Bill Emmott - International Author & Adviser


How to save the euro
L´Espresso - January 21st 2011

The euro is like a beautiful modern building, one that is still attracting new tenants (Estonia joined on January 1st) and hosting a helluva rooftop party for its richest, most successful residents (the Germans). But down in the basement there is a huge time-bomb, its clock ticking away. Unless that bomb is defused, and soon, the building risks being destroyed. 

            The bomb is the sovereign debt burden held by Greece, Ireland and Portugal. You could be forgiven for thinking that this has already been dealt with last year, by the much-fanfared creation of the European rescue fund, in combination with loans from the International Monetary Fund. If so you would be wrong: the packages for Greece and Ireland simply bought some time by refinancing some of those countries’ debt. It is like our building’s landlords simply changing the clock on the time-bomb in the belief that the weapon will eventually become less explosive.

            Admittedly, the problem for these highly indebted countries is simple to describe, hard to solve. It is that thanks to the 2008-10 recession and to property collapses, several countries—clearly Greece and Ireland, but also possibly Portugal and Spain—have accumulated public debts that are so big that they need strong economic growth to be able to repay them. Yet the measures they are having to take to reduce borrowing and restore competitiveness, namely budget and wage cuts, are weakening their growth.

            Meanwhile, investors in government bonds are seeking to protect themselves against the chance that one or more of these countries might default on their loans by demanding higher interest rates (ie bond yields). They do not believe promises by European leaders that they will do whatever it takes to protect the euro and avoid debt defaults, because what it could take is likely to be politically unacceptable: the use of German, French and other taxpayers money to finance the debts of the Irish, Greeks, Portuguese and others.

            And they suspect that economic growth in those indebted countries is going to be too slow to provide the money to service the debts. Moreover they suspect that the politics of those countries could turn in favour of default or a renegotiation. Greek unemployment is rising painfully. Ireland faces a general election this spring in which the likely new governing parties have spoken in favour of renegotiation.

            So is the euro doomed? I don’t think so, though only a fool would deny that it is in danger. A big point in its favour is that the currency is currently helping the European Union’s main paymaster, Germany, to prosper. Germany’s recovery in 2010, with a GDP growth rate of 3.6% (Italy’s was about 1.1%), counts as the West’s most remarkable success story. With unemployment falling (now just 7.5% of the labour force, against 8.6% in Italy), incomes rising and exports booming, why should Germans be angry about a few problems in the eurozone?

            Much of the commentary about solutions has focused on a perceived need for greater interference in the fiscal policies of members, and for a “transfer union”, making strong countries’ tax money available to help weaker countries. The greater interference, however, is irrelevant to the current crisis: it just might be necessary to convince voters and investors that the crisis won’t be repeated. The notion of fiscal transfers seems to me a political non-starter. If they are politically sensitive even within Italy, why should German, Dutch or Italian voters accept them across national borders?

            No, a much cleaner and politically viable solution is a debt restructuring. This is not easy: it would entail debtor countries swapping their existing debt for lower value, lower cost bonds, and so holders of the old bonds—chiefly foreign banks—would take a loss. It raises two big difficulties: how to prevent a debt restructuring by Greece or Ireland from causing a market panic about Spain, Belgium, Italy or other big euro debtors; and how to make it possible for the debtor countries to return as borrowers to the capital markets later, having caused these losses.

            To solve this, the debt restructuring has to be large and impressive: rather than arranging it country by country, it should be offered to any eurozone country with debts above a certain share of GDP, perhaps 100%. It must then also have penalties attached that make it unattractive for other countries to join in: reduced voting rights in EU councils, for example, and enforced liberalisation of domestic markets and privatisation. This is the sort of thing that was done for Latin American debtors during the 1980s.

            The losses that this will force on banks may well mean that their governments have to support them with taxpayers’ money, just as they did after the Lehman Brothers collapse of 2008. That will be controversial, again—but at least it will be a matter of domestic banks being supported by domestic taxpayers. This will also apply in Britain, which although not a euro member does have banks holding huge portfolios of Irish, Greek and other debt.

            The most important point is to do this soon, before the debts get even bigger but also before something else crucial could happen. This is the rise of inflation inside Germany. For the moment, the euro is helping Germany boom. But if low interest rates and a cheap currency blend together with rising global food and oil prices to push German inflation higher, the politics of the euro could turn savage. Taught by their history to fear inflation, Germans might then turn completely against the euro.

            So defuse the bomb now, and accept the pain of renegotiating debts and a fresh rescue for European banks. The alternative really is the death of the euro.


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