Europe has the tools to stabilize and grow

Financial markets are in a severe sell-off. The extended U.S. soft patch is a big part of it, though corporate profits, one of the most dependable leading indicators of an economy’s health, are holding up fine. The debt-limit fiasco undermined any hope that Washington’s current system of diffuse responsibility would provide spending restraint or structural reforms. Of more immediate concern, Europe’s debt crisis is getting worse.

Europe still has several ways to stabilize the debt situation, but it’s not moving fast enough. A salvage plan would have the European Central Bank (ECB) buy periphery bonds now in large quantities, in effect funding the fiscal deficits and debt rollovers. Once the European Union’s new financing facility is ratified by member countries, it will be able to buy periphery bonds, lend directly to countries and recapitalize banks. Since the euro zone’s long-term borrowing costs are very low (the yield for 30-year German bonds is 3%), the excess debt of the periphery countries could be amortized over several decades. With structural reforms that increase labor flexibility, lower wages for new workers and restrain defined-benefit plans, the troubled countries could grow, move into fiscal surplus and stay in the euro.

Today, the ECB announced that it is again buying periphery bonds. If done on a large enough scale, that move could stabilize markets. However, traders say the ECB bought limited amounts of Portuguese and Irish bonds, not Italian or Spanish bonds. Further, the Bundesbank, a key member of the ECB, opposed the resumption of ECB bond purchases, suggesting to markets that the ECB may not be aggressive in its bond buying. Yields on Italian bonds rose to 6.2% from 5.95% earlier in the day while the 10-year yield on Spanish bonds rose to 6.3% from 6% this morning.

Meanwhile, depositors are fleeing banks in Italy and other peripheral countries. Depositors worry that the banks will fail or their deposits will be converted into lira as part of a devaluation. Safe deposit boxes are in heavy demand. This shouldn’t be an insurmountable problem. The ECB is now providing unlimited backup funding for banks and there’s no evidence of flight from the euro itself. Many of the Italian banks are sound, with good loan portfolios in Eastern Europe and adequate capital in reserve.

From a global growth standpoint, the major issue is whether any euro country will depart the euro. That would cause a catastrophic run on euro deposits in other euro countries. As long as that is avoided — German Chancellor Angela Merkel has ruled it out — then part of Southern Europe’s lost growth will be picked up by Northern Europe and global growth rates can probably hold up through a prolonged European debt crisis.

Some analysts are comparing Europe’s debt crisis to the 2008 financial crisis, but I think the Latin debt crisis (which I worked on when I was in the Treasury and State Departments) has more relevance to Europe’s plight. The Latin crisis lasted a long time — from Mexico’s original banking/currency collapse in August 1982 through the Brady bond issuance that began in 1989. During that time, the countries involved went through numerous debt-related crises and declines in per capita income, culminating in Argentina’s total collapse in 2002. Argentina’s example is instructive for Greece because of the depth of the slide in Argentine incomes and the trigger point — a devaluation from the currency board that had been imbedded in its constitution and contracts.

Like Latin America, Southern Europe is probably stuck with a slow bailout from decades of over-borrowing. That will cause years of strain. The goal should be for the countries to institute pro-growth policies — labor flexibility, defined-contribution pension systems like Chile has used so successfully, low tax rates on a broad base — as soon as possible while they work with the European Union to stay firmly in the euro and divide up the losses.

David Malpass is president of Encima Global, an economic research and consulting firm serving institutional investors and corporate clients. Malpass is also chairman of GrowPac.com, an organization dedicated to restraining the growth in government. He ran for U.S. Senate in the New York Republican primary in 2010.

  • C Bronw

    This is the problem in your last two paragraphs.  Any realy solution is goinjg to admit that long slow growth is the outcome of a real bailout.  To admit that would send evertone into a tailspin.  There are plenty of ways to deal with this.  I say bailout the banks through printing of money and loan it to the banks in off balance sheet instruments only forcing them to show the interest that needs to be paid as a liability.  Then all profits go to pay back principle over a very long-time.  Not good for the bankers but good for the rest of the world so we can move on.  Check out http://www.theamazingreset.blogspot.com to get more info on this.  Its the banks not the economy that is killing US and Europe.

  • http://www.facebook.com/people/Ryszard-Ewiak/100001202215731 Ryszard Ewiak

    Before us is the economic and political earthquake. The Bible says: “At the time appointed he [the king of the north = Russia] will return back.” (Daniel 11:29a) It also means the disintegration of the European Union and NATO. This will be a prelude to the war. (Daniel 11:29b, 30a; Matthew 24:7) It will be a nuclear war. (Revelation 6:4) “A great sword” = a nuclear sword. It will not be the end of the world. It will be “the beginning of birth pangs”. (Mark 13:8)

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  • gc

     as a trader that earns 100% of his retirement in that manner i do not share the authors optimism. refinancing un-payable sovereign debt while new un-payable sovereign debt is assumed every day for which all of European banks combined do not have near the reserves to cover leaves two options to avoid default. currency debasement and or tax payer bailout. both of which require the end of deficit spending by European governments which will never happen due to the inherent reverse incentives of social programs. the cake for Europe and the USA is baked. to believe differently is to believe there are Ponzi schemes in which people will be happy to continue paying into despite the truth that these schemes are impoverishing the current payers and they will never have benefits close to what they pay in since earlier payers get much more than they paid in. not to mention the cost/loss of interest. sooner or later people will begin to stop believing in magic beans. then the whole house falls down as people stop or cease to be able to fund the greater and greater costs of the whole social scheme that was never functional from day one. all the hopes people have with keeping these schemes going rely on them jumping off before the crash saving themselves and letting others be killed. nice.