Just a few weeks ago, all was right with the world. The kids were dressed as ghouls and goblins. The Federal Reserve was preparing a massive $600 billion money printing operation. The "pro-business" Republicans were poised for electoral victory. And Europe was on a roll and preparing to withdraw stimulus as the euro soared and the memory of the Greek debt crisis faded.
But that's all changed.
Ireland has been bailed out to the tune of $110 billion. Greece, struggling to repay its bailout loan under the weight of severe budget cuts and tax hikes, asked for a six-year repayment extension. Spanish and Portuguese bond yields have soared to record highs. Spain and Italy are having trouble raising money from private investors. Even so-called "semi-core" countries, which include the likes of Austria and Belgium, are coming under pressure in the credit derivatives market.
Slowly, people are beginning to realize that the eurozone's debt problems are structural. And that means adding more debt to countries like Ireland, already struggling to repay creditors, is a recipe for disaster -- a disaster that could pull the global economy into the double-dip recession that was so feared earlier this year. And it could potentially undermine the euro.
On Tuesday, the fears spread to the "core" countries of the eurozone and the center of Europe's financial system. There was trading desk chatter, reported by the folks at TradeTheNews.com, that Germany's Landesbank was facing liquidity problems and that the analysts at Standard & Poor's might downgrade France's credit outlook to negative. And there were rumors that U.S. banks were refusing certain euro-based banks in the swap market -- a sign of extreme risk-aversion.
So while it may be tempting to just write off Europe, we've all got a lot riding on the question of whether Europe can save the euro and itself.
Reasons for worry
One big worry: Germany and France are both still determined to hand losses to bondholders in the case of any future government debt restructuring. While this makes political sense (blame the speculators!), it results in nervousness and further damages the solvency of Europe's banks because they are the major holders of eurozone debt -- not villainous Wall Street hedge funds.Indeed, according to JPMorgan's Michael Cembalest, a 20% loss on French bank exposure to Greece, Ireland, Portugal and Spain would wipe out French bank equity. Widen the net to include German and British banks, and you can see the scale of the potential losses that would result from even a small debt restructuring.
Two, Ireland's bailout is fighting a problem of too much debt by adding on more debt -- albeit at below-market rates. At best, this is merely giving the Irish time -- in the hope that the global economy will recover, that Ireland will recover, and that the government's fiscal position will recover as tax collection rises and spending on things like unemployment benefits and bank bailouts subsides.
Unfortunately, the bailout will force strict austerity measures on the country. The government will have to cut its budget deficit from 9.5% of GDP next year to just 3% by 2015. That will be tough even if the Irish government's rosy growth predictions are true. Some $5.2 billion will be cut from social welfare and $4 billion from investment in physical infrastructure, income taxes will rise by $6.8 billion, and government workers will see a $1.6 billion cut in pay. All of this will dampen consumer confidence and spending -- amplifying the problems in the Irish housing market, where prices are still falling.
Continued: The burden shifts to taxpayers
