There are three possible scenarios. First, the ECB may be allowed to really let loose with “liquidity” – and somehow buy up all the bonds of troubled eurozone nations. But this is exactly the process that always and everywhere brings about high inflation. The Germans would fight hard against such a policy, although it would prevent default.
Second, officials still hope that bond yields for weaker governments widen but then stabilize. This is bad news for troubled eurozone countries, but they manage to avoid default. The rest of the world grows by enough to pull up even the European “Club Med + Ireland”. Call this the trickle down scenario or just a miracle.
Most likely, the situation is about to turn much worse and a third scenario unfolds. The nightmare for Europe is not at this point about Greece or Portugal – it is all about Italian and Spanish bond yields. This week those yields are rising quickly from low levels, while German yields are falling – so this spread is widening sharply. The yields for Spain – for example – are rising because hitherto inattentive investors, who always thought these bonds were nearly as safe as cash, suddenly realize there are reasonable scenarios where those bonds could fall sharply in value or even possibly default. Given that Spain has 20% unemployment, an uncompetitive exchange rate, a great deal of public debt, and a reported government deficit of 11.2 percent (compared with headline numbers for Greece at 13.6 percent and Portugal at 9.4 percent), everyone now asks: Does a 5% yield on Spain’s ten year bonds justify the risk? The market is increasingly taking the view that the answer is no, at least for now. So, we can anticipate Spanish (and Italian) yields will keep rising. In turn, this causes other asset prices to fall in those nations, thus worsening their banking systems, and hence leading to credit contraction and capital flight. It is a dismal prognosis.
Then it gets worse. As rates rise, traditional investors in euro zone bonds, which are pension funds and commercial banks, will refuse to take more. There will be no buyers in the market and governments will not be able to roll over debts. We saw the first glimpse of this on Tuesday, when both Spanish and Irish short term debt auctions virtually failed. Once this happens more broadly, the problem will be too big for even Mr. Trichet or Ms. Merkel to solve. The euro zone will be at risk of massive collapse.
If this awful but unfortunately plausible scenario comes about, there is a clear solution – unfortunately, it is also anathema to Mr. Trichet and Ms. Merkel, and thus unlikely to be discussed seriously until it is too late. This is the standard package that comes to all emerging markets in crisis: a very sharp fall in the euro, restructuring of euro zone fiscal/monetary rules to make them compatible with financial stability, and massive external liquidity support – not because Europe has an external payments problem, but because this is the only way to provide credible budget support that softens the blow of the needed austerity programs.
The liquidity support involved would be large: if we assume that roughly three years of sovereign debt repayments should be fully backed – and it takes that kind of commitment to break such negative sentiment – then approximately $1 trillion would be needed to backstop Greece, Portugal, Spain and Italy. It may be that more funds are eventually needed – but in any case, the amounts would be less than the total reserves of China. These amounts would also be reduced as the euro falls; it could be heading back to well under $1 per euro, which is where it stood one decade ago.
External financial support would only make sense if combined with key structural reforms, including an end to the repo window at the ECB. As former UBS banker Al Breach recently argued, the ECB could instead issue bonds to all nations which would then be used subsequently for monetary operations – every central needs a way to add or subtract liquidity from the financial system. These bonds would need to be backed by a small “euro zone” tax, thus making the ECB more like other central banks around the world. It would no longer accept bonds of “regional governments” in the union as collateral, and instead would buy and sell “eurozone” bonds. These new eurozone bonds would also offer a way for governments to roll over some of their existing debts.
If the eurozone does need this package, it cannot be managed under a “business as usual” model. The funds would need to come from the G20, and extremely tough decisions over fiscal and monetary policy need to be handled in a fair and reasonable manner.
Source: The Baseline Scenario