decision time

In August, I gave an interview to Der Spiegel, saying that the Euro can't last another 5 years in its current form. At the time, many people thought I was nuts. Now, some 3 months later, it looks as if the beginning of the end is near. Yields on AAA-countries like Austria are moving up. Bloomberg reports that Spanish 10-year yields are now above 7%. That's not a catastrophe just yet - Spain can pay a bit more interest, and the debt profile isn't that short-term. But if it lasts any length of time, this is going to be very painful: Higher interest rates mean that the country will need more austerity measures to keep the future debt path under control; output will fall yet further; yields may increase even more. It's now abundantly clear that the last rescue package was a disaster on a monumental scale - forcing a 50% haircut on the private creditors felt good, but now everyone is asking who will be next. If all the promises over Greece were worthless, is the same true for Spain and Italy? Of course; they are too big to rescue outright. The only solution is to convince the markets to keep buying. It's a confidence trick that makes the markets work; once confidence goes, the spreads explode. The more people worry, the higher the yields, the higher the collateral requirements, the weaker the banks.

As the ECB tried to tell politicians for the last year - sovereign bonds are too important as a risk-free asset in the financial system to mess with them. The only solution now, to avoid defaults of Spain and Italy in the near future, is to offer a blanket guarantee of all existing EU debt, incl. Greece; undo the haircut on Greek bondholders; and introduce unlimited bond-buying by the ECB. I won't like it any more than the average German, but there is really no alternative short of a wholesale implosion of the weaker Eurozone economies.  

Europe's spectacular own-goal

The latest Euro summit was meant to build a firewall around Greece, and to isolate it from the other weaker members of the Eurozone. One week later, it is clear that this has failed spectacularly. Yields on Italian bonds are rising; the IMF has now been called in to monitor the budget. What is going on? Why does even the extended bailout fund not do more to stabilize investor confidence? The truth is actually very simple. The 50% "haircut" imposed on the private sector lenders to Greece is a gross violation of everything that European politicians promised until a few months ago. That's a bad way of reassuring investors.

Remember all the claims that no member of the Euro zone would ever default? That speculators betting on this would go bankrupt? That there would be no touching the creditors before 2013? All of this has gone out of the window, as a result of an ugly display of political strong-arming. Just as Germany's first post-war Chancellor Adenauer once said - "what do I care about the rubbish I talked yesterday". True, the politicians had the banks over a barrel; Ackermann could not say no to Mrs Merkel when she insisted on this voluntary write-down. But the obvious implication is that all other promises and declarations are equally empty - that bondholders of Spain and Italy might find themselves in exactly the same spot as the ones who hold Greek paper. Guess what? If you know you can lose up to 50% (up from 21% just 3 months ago -- latest update in November - Greece would now like to default/"voluntarily restructure" 75% of its debt in NPV terms), you don't feel that confident. About anything. How this was meant to solve the deeper crisis is anyone's guess.

With the benefit of hindsight, it's pretty clear that Europe should have just written an XXL-sized cheque for Greece a year ago. The Financial Times Germany is citing a few economists - Aghion, Alesina, me - saying precisely that. Austerity isn't working, and won't work. A single bad day on the exchanges destroys more value than all of Greece's external debt. Yes, Greece don't "deserve" another penny, but that's not the point. Europe has to do what is right for itself, without worrying about moral hazard (let's be honest - how many countries would want to follow the Greek route even if they get a big cheque?) It's time to switch from moralizing and punishing to actual crisis prevention.