Mohamed El-Erian, chief executive of the bond giant Pimco, said investors were selling risky assets like stocks “globally prompted by concerns about the weakening economic outlook, spreading contagion in Europe and insufficient policy responses.”
With Thursday’s dive, the three major American indexes had erased all of the gains made so far in 2011, with the S.&P. and Nasdaq markedly below the start of the year.
Read it all and take a look at this graph picture which says it all.
Behind the paralysis in Washington and prevarication in Berlin lies a troubling thought. Political systems in thrall to 24-hour rolling news have lost the capacity to make difficult choices. Globalisation imposes wrenching change and simultaneously saps the ability of governments to adapt. Politicians find it easier to argue about taxing the rich or cutting Medicare and about central bank bond purchases versus default than to confront the consequences for western societies of the profound upheaval in the global economy.
So it is tempting to say all is lost ”“ that a political and economic model built on western primacy is cracking under the strain of the shifting balance of international advantage. The American dream and European welfare state are bending to the competitive winds of globalisation.
Tempting but premature. It is too early to despair. What makes the crises in Washington and Europe so infuriating is the fact that, for all they demand hard decisions, they are susceptible to political solution. The missing ingredient is leadership.
Five years ago, I was among those who argued that the probability of a collapse of the eurozone was close to zero. Last year, I wrote it was no longer trivial, but small. The odds have risen steadily since, not because of the crisis itself, but the political response. I now would put the odds of a break-up of the eurozone at 50:50. This is not because I doubt the pledge by the European Council to do whatever it takes to save the euro but because I fear it has left things too late. The council may be willing but it will not be able to deliver. As I argued last week, a eurozone bond is the only solution to the crisis. But this gets progressively more expensive, and politically less realistic, once bond spreads of large countries widen.
The reason a currency union needs a political union is simple. The centre has to have some way of stopping parts of the union from borrowing too much in the common currency at the common interest rate. If some borrow too much they are free riders on the backs of the more prudent areas.
If they go on borrowing too much they undermine the credit rating of the whole area, and force up the cost of borrowing for the prudent parts. To achieve discipline, the centre also needs to send subsidies and payments to the poorer parts, to compensate them for their inability to devalue to price themselves back into a competitive position.
Today the single currency system is suffering from the double stresses of too much borrowing by countries such as Greece and Portugal, who have spent too much and raised too little in tax, and from the need of countries like Ireland to bail out their overstretched banking systems….
The European Union seems to have adopted a new rule: if a plan is not working, stick to it….But their strategy of denial””refusing to accept that Greece cannot pay its debts””has become untenable…
An orderly restructuring [for which the Economist advocates] would be risky. Doing it now would crystallise losses for banks and taxpayers across Europe. Nor would it, by itself, right Greece. The country’s economy is in deep recession and it is running a primary budget deficit (ie, before interest payments). Even if Greece restructures its debt and embraces the reforms demanded by the EU and IMF, it will need outside support for some years. That is bound to bring more fiscal-policy control from Brussels, turning the euro zone into a more politically integrated club. Even if that need not mean a superstate with its own finance ministry, the EU’s leaders have not started to explain the likely ramifications of all this to voters. But at least Greece and the markets would have a plan with a chance of working.
No matter what fictions they concoct this week, the euro zone’s leaders will sooner or later face a choice between three options: massive transfers to Greece that would infuriate other Europeans; a disorderly default that destabilises markets and threatens the European project; or an orderly debt restructuring. This last option would entail a long period of external support for Greece, greater political union and a debate about the institutions Europe would then need. But it is the best way out for Greece and the euro. That option will not be available for much longer. Europe’s leaders must grab it while they can.
Investors are withdrawing cash from money market funds heavily exposed to short-term debt issued by European banks out of fear that a Greek default could spark contagion across the region’s financial sector.
At the same time there is increasing reluctance among US banks to lend to their European counterparts in the past two weeks because of growing worries over Greece, according to brokers and bank traders.
Portugal’s admission that it will probably need a financial bailout raises a question that will shape the outcome of the euro zone’s debt crisis: Is Spain next?
The cost of saving Spain, a €1.1 trillion ($1.56 trillion) economy, would dwarf previous bailouts and could test the financial strength of Europe as a whole.
But if Spain can continue to repair investors’ trust, as in recent weeks, then Europe stands a chance of containing the debt crisis to three countries, Greece, Ireland and Portugal, whose combined economies are half the size of Spain’s.
Brussels has called for sweeping powers for regulators to seize failing EU banks, sack board members, and impose haircuts on senior bank debt, aiming to ensure that taxpayers are never again held hostage by high finance.
Credit default swaps (CDS) measuring risk on German, French and Dutch bonds have surged over recent days, rising significantly above the levels of non-EMU states in Scandinavia.
“Germany cannot keep paying for bail-outs without going bankrupt itself,” said Professor Wilhelm Hankel, of Frankfurt University. “This is frightening people. You cannot find a bank safe deposit box in Germany because every single one has already been taken and stuffed with gold and silver. It is like an underground Switzerland within our borders. People have terrible memories of 1948 and 1923 when they lost their savings.”
The refrain was picked up this week by German finance minister Wolfgang Schäuble. “We’re not swimming in money, we’re drowning in debts,” he told the Bundestag.
There will be sovereign defaults in the eurozone, with a default by Greece now inevitable. Ultimately the thing that underpins any country’s debts is its ability to raise enough tax to service and eventually repay them. Greece cannot hope to do that. Ireland will be pushed to do so but probably can. I would, however, worry about the long-term credit-worthiness of Portugal, Spain and Italy.
So then you have to ask whether a default of a eurozone state breaks up the eurozone. I don’t think we know the answer to that yet. We do know that the Germans, who hold the cards, will do absolutely everything they can to stop such a default, even if they have to grit their teeth as they do so. My instinct is that a country defaulting would not of itself lead to that country leaving the euro, but if its costs and prices were totally out of line, that probably would be the least painful way of extracting itself. If that is right in the short-term, things will be patched up and the euro will come through this downturn intact. But the next downturn, in five or 10 years’ time? Surely not.
If the trouble starts — and it remains an “if” — the trigger may well be obscure to the concerns of most Americans: a missed budget projection by the Spanish government, the failure of Greece to hit a deficit-reduction target, a drop in Ireland’s economic output.
But the knife-edge psychology currently governing global markets has put the future of the U.S. economic recovery in the hands of politicians in an assortment of European capitals. If one or more fail to make the expected progress on cutting budgets, restructuring economies or boosting growth, it could drain confidence in a broad and unsettling way. Credit markets worldwide could lock up and throw the global economy back into recession.
For the average American, that seemingly distant sequence of events could translate into another hit on the 401(k) plan, a lost factory shift if exports to Europe decline and another shock to the banking system that might make it harder to borrow.
“If what happened in Greece were to happen in a large country, it could fundamentally mark our times,” Angelos Pangratis, head of the European Union delegation to the United States, said Friday after a panel discussion on the crisis in Greece sponsored by the Greater Washington Board of Trade.
SPIEGEL: So, what was in danger? Just the banks? The euro? The European Union?
Trichet: We are now experiencing severe tensions, which are coming after the events of 2007-2008. At that time, private institutions and markets were about to collapse completely. That triggered a very bold and comprehensive financial support by governments. And now we see the signature of some governments put into question. This is a problem for almost all industrialized countries. In the G-7, the major economies have a yearly deficit of around 10 percent of gross domesitc product (GDP). In the euro area as a whole it averages 7 percent of GDP. In this situation with extremely elevated deficits across the globe, the markets have singled out a weak link: Greece. Also taking into account the fact that its statistics were incorrect at one time, market pressure was concentrated there and a drastic adjustment program was necessary.
SPIEGEL: Apparently it was not only Greece that came under attack. Portugal was next …
Trichet: In the market, there is always a danger of contagion — like the contagion we saw among the private institutions in 2008. And it can occur quickly. Sometimes it is a question of half days. This is an issue for the industrialized world as a whole….
“We have not relented on our principles,” Mr. [Jean-Claude] Trichet told Der Spiegel, the German newsmagazine, according to a transcript on the bank’s Web site. “Price stability is our primary mandate and compass.”
And in an interview broadcast on Sunday, the U.S. Treasury secretary, Timothy F. Geithner, signaled his confidence that Europe would resolve its debt crisis and that the American economy would withstand its impact. “Europe has the capacity to manage through this,” Mr. Geithner told Bloomberg Television. “And I think they will.”
As investors absorb the details ”” and the potential weaknesses ”” of the $1 trillion European rescue plan, Mr. Geithner seemed to be trying to draw a sharp, if implicit, contrast to remarks last week from another senior economic adviser to President Barack Obama, Paul A. Volcker. Mr. Volcker, a former Federal Reserve chairman, startled some investors when he spoke of a possible “disintegration” of the euro zone ”” a striking shift from his expressions of confidence of only two months earlier.
Ever the academic, Benedict’s speeches to leaders in culture, science and the arts are always among the most personal and carefully considered during his foreign trips. In his address…the pope made three basic points:
”¢ The best of modernity lies in a broad humanistic “wisdom,” expressed in values such as universality and fraternity. That wisdom rests on a three-legged historical stool formed by Christianity, the Enlightenment and secular thought. Trying to suppress Christianity makes the stool wobbly, so the church’s defense of objective truth is a matter of saying “yes” to those values rather than “no” to rival ideas.
”¢ Dialogue among different cultures and philosophical systems is a “priority in the world, from which the church does not intend to withdraw.” In fact, Benedict quoted Pope Paul VI to the effect that “the church must enter into dialogue with the world in which it finds itself.”
”¢ The Second Vatican Council (1962-65) “welcomed and recreated the best of the longings of modernity,” thereby generating “an authentic Catholic renewal.”
Portugal has been seen as one of the European Union members most vulnerable to an attack by the markets after Greece.
The austerity drive is designed to reduce the Portuguese budget deficit from 9.4 per cent of gross domestic product in 2009 to 7 per cent this year and 4.6 per cent in 2011. Portugal had initially targeted deficits of 8.3 per cent of GDP this year and 6.6 per cent in 2011. As part of the cuts, politicians and public sector managers will see their salaries fall five per cent.
The tax rises, which are being called a“crisis tax”, include a 2.5 percentage point increase in corporate tax to 27.5 per cent on annual profits above €2m, a 1 percentage point increase in value added tax to 21 per cent and increases of up to 1.5 percentage points in income tax.
Asked why he had broken a pledge not to increase taxes, Mr [José] Sócrates said: “The world has changed, and how, in the past two weeks.”
Ours is a time which calls for the best of our efforts, prophetic courage and a renewed capacity to “point out new worlds to the world”, to use the words of your national poet (LuÃs de Camões, Os LusÃades, II, 45). You who are representatives of culture in all its forms, forgers of thought and opinion, “thanks to your talent, have the opportunity to speak to the heart of humanity, to touch individual and collective sensibilities, to call forth dreams and hopes, to broaden the horizons of knowledge and of human engagement. [”¦] Do not be afraid to approach the first and last source of beauty, to enter into dialogue with believers, with those who, like yourselves, consider that they are pilgrims in this world and in history towards infinite Beauty!” (Address to Artists, 21 November 2009).
Precisely so as “to place the modern world in contact with the life-giving and perennial energies of the Gospel” (John XXIII, Apostolic Constitution Humanae Salutis, 3), the Second Vatican Council was convened. There the Church, on the basis of a renewed awareness of the Catholic tradition, took seriously and discerned, transformed and overcame the fundamental critiques that gave rise to the modern world, the Reformation and the Enlightenment. In this way the Church herself accepted and refashioned the best of the requirements of modernity by transcending them on the one hand, and on the other by avoiding their errors and dead ends. The Council laid the foundation for an authentic Catholic renewal and for a new civilization ”“ “the civilization of love” ”“ as an evangelical service to man and society.
At a Mass for more than 100,000 people in Portugal, Pope Benedict XVI urged Catholics to re-evangelize society by witnessing the joy and hope of the Gospel in every sector of contemporary life.
“Today’s pastoral priority is to make each Christian man and woman a radiant presence of the Gospel perspective in the midst of the world, in the family, in culture, in the economy, in politics,” the pope said May 11 at an open-air liturgy in Lisbon, the Portuguese capital.
To evangelize effectively, he said, Catholics themselves need to grow closer to Christ.
“Bear witness to all of the joy that his strong yet gentle presence evokes, starting with your contemporaries. Tell them that it is beautiful to be a friend of Jesus and that it is well worth following him,” he said.
Put yourself in the position of a holder of Greek government debt a few years out, just prior to a probable default. Anticipating a default, you would liquidate the bonds to a level that reflects the likelihood of incomplete recovery. Working backward, and given the anticipated recovery projected by a variety of ratings services and economists, one would require an estimated annual coupon approaching 20% in order to accept the default risk. For European governments and the IMF to accept a yield of only 5% is to implicitly provide the remainder as a non-recourse subsidy. Even then, investors are unlikely to be willing to roll over existing debt when it matures – the May 19th roll-over is the first date Europe hopes to get past using bailout funds. In the event Greece fails to bring its budget significantly into balance, ongoing membership as one of the euro-zone countries implies ongoing subsidies from other countries, many of which are also running substantial deficits. This would eventually be intolerable. If investors are at all forward looking, the window of relief about Greece (and the euro more generally) is likely to be much shorter than 18 months.
Still, for Greece, it appears that the IMF and EU will provide the funding for the May 19th rollover of Greece’s debt, so there’s some legitimate potential for short-term relief. The larger problem is that Portugal and Spain are also running untenable deficits (think of Greece as the Bear Stearns of Euro-area countries). European officials deny the possibility of contagion that might call for additional bailouts, but my impression is that Greece is the focus because its debt is the closest to rollover. The attempt to cast Greece as unique is a bit strained – Christine LaGarde, the French finance minister suggested last week “Greece was a special case because it reported special numbers, provided funny statistics.” In other words, Greece gets the bailout because it had the most misleading accounting?
The bottom line is that 1) aid from other European nations is the only thing that may prevent the markets from provoking an immediate default through an unwillingness to roll-over existing debt; 2) the aid to Greece is likely to turn out to be a non-recourse subsidy, throwing good money after bad and inducing higher inflationary pressures several years out than are already likely; 3) Greece appears unlikely to remain among euro-zone countries over the long-term; and 4) the backward induction of investors about these concerns may provoke weakened confidence about sovereign debt in the euro-area more generally.
With Greece inching closer to the brink of financial collapse, fear that the debt crisis will spread rattled markets for a second day Wednesday, while an extraordinary collection of global financial leaders gathered in Berlin to seek a solution.
Shares fell 2 percent or more across Europe and parts of Asia as investors increasingly wonder if Portugal, Spain and even Ireland may not be able to borrow the billions of dollars they need to finance their government spending.
“It’s like Lehman Brothers and Bear Stearns,” said Philip Lane, a professor of international economics at Trinity College in Ireland, referring to the Wall Street failures that propelled the financial crisis of 2008. “It is not so much the fundamentals as it is the unwillingness of the market to fund you.”
Standard & Poor’s cut Greece’s debt to junk level on Tuesday, warning that bondholders could face losses of up to half of their holdings in a restructuring. The agency also downgraded Portugal’s debt by two notches.