Posted by:
Andrew Bell

14 June 2011

The financial columns don’t add up for Greece and the political rows don’t make a lot of sense either. Europe’s management of the sovereign debt crisis has become as unproductive as an Excel spreadsheet with a computer virus.

The rescuing authorities (Northern Europe and the European Central Bank [ECB]) cannot agree on whether the priority is to exact a price from those who have imprudently lent to Greece and other sovereign debtors or to instil confidence that a line has been drawn under the losses, so that borrowing costs for other countries can return to more normal and sustainable levels. If Greece were a company, its banks would probably have withdrawn support and, provided it was not too big, the economy would have sailed on without it. However, countries are not companies, as they can influence the political consequences of financial actions imposed upon them.

Although the principle that bad lending decisions are best deterred by the red ink of experience is a good one, the flawed approval process for approving countries for Euro membership cannot escape blame for contributing to the subsequent lack of discrimination in judging the credit quality of Euro-zone sovereign borrowers.

Whether lenders to Greece were careless or led into error by the way the Euro was conjured into existence (when a liberal attitude was taken towards economic imperfections) is no longer the main question. Just as the banking crisis grew in significance by markets focusing on the next weakest bank after one had failed, Europe has a number of countries with fiscal problems. The lack of closure on the Greek financial rescue has led markets to impose punitive interest rates on other countries whose problems would be manageable with a following wind from economic growth and low interest rates. The problem of market confidence is exacerbating doubts over the solvency of a range of countries. The more the markets lack confidence in the European authorities’ ability to restore normality to government bond markets, the longer the list of potential problem countries becomes. A debt burden that would be perfectly sustainable with 4% interest rates could be insupportable if markets impose rates of 8%.

Whatever “deal” is finally struck to solve (or defer) Europe’s sovereign debt problems has to address the need to boost confidence that the resulting process is both agreed and sustainable. One of the issues haunting markets is that Germany, particularly, seems insensitive to this need and intent on “creating a drachma out of a crisis”.

Aside from this European echo of summer 2010, markets appear to be replaying other worries about a stalling in the global economic recovery. Similarly to 2010, growth has slowed in recent months, while inflation has risen. This has caused renewed concern about “stagflation”, though not much speculation about a renewed recession, which is probably why so far equity markets have taken developments more calmly than a year ago.

Some of the factors which have disrupted growth in recent months are fading (the oil price having fallen back since April and with signs that the worst of the disruption from the Japanese earthquake is over). Others, such as the upward pressure on interest rates from the rise in inflation in emerging economies have not yet reached a turning point, although there are signs of slower growth and softer commodity prices, which suggest that we may be further through the tightening cycle than is generally realised.

Left to economics, the current slowdown in growth and consolidation in equity markets would probably be viewed as a mid-cycle transition period holding relatively few fears for investors. The bugbear is politics, whether the US Congress playing Russian roulette with the threat of a “temporary” debt default or the mess in Europe. Discounting the risk of a US default (with fingers crossed), much will depend whether Europe can resist the temptation to turn crisis from an event into a way of life, since the European financial system is heavily invested in the Euro-zone’s sovereign bond markets. As a result it is vulnerable to multiplied losses if the European authorities fail to put a cordon sanitaire around the unavoidable losses from a small number of minor economies, leading to a more general corrosive erosion of market confidence.

Comments or feedback are always welcome at theblog@witan.co.uk

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