politically driven or not, the EU initiative will have an impact. In particular, it will draw attention to the fact that there is a structural element to the European countries' deficits, as well as a cyclical one. The prime problem of European public finance is not the cyclical deficits, which have been exacerbated by recession. It is the structural problem of the costs of running their social security networks and in particular their unfunded pension liabilities. Given the ageing population of Europe the area as a whole ought now to be running public- sector surpluses. And the surpluses in the countries that are ageing fastest, like Italy and Spain, should be the largest. Instead both are in serious deficit.

Britain, incidentally, has a much less serious structural deficit than any other European nation. Not only is its stock of debt relatively low; it will also become the 'youngest' of the large EU nations by 2020. Thus just over 16 per cent of its population will be over the age of 65, against 20 per cent for France and Italy and 22 per cent for Germany. Add to this that it is the only country in the EU, aside from the Netherlands, with funded pensions covering half the population, and the UK's relatively favourable position becomes even more evident. We have a problem, but it appears manageable when compared with the rest of Europe.

It is curious, though, that the structural weakness of the European nations' public finances is not yet fully reflected in bond yields. Yields vary, but much of the variation can be explained in terms of past inflation performance.

Thus 10-year German bonds yielded about 7.6 per cent at the end of September against 8.8 per cent on the equivalent UK gilts. That would be about right, were the inflation experience of the past 10 years to be repeated over the next 10. French yields, at around 8.2 per cent, fitted in neatly between Germany and Britain, again mirroring the different inflationary experience. But there was no allowance for the different structural position of the budgets in the three countries.

In the case of the countries with worse fiscal positions - for example, Italy and Spain - there does seem to be some allowance for the mounting scale of public indebtedness. Thus 10- year Italian bonds yielded 11.7 per cent and Spanish bonds were at 11.1 per cent. To justify this gap on inflationary grounds alone you have to assume a really dreadful performance in these countries over the next decade, even though the world trend of inflation is likely to be down.

This raises an important question. Are the markets trying to say that Italian inflation will be four percentage points higher than Germany's in the next decade? Or are they saying that it will be three points higher and the markets want 1 per cent as a risk element? Or, and this is the radical possibility, that they are not so worried about inflation, but that they expect there to be some form of partial default and Italian debt will come to be traded at well below its face value, rather like Latin American debt?

This should have been the chilling thought for the finance ministers meeting yesterday in Brussels. There are indeed political reasons for wanting to see a narrowing of fiscal deficits if you are interested in a single European currency. But the level of yields suggests that in some cases at least the markets are sensing another reason for concern: the danger of default.

Default is not a nice word in the banking parlours of the developed world. It has long been the last resort of less developed countries. European countries have been allowed to whittle away the real value of their debt by inflation, and they have done this for much of the post-war period. But actual default has not been on the agenda.

Not yet. The decisions that will render default unnecessary or inevitable will be taken in Europe during the next three or four years. The big deficit countries must move determinedly over this period if they are to avoid it. The 3 per cent of GDP for fiscal deficits will come to be seen as very much the top limit for safety . . . and what started as a political totem will take on a practical market significance.