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European Debt Crisis

Why the Eurozone is going to break apart


Source:  Oregon Office of Economic Analysis

Note 1: General rule of thumb: the nominal economic growth a country needs to stabilize its debt, if in fiscal balance, is equal to the interest rate paid on the debt

Note 2: These estimates are approximate growth rates and are based on static estimates. Obviously there are dynamic effects at play, especially regarding automatic stabilizer spending on the cost side of the ledger should a country’s GDP contract.


How to interpret this table? Assume that the government of Italy and Spain were able to balance their budgets tomorrow, so as to not grow the debt capital any further. The right-hand column indicates the GDP growth rate that would be necessary to pay the interest on the outstanding debt at current market prices. It becomes very clear that Greece and Portugal are not only illiquid, but insolvent…in other words, there is no way on Earth they can ever grow their way out of debt. But that is not very disturbing, they are relatively small economies with small debts and the rest of the Eurozone could and would absorb their losses in the inevitable event of a default.

Ireland is in a similar camp, though an 8% GDP growth rate was achieved and even surpassed for a time during the “Celtic Tiger” years. Fiscal austerity and anemic aggregate demand among Ireland’s principal trading partners ensures that these rates of growth are truly historic. So the EU has assumed that Ireland will also require some sort of bailout, which will also be managed through the Europeans Financial Stabilization Fund (EFSF).

What about Spain and Italy? Italy has a small fiscal surplus, one of the only G7 countries that can make this boast. The problem with this scenario is that Italy has averaged 1.4% per year over the past 20 years – even excluding the 2008 recession.

Spain, far from having a balanced budget is projected to have a fiscal deficit of 6% this year and 4.4% next year…and Brussels is already warning that Spain will miss its deficit reduction target this year. Thus Spain must grow GDP much more than 5.9%…but with 5 million unemployed (23% of the workforce) and the imposition of “ever greater austerity”, Spain’s economic is even more wretched than Italy’s.

What all this means is that Europe cannot continue down its current path and cannot hope to grow its way out of its debt troubles. What Europe needs to do is to reduce the borrowing costs of the two “too big to fail members”, Spain and Italy, while moving – swiftly – to an orderly restructuring of the debts of Greece, Portugal and Ireland. The longer the latter is put off, the greater the market pressure on Italian and Spanish bond prices will be. In order to reduce borrowing costs, the ECB must 1.) make an unlimited guarantee of liquidity to Spain and Italy; and, 2.) back it up with massive purchases of Italian and Spanish debt.

Spain and Italy both have to roll-over approximately 20% of their public debt in 2012. Much of that will have to be bought by the ECB. The question is whether Germany and France will be willing to pay the price. If Berlin is seriously considering a “core Europe”, then they won’t want the ECB to be saddled with the junk bonds of the members departing the euro. We will very quickly learn which way the winds are blowing, but if Germany lacked the political will to take much smaller measures 18 or even 12 months ago, it is unlikely that it will take the much larger and more painful measures now.

The Euro has almost certainly entered a death spiral, and I would look for a very rapid conclusion to it.

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