European Sovereign Debt Crisis—What’s the End Game?
Why is Europe standing on the cliff’s edge? What went wrong? How did we get here?
These are simple questions with anything but simple answers. To help illuminate the issues, I hosted a live webinar on 11 October 2011 featuring two experts on the eurozone crisis: Riccardo Barbieri, director of economics at investment bank Mizohu International, based in London; and Toby Nangle (pictured left), director of fixed income at Barings Asset Management, based in London.
Barbieri sees the eurozone’s travails primarily through the lens of a sovereign debt crisis that has been exacerbated by structural flaws in the European Monetary Union (EMU). Nagle, for his part, sees a witch’s brew of too much debt everywhere — from banks, to governments, to the financial system itself — due to the massive amount of derivative assets in play.
The complete webinar is available on the CFA Institute website. My four key takeaways from the discussion are as follows:
- The “easy money” policy of the European Central Bank was driven in part by the need to keep interest rates within striking distance of the U.S. Federal Reserve. As the Fed reduced interest rates in the mid 2000s, the ECB largely followed suit, keeping rates in the eurozone only marginally above the Fed’s so as to protect the euro and maintain European exports. Did the ECB have a choice? It did not, Nagle asserted, “lest Europe cease its export business due to a strong euro.” The result was that in Europe, as in the United States, a dovish monetary policy led to an excessive ramp-up in debt across the consumer, banking, and government sectors.
- Europe’s lack of a common fiscal policy is a monetary straightjacket. Although the EU has been criticized for not having engineered a fiscal union from the outset of monetary union, there were some good reasons that leaders didn’t take those steps. Most importantly, it would have required eurozone nations to cede their sovereignty to a superregional entity, and many nations were (and are) understandably cautious. So it’s not so much that European officials dropped the ball — it’s that they took what they could get given that they wouldn’t have been able to secure agreement on a fiscal union back when it was being formed. Still, the absence of a fiscal union leaves weaker European nations subject to harsh borrowing conditions. And it is surprising that many of these nations don’t actively work to coordinate their fiscal policies for a more successful functioning of the monetary union. As Barbieri put it bluntly: “I find it amazing that these 17 countries do not cooperate on fiscal policy.”
- Persistent trade imbalances within Europe and with external countries play a key role in this crisis. The common currency absolved exchange rates from performing their normal trade-balancing function, leaving individual countries to act as stewards of their own trade balances. In the absence of willpower, however, the lack of a trade balancing mechanism virtually assures that these nations will incur persistent trade deficits (or surpluses), thereby guaranteeing that they must finance them locally — in good times or bad — a situation that has contributed to the build-up of excess leverage that is now haunting the governments of peripheral economies.
- The massive scale of government intervention is destroying the market pricing mechanism. Market prices are supposed to signal to producers whether or not there is too much or too little of any given product. But excess debt and distorted prices leave market participants wary and confused, with prices trading up on the hope that government stimulus will be large enough and then down again on fears that it won’t be. In that sense, markets are behaving much like a drug addict desperate for just one more fix to get through the day. Unfortunately another hit may provide immediate relief, but addiction never ends well without meaningful intervention and enduring changes in attitude and behaviors.