It really is a shame about Greece. Not that the Greeks deserve sympathy for fudging the numbers to qualify for Euro accession, or their culture of tax evasion, or the political patronage that defines their public sector. Rather, it is a shame that Greece collapsed first. No other European economy is guilty of the types of sins that the Greeks have committed. After the introduction of the Euro, currency risk disappeared, pushing down interest rates in the periphery and unleashing a flood of capital that eventually produced over-investment and asset bubbles. Remember that Ireland and Spain ran fiscal surpluses for years and had modest levels of public debt.
But Greece’s example has allowed politicians in ‘core’ Europe to frame the debate about the financial and sovereign debt crisis as a morality play: ‘Lazy’ Mediterranean countries have lived beyond their means for many years, and are now calling on ‘prudent’ and hardworking savers in the north to bail them out.
Such views are nonsense, of course. For every irresponsible borrower in the periphery there is an equally irresponsible lender in the core. The crisis in the Eurozone is due in no small part to the ‘sudden stop’ of capital inflows to the periphery. Moreover, it is hard to think of a more irresponsible course of action than to paint Spain and Italy with the same brush as Greece in the midst of a liquidity crisis. Liquidity crises are contagious, and they can force otherwise sound institutions into insolvency.
Usually, the institutions at risk from a liquidity crisis are banks and other financial institutions. The collapse of one bank can trigger fears about the safety of the financial sector in general, causing a systemic run. Because banks engage in maturity transformation by turning short term liabilities into long term assets, mass redemptions can quickly force them into bankruptcy even if the loans they have on their books are fundamentally sound and would be paid back in full if held to maturity.
This is why we have central banks – to provide sound banks with liquidity during periods of market stress and turmoil. Indeed, the ECB system has been providing unlimited liquidity to banks throughout the Eurozone for some time. So even though loans from private creditors have dried up for many banks in the periphery, they are still able to secure funding through the lender of last resort facilities of the central banks.
But here is where things get tricky. Central banks provide liquidity through their ‘discount window.’ Borrowers must provide collateral, which is discounted by the central bank, in return for a loan. The collateral must be a high quality asset, because the central bank does not want to take credit risk onto its balance sheet. Banks have thus been accumulating sovereign debt – usually among the safest of assets – to post as collateral.
As we all know, the sovereign debt in the Eurozone is no longer considered uniformly safe. Markets now expect a Greek default, and are increasingly worried about the sovereign debt of Portugal, Ireland, Spain and Italy. As sovereign debt in the periphery becomes less and less credit worthy, market fears grow that their banks will become insolvent and will have to be bailed out. During a crisis, the private sector will not provide such capital, so it must be supplied by governments in these countries. But the costs of bailing out domestic financial sectors could prove crippling to sovereigns already struggling to manage their existing debt loads, which in turn feeds the fear that sovereigns themselves will default.
The Eurozone is thus caught in a vicious cycle whereby a liquidity crisis in its financial sector is infecting sovereign debt. If any of these sovereigns default, their domestic banking sectors will instantly become insolvent, for not only is sovereign debt used to secure liquidity, it also constitutes the core capital that banks are required to hold. Now, Greece very well might be insolvent. Its debt burden now stands at 140% of GDP, and its growth prospects are so poor that it is hard to see how it can meet its obligations. But Spain and Italy are not insolvent. So long as they can continue to borrow at reasonable interest rates, they should manage. Except that they are caught in a vicious liquidity cycle that is pushing their borrowing costs above their long run growth rate. If Italy were paying 1.89% on its 10 year debt, like Germany, it would have no trouble meeting its obligations. But because markets fear a default, Italy is now paying 5.86% on 10 year debt, which may become a self-fulfilling prophecy of default.
Eurozone members, because they no longer control their own monetary policies and have borrowed in a ‘foreign’ currency, are vulnerable to a sudden stop of capital inflows, just like emerging market economies. What they need is a lender of last resort that can guarantee them access to affordable funding. Unfortunately, the nation states that make up the Eurozone have no such lender of last resort. The ECB is expressly forbidden from buying sovereign debt in the primary markets, and its purchases of sovereign debt in the secondary markets have become very controversial, particularly in Germany. The current proposal for yet another Greek bailout won’t avoid a Greek default, and in fact might make the eventual restructuring more difficult, by replacing existing Greek bonds that are governed under domestic law with new bonds from the EFSF that contain stricter covenants.
Moreover, it also won’t solve the illiquidity problems of Spain and Italy. Solvent sovereigns need to be guaranteed access to affordable funding so they have time to make the structural reforms necessary to grow their way out of their debt burdens. Banks need safe assets that meet their core capital requirements and that can be posted as collateral in their wholesale funding operations. The Eurozone needs some sort of Eurobond – a safe, liquid financial asset that can break the vicious cycle of contagion.
A Eurobond need not require a full fiscal union – which seems politically untenable anyway – there are many creative suggestions out there that thread the needle between what is economically necessary and politically possible. This proposal, from economists Markus Brunnermeier, Philip Lane and others, is a good example. The broader point, however, is that Europe’s crisis is the result of structural flaws in the design of the Eurozone, and not a morality play pitting prudent northern savers against irresponsible southern borrowers. Austerity measures will simply deepen the debt deflation spiral. Better to fix the fundamental flaws in Europe’s debt markets. Nothing else can halt the contagion.
Ben Carliner is a Fellow at the Economic Strategy Institute. Prior to joining ESI, Mr. Carliner worked as a financial journalist in New York for Project Finance International. Mr. Carliner has also worked for Barron’s Business and Financial Weekly and WBAI Radio in New York. He holds a B.A. from the University of Wisconsin-Madison and an M.A. in International Political Economy and Public Policy from the University of Texas-Austin. The original article can be found on Ben Carliner’s blog.