What’s best for politicians is not for the euro

Angela Merkel

Solvency is a concept that bears a variety meanings. It depends on the moment of time that it is required. An entity (nation, bank, company, person) can be solvent in a time T and be insolvent in T + 1. There are a few factors that determine the solvency and that can quickly change. In 2007 Spain was a solvent nation: its debt was 34 per cent of GDP. Today it is solvent/insolvent, according to a number of factors such as the interest rate, the deadline and GDP's growth.

The Spanish official debt figure (according to the protocol of excessive debt of Brussels, that dismisses certain notions of debt, say, defaults) is 78 per cent of GDP. But that number does not say anything if you don't know how much GDP will grow in the years of maturity and which was yesterday's accrued interest rate.

According to Wofgang Münchau in “Why I remain a pessimistic on Europe's solvency“, there is only a decidedly insolvent country now in Europe, which is Greece. He considers Italy and Portugal as solvent countries as long as they are able to grow. Spain is solvent, but their banks aren't, what puts it on the brink of insolvency. The same happens to Portugal and Ireland. Mostly, if we consider the potential multiplier of sovereign risk in the banks of these countries and vice-versa. If the government loses credit, banking assets are depreciated. If banks wobble, public debt increases. These two risks are enhanced by the lack of growth and because European countries are at the same time in a fiscal consolidation phase.

Munchau highlights the conditions that should be taken to reduce the risk of insolvency of the Euro.

“John McHale, economics professor at the National University of Ireland, Galway, has argued that official policy can restore financial health in a self-perpetuating solvency crisis, provided a number of conditions are met. He lists four. First, the liquidity support given through the European Central Bank’s Outright Monetary Transactions program and other mechanisms must be reliable. Second, the conditions must be reasonable. Third, the conditionality must be flexible–unanticipated shocks should not trigger fiscal adjustments in future. Fourth, the link between banking sector losses and state debt must be broken.”

These conditions are not taking place. And what is worse, they are unlikely to materialize.

Draghi's OMT program of purchases of sovereign debt firmed should be in place although Münchau believes it is more and more likely to die before even it starts functioning. It is necessary for the country to have requested a bailout and to have it granted. Something that hasn't been done, yet.

As for fiscal consolidation demands, for the time being it is imperative that a country which does not reach the deficit target must increase savings. We have already seen that this has not worked because during a crisis the negative fiscal multiplier is powerful, and GDP shrinks more than the deficit.

The separation between banking and sovereign debt could succeed with a Banking Union, but German Chancellor Angela Merkel has already said this will not happen.

To sum it up, the assumptions that must be made to foresee a way out of the hole are difficult, and they should all come true. Just an exception: Münchau discards that the ECB could maintain financial stability for more than three years with an unlimited QE. I half disagree since I believe a truly unlimited OMT could boost growth. This has been the U.S. main weapon and so far it has worked.

In any case we can only speak in probabilistic terms. But the truth is that we are most likely to stay stuck. Meanwhile, politicians with more or less influence in Europe have decided that it is better for their career to kick the can down the road.


About the Author

Miguel Navascués
Miguel Navascués has worked as an economist at the Bank of Spain for 30 years, and focuses on international and monetary economics. He blogs in Spanish at: http://http://www.miguelnavascues.com/