Ruin can be averted but long-term reform needed

ASB chief economist Nick Tuffley remains convinced European policy-makers will do enough to avert disorderly financial disruption, but says it may take decades of adjustment to ensure the long-term survival of the euro zone. Business editor DeneMackenzie looks at Mr Tuffley's reasoning.

The debate about how to fix the European cash crisis continued this week as the world's rich and famous gathered at the World Economic Forum in Davos to lend their thoughts to solving what has become a long-term funding issue.

Some of the world's top bankers are increasingly hopeful the euro zone's debt crisis can be resolved and are confident of a deal to ensure Greece's now inevitable debt default will be orderly.

Participants at a private meeting in Davos, which included chief executives from JPMorgan Chase & Co, Barclays, Citigroup and UBS, acknowledged there had been significant progress. Most pointed to the European Central Bank's launching last month of half a trillion euros ($NZ797 billion) in cheap three-year loans as a possible turning point after almost three years of market chaos that has threatened some of the sector's biggest players.

ASB chief economist Nick Tuffley said the long-term survival of the euro zone in its present form would not be assured simply by averting a financial crisis.

"Economic imbalances have built up and to eliminate them will likely require greater fiscal integration and economic reform. The likelihood is that that adjustment will take many years, possibly decades, and will necessitate prolonged economic underperformance and stagnant wages in the peripheral euro-zone nations - eventually restoring their competitiveness.

"This is harsh medicine, but the alternative of exiting the euro would almost certainly prove more costly still."

The catalyst for the present crisis could be traced back to late 2009, when the incoming Greek Government increased the estimate of that year's fiscal operating deficit to about 13% of GDP from the previous estimate of 6%, Mr Tuffley said.

Its European neighbours had since provided two bail-outs but by mid-2011, it was becoming clear that Greece's fiscal position remained untenable.

The wary eyes of investors began to look with doubt on other euro-zone nations with large amounts of government debt. Initially, they were focused on small peripheral countries such as Ireland and Portugal. But towards the end of last year, attention turned to Italy and Spain.

Those two economies were among the largest in Europe and a government default by either would have disastrous consequences for world financial markets, he said.

The huge quantities of Spanish and Italian debt were too widely held and the institutions that held it often relied on its valuation - the perception that it would be paid back - for their own solvency.

"This factor, the perception, is at the heart of the euro-zone crisis." If investors feared a government would not be able to pay back its debts, they would demand higher interest rates on new debt.

That made the cost of servicing that debt higher for the embattled government, Mr Tuffley said.

Higher debt-servicing costs worsened the government's fiscal position even further, which in turn heightened the concerns of investors.

"The danger is this becomes a self-fulfilling cycle whereby the fears of investors drive an otherwise solvent government into default.

"In all likelihood, the peripheral euro-zone governments - with the exception of Greece - are solvent and, given a sustainable cost of borrowing, would be able to reduce their deficits and, eventually, their overall level of debt over time."

The perception the crisis had been brought on by fiscal irresponsibility was not completely accurate, he said.

Before the global financial crisis of 2008-09, Italy's government debt had been falling as a proportion of GDP.

Additionally, the likes of Spain and Ireland were being praised as examples of low-debt, low-deficit governments.

"In fact, Ireland's fiscal position bore a striking resemblance to New Zealand."

Countries that had high levels of outstanding debt, such as Italy and Belgium, had done so for many years without defaulting or investors panicking, Mr Tuffley said.

In the short term, it would seem the disaster of a sovereign default could be avoided as long as borrowing rates for those countries were kept at sustainable levels. The simplest way to guarantee that would be for a third party effectively to guarantee the sovereign debt of troubled nations, thereby restoring confidence among investors.

That could be done by the euro-zone nations collectively, or by the European Central Bank (ECB). So far, both had been reluctant to do so, he said.

The powerful core nations of the euro zone, led by Germany, were reluctant to guarantee or subsidise their southern neighbours, whom they saw as wasteful spenders.

The ECB insisted it was prevented by the European treaties from directly monetising sovereign debts - printing money to fund deficits directly.

The ECB had bought up European government bonds in the secondary market. That had helped to keep the lid on interest rates.

In December, the ECB initiated a three-year long-term refinancing operation in which it lent 489 billion to European banks. The goal of the operation was to provide cheap long-term funding to banks to help them refinance their own balance sheets, meet their own debt repayment obligations and ease credit conditions in the economy.

Also, it would encourage banks to buy more sovereign debt. A second operation was scheduled for next month.

Alongside those ECB measures, the euro-zone countries and the International Monetary Fund had together set up their own assistance measures.

"To be sure, there are several potential risks and road blocks to overcome. The necessary treaty changes need to be implemented and the capital contributions must still be provided by the respective nations.

"Assuming all this goes smoothly, it would seem, then, that these measures will be able to prevent any default in the near term."