It is hardly three weeks ago that the political leaders of the Eurozone decided once more on seemingly far reaching measures to contain the spreading sovereign debt crisis. But within days, the intended effect faded away. Italy and Spain, the 3rd and 4th largest economies of the Eurozone, are on the brink of a situation in which they will not be able to refinance themselves on the financial markets and may have to call on the EU and the IMF to help them out with credits and guarantees.
The yields on Italian and Spanish bonds have almost reached the level of Greece’s, Ireland’s and Portugal’s when they had to start negotiating their rescue programs. Bond yields are in indicator for probable interest rates governments have to expect when they issue new bonds. Interest rates of 6-7 % for ten-year government bonds are widely seen as the upper limit for refinancing costs.
The sovereign debt crisis has hence escalated to a new level for which the Eurozone is not yet prepared. The measures taken by the special summit of July 21 were once again seen by market participants as being too little too late.
The sovereign debt crisis that has been evolving since the end of 2009 has all the elements of a self-fulfilling financial crisis. Market actors react according to their risk/benefit analysis: if they see a risk of deterioration, they pull out of certain assets – and hence push up its price. Speculative movements on the markets for Credit Default Swaps can deteriorate the situation. All this will show them and others that their assessment was right – and anticipation fulfilled itself without a change in the fundamentals. The government meanwhile has to face higher refinancing costs and may even have to be taken off the market, as has been the case for Greece, Ireland and Portugal.
In order to calm down markets in such a situation – or better, to prevent a self-fulfilling crisis in the first place – only blunt measures can make a difference. Right now, it seems that only a vast guarantee for the debt of the infected member states will be able to break the spiral of market reactions. But the existing and future rescue mechanisms are not designed for handling a sovereign debt crisis in which Italy and Spain need liquidity help. Wishful thinking guided the decision to provide only sufficient money to be able to stabilize the smaller Eurozone members.
Now, financial market reactions have driven the governments into a precarious situation. A much larger rescue mechanism is extremely difficult to implement, and not only from a political perspective. Market conditions have made it economically unfeasible to extend the rescue mechanisms to much larger volumes. If for instance Spain switched sides from being a creditor country to becoming a recipient country of EFSF loans, this implies a much larger load on Germany and France. France could lose its AAA credit rating, which is at risk anyway. It is hence unlikely that the volume of the rescue funds can be considerably increased.
But what if the crisis does not stop? What if Spain and Italy will not be able to get fresh money from the markets when it issues new bonds?
The only actor that is able to contain the crisis at the moment is the European Central Bank. It has restarted its bond purchasing program in order to stabilize the bonds of the shaky Eurozone periphery, including Italy and Spain. The ECB hence fills the gap that the governments have left open. While the ECB has naturally not floated information on the volume of intended purchases of Italian and Spanish bonds, financial analysts estimate that several hundred billion euros will need to be spent.
This strategy comes at a price for the European Central Bank as questions about its independence and credibility are raised. It can hence only be an interim solution, before governments have implemented the agreed reforms of the EFSF – and have maybe taken even more far-reaching decisions.
If the crisis evolves even further, the governments of the Eurozone may be faced with an even tougher decision than they had to face so far. The strategy to contain the crisis and to prevent a disorderly default may not seem viable any longer as they missed the point at which they could have contained the self-fulfilling crisis. The choice may then be either to embark on a substantial step forward by introducing euro bonds, i.e. by jointly guaranteeing for government debt, or to accept a partial and possibly disorderly default of a member state. The latter would, among other moves, require immense efforts to stabilize the financial sector.
Either way, if the crisis deteriorates further, member states face costly options. A serious problem is that national constituencies have not been prepared for these tough choices that are to come. Taxpayers become increasingly reluctant to accept “emergency decisions” over night, particularly if they are expensive and have long-term implications. Throughout the handling of the current crisis, most politicians have shied away from putting the alternatives on the table and from defending their policy choices in a convincing way. All too often, the story was that there were “no alternatives” to the choices taken. There are always alternatives. In order to prepare voters for tough decisions that are to come, the price of the alternatives has to be quoted.
If substantial decisions once again are taken on a Sunday night emergency meeting, populism will be fuelled, polarization between “the creditors” and “the recipients” will sharpen and ratification of these choices through national Parliaments will become more and more difficult. In the battle of interpretation of the quickly evolving events, the Euro skeptics will gain ground. Meanwhile, there is a risk that people forget that it was also reluctant leaders and insufficient European answers that drove the market reactions in the sovereign debt crisis – but not the Euro as such.