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Why isn’t the European debt crisis resolved yet?

by
Rick Miller
Ph.D., CFP® - Founder

June 1, 2012

The European debt crisis drags on and on. It seems to be in the news every day.

Recently, every country in the European Union except Great Britain came to an agreement to draft a treaty among all of those agreeing with tougher budget discipline, automatic sanctions for violators and a small increase in the size of the European Stability Mechanism (ESM). For a day at most, bond (debt) markets seemed satisfied.

Unfortunately, however, that satisfaction was short-lived. We are back to a steady drumbeat of concerns about European sovereign debt, and specifically about the bonds of Italy, Ireland, Portugal and Spain. (Not Greece anymore, as it has been “bailed out.”)

Why isn’t the planned treaty enough to solve the problem?

Fundamentally, the treaty might well help prevent future problems, but it has no impact on the current debt issue. That is, in the future it might prevent countries from getting in to deeper trouble or into trouble at all, but it provides no tools today to get them out of the trouble they are already in.

What is the problem, then?

There is a fairly broad consensus that the current Eurozone debt situation is largely a crisis of confidence. There is uncertainty among many lenders about the willingness and ability of (especially) Italy, Ireland, Portugal and Spain to pay the interest and principal on their current debt outstanding. This has several effects:

Banks and other financial institutions are reluctant to hold those bonds – they are afraid if the issuing country defaults, they will lose principal. This causes the price of the debt to fall and the implied interest rate to rise (bond interest rates and bond prices move in opposite directions).

Then, as the countries in question issue new debt (borrow more money), they must pay higher interest rates. This increases the size of the deficit that they have to cover through lower spending and higher taxes. It is something of a vicious circle.

Lenders (including depositors) to banks and other financial institutions that do hold the bonds develop doubts about the credit-worthiness of those institutions. (Will the bank be able to pay the depositor if some of the bank’s assets decline significantly in value?) At the extreme, lenders may refuse to lend to those institutions – they may demand their money. This would result in a “run” on the bank or institution in question.

What might work?

Confidence must be restored. Lenders must become confident that the bonds in question will not lose value. Two approaches have been proposed:

A “lender of last resort” could emerge. The US Federal Reserve Bank and the US Treasury played this role in the US credit crisis. You may recall that the US Treasury purchased large quantities of mortgage-backed securities in 2008 and 2009. The Federal Reserve also guaranteed money fund assets, preventing a run on those funds. There are at least two candidates for this role:

The European Financial Stability Facility (EFSF). This entity has lending capacity of €440 billion. It is to be replaced by the European Stability Mechanism (ESM), with a slightly larger capacity. As Italy’s outstanding debt is €1,800 billion, the inadequacy of either of these mechanisms is clear.
The European Central Bank (ECB) could buy the questionable debt. The ECB is the direct analog of the US Federal Reserve. In theory, its capacity is very large – probably large enough. However, so far, the ECB has declined to buy bonds, indicating that its charter does not permit this.

The ECB has just made large three-year loans to many European banks on very favorable terms. This provides the participating banks with funds that they can use to (among other purposes) buy bonds from the sovereigns whose credit is in question. It remains to be seen whether this action will be sufficient to restore confidence.
Alternatively, the Eurozone countries could collectively issue Eurobonds, and purchase the questionable bonds with the proceeds. This would effectively position the entire Eurozone as the borrower, in the place of the individual countries. As I mentioned in my last email, the entire Eurozone does have sufficient capacity to inspire confidence. There has been no move in this direction, however.

Why have the Eurozone countries rejected these solutions so far?

The Eurozone countries whose participation or approval would be essential for any of these solutions – France and Germany are the largest of these – do not want to take financial responsibility for the countries in trouble.

More articles by Rick Miller Filed Under: Investments Tagged With: Economy, Investments

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