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.