Wednesday, January 12, 2011

Portugal on the brink

For the third time in less than a year, a eurozone member state is on the brink of a bailout. Portugal is about to fall. Today, the governor of the Portuguese central bank finally admitted what everyone else already knew - the country needs external assistance.

A grim pattern has now emerged within the eurozone. In the spring, Greece first paved the way. Before Christmas, Ireland traced out the same sorry steps as Greece. Now, it is the turn of Portugal.

Here is the eurozone crisis roadmap. The journey starts when a vulnerable member state cultivates a serious short-term fiscal difficulty. Financial markets react to this difficulty by raising the costs of government borrowing. Credit rating agencies begin to perceive the growing probability of a crisis and start to downgrade sovereign debt. Despite these howling signals from a market, the government is slow to understand the dangers that are about to befall the country.

Eventually, the penny drops. Faced with growing market pressures, the government attempts to reduce the deficit with a consolidation plan. However, financial markets remain unconvinced and bond yields and CDS spreads continue to rise. Fearing contagion, other stronger eurozone members start a whispering campaign. They privately demand that the failing member state obtain assistance from the European Commission, while publicly denying any attempt at coercion.

Finally, someone from the central bank puts the country out of its misery by acknowledging the need for a bailout. Although the denial continues for a few days within a government, eventually everyone comes to their senses and the bailout operation begins. European public money flows in, and the member state is locked out of financial markets.

Already, another country is lining up to take the place of Portugal. This time, it is Belgium, an ethnically divided country, without the government, and a massive public sector debt to GDP ratio. Beyond Belgium, we have the elephant that will break the camel's back - Italy. A country with one of the largest outstanding debt stocks in the world.

The options before the eurozone are bleak. In principle, the eurozone needs a large fiscal transfer system. Richer northern countries would have to give up a large proportion of their tax revenues and send train loads of cash south to finance the huge deficits on the eurozone periphery. Politically, this option is a non-starter. The governments of France, Germany, and the Netherlands will find it impossible to explain why they need to cut public expenditures at home in order to sustain them abroad.

Since the fiscal transfer system is not an option, Eurozone periphery countries must reduce their deficits in order to minimize their reliance on financial markets. This will mean years of extreme fiscal austerity, declining living standards and deteriorating public services.

There are, of course, two other unmentionable options. The eurozone periphery could default on its debts. The polite description for this option is debt restructuring.  However, a huge proportion of these debts are held by banks in northern Europe. A default is likely to engender a further round of banking sector difficulties where the consequences are much more serious than the last financial crisis. The shock will almost certainly rebound back onto the eurozone periphery, creating even greater fiscal and financial sector difficulties.

The final option is dissolution of the eurozone. The consequences of a euro disintegration are almost too appalling to contemplate. Trade within the Union would collapse completely, and growth would fall into a black abyss. The weaker Eurozone countries would see their inflation rates explode, as their newly minted currencies devalue. Indeed, hyperinflation cannot be ruled out.

If this latter claim seems a little rich, there is a precedent for it within Europe. At the end of the First World War, the Austro-Hungarian Empire collapsed, and with it went the Empire's single currency. The newly independent states introduced their own currencies, which rapidly hyper-inflated.

Therefore, severe fiscal austerity and a temporary bailout seems to be the least bad option. It is one that Portugal is about to embrace. It is one that Belgium will embrace shortly afterwards.

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