Downgrades and Default
While financial markets seem to have shrugged off last week’s downgrade of France and other euro zone members by the rating agency Standard & Poor’s as yesterday’s news, Europe’s politicians are still up in arms. Some even suggest a concerted attack by the United States against the Euro is under way. In an interview late last week with the German daily “Die Welt”, Elmar Brok, an influential European MP representing the German Christian Democrats, lumps together rating agencies, politicians like Republican presidential contender Mitt Romney, members of the Obama administration, and U.S. investors into an anti-European conspiracy.
While such blunt assessments don’t yet represent commonly held views, they do seem to be gaining ground in Europe. Many European politicians, not unlike their U.S. counterparts, are tempted to look for scapegoats. Needless to say, such exercises in finger pointing on both sides of the Atlantic will neither solve the euro crisis, nor spur the sluggish U.S. growth.
What many Europeans still fail to understand is the fact that they themselves are largely to blame for fueling widespread doubts about Europe. While nobody ever seriously viewed the financial crisis and the resulting recession as a danger to the cohesion of the United States, many in Europe today are not so sure that the crisis will leave their continent wholly intact. Will the euro survive its first real test? And if it fails, can the European Union absorb such a shock without falling apart?
Many still believe that these questions will remain unanswered as long as a credible and lasting solution for Greece fails to emerge. However, while it is still widely accepted that Athens was the epicenter of the sovereign debt crisis, many in Germany’s government coalition have recently come to the conclusion that the crisis has reached a stage in which the question of the euro zone’s future can be divorced from the Greek mess.
Some leading members of the ruling Christian Democrats in Germany are now openly talking about a Greek default as unavoidable. They believe that an exit of the country from the euro zone is increasingly likely. This assessment rests on doubts about Greece’s capacity to survive the current vicious cycle of austerity measures and a deepening recession without leaving the common currency area. Many economists, looking at the bare facts, have come to the same conclusion.
However, a Greek exit today would be no less disruptive for the rest of the euro zone than two years ago. Although Chancellor Angela Merkel has more breathing room than other European leaders before facing her next general election, she too wants to avoid this crisis from claiming other victims – such as Germany’s export driven economy. Up to now, she has been adamant that a Greek solution will be found within the euro zone. In a recent interview with Bloomberg TV, one of Chancellor Angela Merkel’s main economic advisors Wolfgang Franz predicted that a year from now, the currency bloc would still have all of its current 17 members. However, he did not say whether or not he believes that Greece will default.
With many financial investors still looking for signs of weakness, a Greek default and the increasing possibility of a Greek exit from the Euro would doubtlessly set off a new bout of uncertainty and increase market pressure on euro zone countries. The fact that France has lost its triple-A rating, and that Italy has been further downgraded, increasingly complicates the picture. The already fragile balance recently achieved by the combination of fiscal austerity and a more active role of the European Central Bank could be severely disrupted by a dramatic worsening of the Greek crisis. The result would likely be a new round of attacks against almost all other peripheral and core Euro countries, including France. The situation might look something like this: Interest rates for sovereign bonds would shoot up and banks would further reduce exposure to risk; The European Central Bank would be forced to write down its stockpile of Greek debt and face rising doubts about all its sovereign debt holdings; Faced with crippling recessions, most European governments would resist any additional austerity measures and openly revolt against what is perceived as Germany’s diktat; The upcoming presidential election in France would turn even nastier and some European governments that have enforced draconian austerity measures would be toppled, unleashing a new round of uncertainty. In short, there would be no winners.
It is therefore clear that, unless the euro zone erects an impenetrable firewall around Greece in the next few months, any further movement towards a Greek default would make things much worse.
But the German government still pins too much hope on a timely agreement for a tight fiscal compact. The treaty, in whatever form it takes on January 30th, will probably not be sufficient to lower interest rates in peripheral countries, unless accompanied by a credible German commitment to put more hard cash on the table. To create a real deterrent, the cap for the combined forces of the temporary bailout fund, the European Financial Stability Facility (EFSF) and its future successor, the European Stability Mechanism (ESM), needs to be raised substantially above the current limit of 500 billion Euros. The ECB needs to stand by with all of the weapons at its disposal, conventional and unconventional. Unless all of the above can be achieved, allowing a Greek default or worse, namely an exit from the euro zone, would be close to suicidal.
Critics might say that, even if enacted, such steps would only buy time and fail to solve the underlying, structural problems of the euro zone. Some suggest that there are too many moving parts for this movie to have a happy ending. Perhaps. But the unquenchable human desire to create a perfect world has historically caused much suffering. A perfect Union may be impossible, and will certainly take a long time to build. For now, all that the euro zone can realistically hope for is to correct some of its defects and work its way out of the current crisis of confidence. It is a path that requires patience, a steady hand from all leaders and, last but not least, as little finger pointing as possible.