When the European political classes put their expensive spin doctors behind the need for a bail out, there were two assumptions behind what they said. Firstly, a bail out for Ireland would stop contagion to anywhere else. Secondly, a bail out for Ireland would help solve Ireland’s problems. It is difficult to understand why they believed either of these two things.
They already knew that a bail out for Greece to stop contagion had not worked. Barely seven months after the Greek crisis we were deep into the Irish crisis. If they watched the markets they would have known that the markets were already putting pressure on Portugal as well. As the crisis is all about a country’s ability to borrow and the price it has to pay to borrow, they should watch the government debt markets. Yesterday the price of borrowing for these countries rose again, despite the bail out.
Prior to the Irish loan Ireland could borrow in the markets at close to 8% for ten year money. It now has to pay over 9%. Portugal had to pay around 6% but now has to offer over 7%. Greece still has to pay almost 12% despite its bail out on May 2nd. Yesterday even Germany experienced rising costs to borrow, with its rate going up to 2.7% from 2.5% a few days ago. There is no evidence in these rates that bail outs appease the markets. Indeed, it looks as if one bail out just eggs the market participants on to demand a bail out for another troubled sovereign.
These rates for Greece and Ireland imply something far worse. If you thought that these governments would pay all the interest on time and repay the amount of the loan in full when stated, and still remain in the Euro, it would be sensible to sell German bonds and buy Greek or Irish ones. You would make so much more in the same common currency with “similar” sovereign risk. Over ten years you would earn a sum greater than 90% more of your initial investment in extra income on your Greek bonds than German ones. Clearly by a big majority investors do not expect the countries under pressure to be able to meet all their obligations in full, or they expect them to leave the Euro at some point. The defenders of the Euro have a lot of work to do to reassure people and bond markets that Greece and Ireland will honour all their debts, so that Greece and Ireland can settle back to borrowing at something closer to German rates of interest. I hasten to add I am offering no investment advice on these matters on this site.
So why don’t enough people believe the loan packages for Greece and Ireland will solve their problems? They must fear that the remedy of cuts in spending and higher taxes will not allow the economies to grow quickly enough to curb unemployment with all the cost and waste that brings, or to allow the deficit to reduce quickly enough through more buoyant tax revenues. They must be worrying that these countries could get into a vicious circle of more cuts, less tax revenue, more cuts, less tax revenue. With interest rates as high as they are the country will find an increasing proportion of its public spending absorbed on paying interest charges, leading to the need for further cuts in other spending to try to balance the books.
What would work better? Leaving the Euro would be the simplest solution for distressed countries, allowing them to devalue against Germany and make themselves more competitive again more quickly without so many direct wage cuts. They would still need to control their deficits by spending curbs and growing the tax revenues, as the UK and US have to do with their own floating currencies. They would have more scope to settle the pace of these changes for themselves, and to set tax rates and regulatory burdens that were attractive to enterprise and capable of fostering the faster growth in output they need.
The little discussed issue is why the European Central Bank chose this moment to demand a reduction in its support to Irish banks and their refinancing by the impecunious Irish state.The loan we are all being asked to contribute to is basically a loan to refinance the borrowings Irish banks have been making from the ECB. Couldn’t the ECB have carried on lending enough for a bit longer, and in private worked out a faster and better plan for tackling the problems of the Irish banks with those banks and the Irish government? Such a solution might not have spooked the bond markets as much as their chosen course. If they go on upsetting the bond markets as they have been doing, they might find it makes solving their currency and debt problems more difficult, not easier. In this case, careless talk costs money. Lots of money.