The problems with the European economy are continuing with Fitch's recent downgrading of Portugal's sovereign debt. At the same time as Portugal's downgrade, the EU and IMF released a plan where they would work together to bailout the Greek economy if they are not able to bail themselves out. This article has been republished from The Mess That Greenspan Made.
It was another tumultuous week in Europe but one that, in my view, increased the odds of the common currency surviving over the long-term and carried valuable lessons about what can and should be done in other Western nations such as the U.S. and the U.K. where similar structural budget problems continue to fester.
Early in the week, Fitch Ratings downgraded Portugal sovereign debt and, in the absence of any news flow in the run-up to a meeting of the EU (European Union) on Thursday, the euro tumbled to an 11-month low. The ratings agency warned that another downgrade for Portugal could follow and it looked rather bleak for the “single unit” until an agreement was struck between German Chancellor Angela Merkel and French President Nicolas Sarkozy on terms of a bailout for Greece, should one be required, that included support from the IMF (International Monetary Fund).
Like Greece, Portugal is struggling with large budget deficits, large trade deficits, and continuing economic contraction that has led to high unemployment, though none of these conditions are as bad as their Aegean neighbor to the East is now seeing. With budget fixes not coming fast enough to bring their deficit below the euro zone limit of 3 percent by 2013, Fitch lowered their sovereign debt rating to AA-minus, just above the BBB-plus for Greece, the lowest in the euro zone. In a statement, Fitch noted, “The planned deficit adjustment is back-loaded and the risk of macroeconomic disappointment … is significant”.
While this came at an unfortunate time, just as EU leaders were dealing with new concerns about Greek debt, it was not a surprise as the Portuguese government has struggled in making necessary spending cuts and, importantly, this will not be the last of the debt downgrades in the region.
In a hopeful development late in the week, Standard & Poor’s reaffirmed Portugal’s A+ long-term and A-1 short-term foreign and local currency sovereign credit rating, citing progress made so far in executing fiscal reforms, but they also said their outlook remained negative.
The week’s most important news came in advance of Thursday’s gathering of the 27-nation EU when a deal was finally struck between Germany and France on how to provide tangible support to Greece, Angela Merkel succeeding in getting the IMF involved, noting that, “Europe in and of itself is not in a position to solve such a problem. The IMF simply has more experience.”
While much of the rest of Europe didn’t share this view, it appeared to be the only way in which a consensus could be reached and the 16-nation euro zone – the core of the European Union – ended up supporting the deal.
The agreement lays the groundwork for a combined EU – IMF bailout that would be offered only as a last resort, should the Greek government not be able to borrow funds that are needed to roll over some $27 billion in debt in April and May. Also, it serves to override the “no bailout” agreement amongst European countries, a major impediment to previous rescue efforts, and all European countries will maintain veto power over providing bailout funds since there must be unanimous support for any decision to provide aid.
This development was seen as a major victory for Germany and Ms. Merkel and a big step toward the EU cobbling together a political structure to deal with the economic and financial crises of recent years, a feature that had been absent from the currency union since its formation in 1999, but one that hasn’t been needed until recently.
On news of the accord, Greek officials expressed relief that a compromise had been reached after they had complained loudly in recent weeks that vague guarantees were not sufficient. Greek Prime Minister George Papandreaou said the agreement was “sending a very positive message to the markets” and Greek bond yields fell modestly.
What, if Anything, Does All This Mean?
It’s hard to say what might happen next in this ongoing saga of a monetary union attempting to develop a political structure during a time of crisis, but, last week’s agreement is certainly a step in the right direction – any agreement at all would have been an improvement over the uncertainty of the last month or two.
Unfortunately, there will be little time for credit markets to contemplate the deeper meaning of the accord that was just reached as Greek debt sales will be coming quickly in the weeks ahead, the first big test coming on April 20th when $11 billion in loans must be refinanced. Problems could arise if the Greek government’s finances deteriorate between now and then and, as a result, borrowing costs again rise.
The agreement’s condition for providing aid is that “market financing is insufficient” and there is some debate as to whether sharply higher rates would be considered a trigger. For weeks, Greece has argued that interest rates above six percent were too high and loans at 3.25 percent from the IMF were understandably very appealing. Clearly, the austere Germans are seeking to provide some “tough love” for their neighbors to the south and there may well be even more twists and turns as we get closer to the next Greek debt auctions.
So, what does this mean for the euro and, for that matter, the rest of the world’s currencies?
First and foremost, it is a reminder of the inadequacy of the euro zone as currently constructed. The euro was launched in 1999 as a way to promote cross-border trade and, in that, it succeeded.
But, from the outset of the financial market crises in 2007, its lack of political structure has always been a glaring deficiency as there were no mechanisms in place to enforce strict rules such as annual budget deficits that are capped at 3 percent of GDP and overall public debt that is limited to 60 percent.
As shown in the graphic to the right from the Economist, the recession has caused budget deficits to spiral out of control.
That Greece lied about their finances certainly didn’t help.
The fact that provisions are now being put in place to deal with these shortcomings is a big first step toward a more durable currency union, however, there remain nagging differences between member nations – spendthrift Greeks and austere Germans being the latest example – and there is no guarantee that a one-size-fits-all monetary policy will ever be successful over the long-term. This broader division may ultimately prove to be the currency’s downfall as resentment over what is perceived as heavy-handedness by the Germans grows.
Secondly and, in my view, perhaps more importantly, it is a reminder to the rest of the world that there is such a thing as honoring commitments about fiscal responsibility. As opposed to the U.S. and the U.K., there is more than just talk behind controlling government spending in the euro zone, a reality that should be clear after looking at areas circled in red in the graphic.
While euro zone members put systems into place to enforce fiscal restraint, possibly plunging those nations into a deeper recession in the process, both the U.S. and the U.K. seem determined to “spend their way out” of the economic downturn and it remains to be seen which approach, over the long-run, will be more successful.
Anyone who advocates sound money would surely agree that the Germans are on the right track and that more money printing and bigger budget deficits in the Anglo-Saxon world are destined to produce an undesirable result.
This article has been republished from Tim Iacono's blog, The Mess That Greenspan Made.