The recent bloodbath on equity markets worldwide has given observers an eerie feeling of déjà vu that a global economic crisis is kicking in as it did in 2008. Substitute Bear Stearns and Lehman Brothers for Greece, Spain or Italy and the parallels between the Fall of 2008 and the present become evident — notably, as to how the financial troubles of investment banks or insolvent Euro economies can trigger a sharp downturn in economic activity. Such a replay of 2008 is hardly far-fetched considering the odds on prospect of a double-dip recession in the US, still the most powerful economy in the world.
When the all-powerful US economy seizes up, it is bound to undermine the growth prospects of the rest of the world. Nowhere is this more obvious than for the troubled European economies like Greece, Ireland, Spain, Portugal and Italy that need to grow more rapidly so that their debt burden shrinks as a proportion of a rising gross domestic product. The stock market sentiment all over the world remains depressed as attempts to resolve the debt problems in Europe are failing and the likelihood of contagion spreading to even the region’s stronger economies like France.
That Europe, in fact, is likely to be the epicentre of the unfolding global economic turmoil has been brought out forcefully in a recent policy paper, “Europe on the Brink”, by Peter Boone and Simon Johnson of the Peterson Institute for International Economics. In their assessment, the prospect is for the crisis to spread to other nations in the eurozone. Prices of five-year Credit Default Swaps – that offer protection against default across the euro area sovereigns – in Greece, Ireland, Italy, Portugal and Spain are at all-time highs. Market prices imply an 88 per cent chance of default in Greece in five years!
These countries had an incentive to run reckless policies financed by the easy availability of bank loans within the European Union (EU). There was a widely shared perception that if they were to get into trouble, they would be bailed out by deep-pocketed neighbours like Germany. At the heart of this system clearly was a great deal of “moral hazard”. Thanks to the key rules regarding money creation within the eurozone, all the big European banks acquired substantial portfolios of short-term sovereign debt as sovereigns kept borrowing. The perception was that the European Central Bank (ECB) or the EU would never let a sovereign fail.
A parallel with 2008 is what would happen if short-term financing evaporates from the markets. European banks indeed require massive amounts of short-term funding. A stress test of 90 banks showed they owe ¤5.4 trillion or 45 per cent of EU’s GDP within the next 24 months! “Since the ability to raise such large amounts of short-term finance in Europe rests on market confidence that the ECB and banks’ respective sovereigns are standing by as a lender of the last resort, any rapid shift towards a regime where bailouts are unlikely would create liquidity problems for a lot of banks,” they argue.
Europe’s travails are unravelling as deep structural flaws have become apparent. Six months ago, it seemed as though Greece, Ireland and Portugal needed to be hived off, while the remainder could be included in the safe zone. Now it is clear that Italy and Spain would be out of the safe zone. During the 1997 crisis, South Korea provided loans to Thailand only to find itself requiring an IMF bailout! Similarly, Italy was rescuing Greece, only to find itself needing a bailout!
Boone and Johnson examine three possible scenarios for what might happen in the coming months. Under the first scenario, the euro area would try to reassert its commitment to “do whatever it takes” to avoid defaults and inflation. This continuation of the moral hazard regime would ironically require severe austerity for Greece and others on the periphery of the euro area.
The second scenario decisively eliminates the moral hazard regime. While this will not be orderly, the process entails comprehensive and radical action to restructure sovereign and bank debt. This could be achieved by swapping bonds for longer maturities and reducing principal or interest as needed. Extending maturities would raise confidence that troubled nations could repay their debts. Domestic banks could also be recapitalised through a public sector programme. But the troubled nations would still need to end their budget deficits through severe austerity measures as in the previous scenario.
The final scenario is for the euro area to remain in limbo, unable to choose a clear path. Policymakers continue to contradict themselves by promising selective defaults or restructurings of some countries’ debts while maintaining that they can ensure the stability of the rest of the region. But the authors argue that it is an illusion to believe that selective restructuring would not introduce contagion. Such an approach will trigger panic, massive capital flight and disorderly defaults. There is no doubt that under this scenario the unmistakable feeling that the 2008 days are back will be self-fulfilling!
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