Is the European Crisis Over ?

We are at a bifurcation point: Things can become really good at long last, but they can turn into outright disaster virtually overnight. A column by Charles Wyplosz.

Charles Wyplosz
«In 2010, the markets adopted the darkest possible scenario. Now they adopt the rosiest one.»

For the first time since 2010, following on the footsteps of Ireland, the governments of Greece and Portugal are able to borrow on the financial markets. The European leaders have concluded that the crisis is over. They are self-congratulating themselves for their deft management of the crisis. If this were true, it would be an immense relief, and not just for the European citizens. Unfortunately, it may be premature to declare victory. Worse, the feeling that the crisis has been dispatched could lead to the kind of complacency that created the crisis and made it worse once it got under way.

Even if they are recovering access to the financial markets, the crisis countries still have to offer pretty steep interest rates to be able to borrow. Greece faces an interest rate of some 6% on ten-year bonds, a spectacular decline of 30% just two years ago, but still higher than the 1.6% rate asked of Germany. The difference simply tells us that the financial markets do not consider the Greek government debt as safe, and much the same applies to several other countries. But then, why would markets lend at all? Several stories make the rounds.

First, with interest rates of advanced economies bonds so low, investors are desperate. This is especially the case of insurance companies and pension funds that need the interest income to carry on with their business and are precluded to acquire risky assets. Viewed this way, receiving 6% on Greek bonds is attractive, at least as long as the government honors its debt. If investors believe that there will be no default for a year or two, the interest is well worth the risk. But investors have been burned again and again ever since finance has been invented whenever they believed that it will always be possible to get rid of risky lending when the tide is turning. Panics occur when everyone wants to sell at the same time. Losses mount and the vicious circle that soon unfolds turns a happy story into a nightmare. It may be that financial markets have short memories or it may be that they are smarter than that.

Investors still count on public guarantee

This is where a second story comes in. The situation in the Euro Area has improved dramatically in mid-2012 when the ECB announced its OMT (Outright Monetary Transaction) program, in effect committing to prevent «unjustifiably high» interest rates. This program has never been tested, such is the credibility of the ECB. But the commitment is conditional on a country being under a stabilization program, and Ireland and Portugal just exited their programs. This means that the ECB guarantee is not guaranteed any more. On the other hand, the ECB has indicated that it could soon restart a form of LTRO (Long-Term Refinancing Operations), lending virtually unlimited amounts to the markets or credit institutions. So, somehow, a plausible interpretation is that investors consider that there is one form or another of public guarantee.

The problem is that the Greek public debt now stands at about 175% of GDP. At the end of 2009, it was 130% of GDP, a level that markets then considered as totally unsustainable, hence the crisis. The third story is that Greece (and Portugal, and other countries) have enacted deep reforms that make them able to sustain much higher debts, presumably through faster economic growth. One can only wish that this is the case, but this is not what the financial markets seem to believe either.

So this leaves us with yet another, worrisome story. In 2010, the markets panicked, as they occasionally do. The Greek government was bankrupt, they said. The euro will blow up, some argued. Now they think that the situation has stabilized, at least for a while. In 2010, the markets adopted the darkest possible scenario. Now they adopt the rosiest one. They did not quite believe the disaster scenario, but each investor worried that others did and no one wanted to be the last one to sell. In addition, they calculated that the other governments would eventually bail Greece out, and they were right. Now they make the same bet. But it is just a bet and many investors remain highly concerned. They can easily revert into panic mode. Any small incident could trigger an instantaneous shift back into pessimism. The situation, therefore, remains highly precarious. The sun may be shining, but it is surrounded by dark clouds

Swiss Franc could be stuck at 1.20 again

While markets are subject to huge mood swings, governments are structurally optimistic. They hate to be pressed by events to carry out drastic action, especially when the action is divisive. If there is no urgent need to deal with public debts throughout the Euro Area, they turn their attention to other issues, and they face many of them: countless domestic problems, upcoming elections, Ukraine, Syria, and many more. A new European Commission will have to be created in the fall, and that will lead to the usual intense horse trading that we are accustomed to see. Meanwhile, Europe is a topic that is best ignored. Governments can enjoy a break and spend a happy Summer.

With some luck, market euphoria will last long enough. Maybe the European consumers will take all of this as a signal that the crisis is over. If they do and start spending more, the crisis will be over, indeed. The optimists will have been vindicated as growth will strengthen, tax income will swell and deficits finally decline without more crippling austerity. This could be helped by the ECB if it finally decides to act, officially to fight deflation risk but in effect adopting a more expansionary policy stance. After all, the Bank of England has powerfully helped a rebound in the British economy, much as the Federal Reserve did earlier for the US. Note in passing that this would not be good news for the Swiss National Bank if, as is likely, it means a significant weakening of the euro. While many people start talking of exiting the exchange rate floor, the franc could become stuck at 1.20 again.

Even so, public debts are huge in many countries, including Italy and France. Luck can only take us so far. Even the most ardent optimists do not foresee really rapid growth in the Euro Area so that budget surpluses, if and when they are achieved, are bound to remain small, meaning that it will take decades to bring public debts down to comfortable levels. Meanwhile, public debts will remain a serious threat. To make things worse, private debts, already very high in many European countries, could become ever bigger. Several years of very low interest rates are the surest path to disaster. Borrowers are encouraged to invest in low profit projects. Asset prices rise because future expected incomes are hardly discounted. Housing prices are increasingly disconnected from reality. And then, when interest rates are finally normalized, all previous calculations must be radically changed and disaster happens. We have been there already, we know the story, but it does not mean that we can handle it.

So, where does this all take us? We are in one of these delicate periods where uncertainty about what is in store is enormous. We sometimes call it a bifurcation point: things can become really good at long last, but they can turn into outright disaster virtually overnight. It is very hard to see how the problems that we face can fade away but it is very easy to imagine how the situation can turn sour. The best story to explain the willingness of markets to lend to heavily indebted governments and private borrowers is that the near future is probably safe. Probably. Meanwhile, summer is coming and no one wants to waste this precious moment. Especially if we all know that summer does not last forever. Enjoy!