European Financial Rescue Measures May Not Work As Intended – Italy Facing Higher Borrowing Costs – Besides, Rescue Addresses Only Symptoms – Europe’s Real Problem Is Low Growth
By Paolo von Schirach
October 29, 2011
WASHINGTON – In recent articles (see above) I pointed out that Europe, while moving forward in this never ending debt/financial crisis mess, cannot be trusted to take truly definitive steps. And most recent developments fit the pattern. Last Thursday there seemed to be a major breakthrough: Nicolas Sarkozy, Angela Merkel and all the others announced a ”final plan” to reduce Greek debt, and critical decisions to recapitalize compromised banks and to beef up the eurozone rescue fund currently managed by the European Financial Stability Mechanism.
Questions about missing details
The problem is that key details are missing. Clarifications regarding modalities and timing of implementation will come later. And this vagueness invites suspicion that this is not a firm EU commitment, but just half baked plan that may or may not work. “Doubt Rise on EU Deal“, reads the October 29-30 The Wall Street Journal front page headline.
Higher interest rates for new Italian bonds
The first test came just one day after the big announcement. Italy wanted to place new bonds, and the markets immediately asked for a higher interest rate. And this is the evidence of a EU plan that fails to convince key players. Unmistakable clarity that henceforth the EU will guarantee all sovereign debt would have reassured investors. They would have asked for the same or lower interests on new Italian debt. Well, the opposite happened. The immediate reaction to measures ostensibly conveying the message that risks have been reduced is that investors demand higher interest rates. This means that the markets, so far at least, do not buy the plan, while the also do not buy the seriousness of Prime Minister Silvio Berlusconi’s stated pledges to fix Italy’s finances.
Symptomatic remedies will not do
More broadly, the markets may begin to sense the limitations of all these extraordinary measures. Even if they really worked as intended, these remedies are symptomatic, as they fail to address the root causes of Europe’s ills. In essence, Europe has weak finances because it has bloated public sectors and weak economies that cannot support them. Whereas the Europeans are desperately trying to shore up the present system telling the world that it can work again, just as it used to.
They want to convey that Greece, whatever the past hesitations, is now firmly under control and that there will be no contagion to banks exposed to Greek debt. They also want to convey that other at risk countries, namely Italy and Spain, have got their act together and will now enact policies aimed at reducing deficits and debt, therefore proving to the markets that they are reliable borrowers. To top it all off, Europe will also increase the firepower of its rescue mechanism, thus telling investors that, whatever may happen, sovereign debt will be somehow guaranteed.
Europe’s real issue is anemic growth
This is of course fine. Except for one basic fact. Europe is not having just a temporary liquidity crisis. Europe is revealing now the financial consequences of basic economic weaknesses caused by the bad combination of low economic growth, unaffordable welfare states and adverse demographic trends.
Put it simply, in several European countries structural debt is destined to stay dangerously high and possibly grow to unsustainable levels because they no longer produce enough wealth to finance costly public services and entitlement programs. In Greece we have seen the conflation of all these contradictions, magnified by Greek special features: namely massive tax evasion, bad work ethics and massive corruption.
Beyond a rescue plan, Greece needs to become a productive society
In fact, it is remarkable that the Greek farce lasted this long. Here is a mostly unproductive economy that collected little revenue, while most public employees did almost nothing and the rest of the working population did only a little.
This being the case, on top of a debt restructuring plan and a fiscal turnaround –difficult as these are– it is obvious that Greece needs a complete societal make over. If Greece, either with Prime Minister Papandreu or a new government, cannot manage to turn itself into a productive economy in which people are engaged in wealth producing activities that add real value, all the current EU efforts aimed at “saving Greece” are essentially meaningless. Bankruptcy or no bankruptcy, this is a country in decline.
Italy is in a dangerous zone
And the same applies to Italy and Spain. Italy’s gigantic public debt, (third largest in the world), is not a historical accident. For decades debt has been and is the way to finance unsustainable obligations made to public employees, pensioners and all sorts of other categories receiving direct and direct subsidies, while the productive economy advances at a very low speed.
Italy would need to dismantle the current welfare state in order to cut down future obligations. But even assuming such an unlikely radical political transformation, unless Italy moves into high gear and becomes productive, there is no way that this mountain of debt will be reduced. Let’s be realistic. The only way to get out of debt is to reduce current spending while increasing revenue, so that excessive debt can be progressively retired.
But with a feeble 1% or less growth there is no chance that Italy will be able to generate the additional revenue that would be required to start retiring this debt. Until now Italy counted on low interest rates that made it possible to service its debt without a Greek-like crisis. But if, new EU measures notwithstanding, the markets no longer buy the assumption that Italy is and will be solvent, it is the end. If the markets demand much higher interest rates to buy bonds, then the math no longer works. Italy can no longer service its debt and becomes another Greece. Ditto for Spain. And France is not too far behind.
Low European birth rates make everything more complicated
To this disconnect between high expenditures and low growth, do not forget to add adverse demographic trends. With the exception of France, there are few new babies in Europe. This means that the system to finance the welfare state can no longer work as designed. Working people pay into a system that transfers these moneys to the retirees. But now the pool of active people is shrinking, while the number of retirees grows. So, not enough money is generated to pay benefits. Unless fertility rates increase dramatically, this problem is fixable only by cutting payments to retirees or by mandating higher contributions for active workers. Either way, governments would get into a political bind, as people will be financially squeezed.
Parts of Europe in a phase of decline
In the end, either these European countries become vibrant economies capable of shedding all this debt, or all these EU measures promised today, even if we assume that they are seriously meant, will be for nothing.
The hard reality is that significant portions of Europe are not just going through a bad patch. They are in the midst of a systemic crisis –I call it terminal decline– that requires a lot more than EU rescue funds. Getting out of it would require a change of national ethos and a determination to reinvent societies. While this would be an extremely welcome transformation, it is so difficult to do that I am not sure that it is possible.