Hamish McRae: Europeans have a right to feel cheated

Economic Studies

The turmoil of the eurozone continues, with this week already proving a particularly difficult one. The immediate issue is that the second bailout of Greece seems to be faltering even before it is in place. The longer-term one is nothing less than the future of the eurozone, for the decisions taken now will help shape the way it develops.

The Greek issue is at its heart very simple. The price of bonds issued by the Greek government has fallen so much that debt issued with a coupon of 6.25 per cent was yesterday yielding more than 19 per cent. In effect, investors are saying that they believe Greek debt is worth between half and one-third of its face value, for if it were worth more, any buyer would stand to make a huge profit when it was redeemed. But under the terms of the bailout, as proposed, holders of Greek debt would get back most of their money. So the markets are saying the deal is dead.

Of course markets get things wrong. They got things spectacularly wrong when they bought all that Greek debt three or four years ago. But their judgement matters now because Greece, and the other weaker eurozone nations have to be able to fund themselves on the public markets. They cannot rely forever on loans from the rest of the EU.

This simple point – that the individual countries have to be able to borrow on their own guarantee – is at the core of the eurozone as present constituted. The proposal being kicked around that there should be an issue of so-called "eurobonds" would change that. These would be bonds guaranteed by the eurozone members as a whole, in proportion to their size. So Germany as the largest economy would guarantee something like 30 per cent of the loan while France would do another 20 per cent. In theory such bonds would not be quite as good as a true German bond, or even a French one, but issuing these would help fund the countries that are either unable to borrow from the markets or can only do so at prohibitive rates.

There are, however, grave problems with this. One is that Germany would be stretching its creditworthiness, adding to the notional debts of the German state itself, already more than 80 per cent of GDP, a touch higher than the UK. Another is that in exchange for guaranteeing the bond the strong countries would need to have some sort of say over the ways the money was being deployed: they would in effect have to run the finances of the weaker ones. Another is the arithmetic of Europe. Germany and France are large enough to be able to guarantee Greece and Portugal. But were Spain and Italy to need to finance themselves with central funds, even Germany and France might not be strong enough to do so. There has already been talk of France losing its AAA status should it have to extend a guarantee of this nature.

You can always patch things for a few weeks. That is what has been happening. People have given up on Greek debt. The game is over. Everyone knows the country will default. The much more serious worry is Italy and Spain, where investors have been selling in advance of what might be a serious collapse. Since early August, the European Central Bank has been buying Italian and Spanish bonds on the market to stop their price falling too much. But there are obvious practical and constitutional limits to this. The ECB can't just print the money to fund every European country that gets itself into a mess.

Nevertheless, the way the Greek issue is resolved will shape what happens next. One direction would be to let Greece default and sort itself out as best it can. That would lead to months of disruption, huge losses for European banks that hold Greek debt, and the possibility of other countries being forced to default too. The other direction is for the eurozone to become a fiscal union, where tax rates and spending are determined centrally, essentially by Germany but with France tagging along. Those two would in exchange guarantee most of the other countries' debts.

However, this whole process will take a long time and the fork in the path has yet to be reached. European voters have a right to feel cheated. This was not what they were told to expect when the now out-of-office politicians persuaded them to swap their national currencies for the euro all those years ago.

Just how confident do we feel?

The troubles of the eurozone are the principal reason for the blue funk in which the markets have found themselves enveloped in recent weeks, but not the only one. The markets are essentially pricing in, at worst, another leg to the recession or, at best, a lengthy pause before significant growth is resumed. That is, to be clear, significant growth in Europe and North America, for the emerging world is continuing to canter along in decent enough shape.

So what should we look for that will help determine whether it is recession or pause? Since much of the problem in both the US and Europe is one of confidence, policy will matter a lot. If you look around the world there are reasonable reasons for confidence to recover: companies are pretty profitable, debt is being paid off, property prices in many markets have bottomed and so on. But confidence is exceptionally weak.

It will not return suddenly, for that is not the way the world works. Still, even a temporary patch for Europe's woes and a half-credible jobs plan tomorrow from President Obama, would be helpful in turning the tide. Finally the central banks can always print more money. That is the fall-back: concerted action by the Fed, the ECB, the Bank of England and so on to pump more money into the world economy. No one wants to go there, but the idea that policy-makers are helpless is plain wrong.

h.mcrae@independent.co.uk