The huge financial volcano

The huge financial volcano smoking away next to us.
By Nick Louth 

If you are worried about volcanoes, you should forget Iceland.

Right on Britain’s doorstep there is a smouldering debt volcano which threatens to tear apart the  European single currency, ejecting weaker indebted countries like Greece, perhaps Portugal and even Spain, and turn all dreams of European integration and harmony into ashes.

If it goes off, Britain is bound to get caught in the blast.

The eruption would be caused by Greece, which despite all the extra credit and support it has recently received probably cannot pay its debts. If you want to take cover, make a note of 2013 or 2014. That’s when it is likely to happen. But the chances are we’ll get some hefty rumblings much sooner.

“There is a risk that this current crisis could cause the break-up of the Eurozone,” said Ben May, European economist at Capital Economics.

If the worst happens, the euro would collapse, or revert to being a small collection of stronger North European states. The European economy would be paralysed. Banks right across the region, many already on government life support, would take billions in losses in the most indebted countries. Confidence that western governments always pay their debts would be shattered. 

Why we should worry
Should we care? Definitely.

Europe, remember, is Britain’s pre-eminent customer for goods and services, taking more than 55 per cent of our exports and supporting millions of jobs. London’s financial centre, more than any other city, oils the industrial wheels of the continent. UK banks have lent billions to the most indebted countries. Whether we like it or not, we depend on Europe, and on European trade.

Most immediately, we’re not exactly the best creditors ourselves. Britain owes a net £890 billion, and not just to foreigners. Our own pension funds, investment firms and banks are stuffed with government bonds, known here as gilts. Investors already worry that what happens to Greece or Portugal could easily happen to Britain.

If this sounds apocalyptic, I make no apologies. Certainly, the €740 billion (£625 billion) support package for the euro put together at the start of last week by the EU and IMF ended an immediate crisis, but made clearer the dangers of a bigger one. 

Touching the void

Like a group of exhausted climbers ascending an ice wall, the EU this month had to decide whether or not to cut loose its weakest member, Greece, which was dangling over a precipice. Instead, the stronger members, led by France and Germany  pledged to pull harder, while urging Greece, Portugal and Spain to dump as much excess weight as possible. It isn’t hard to see that the risk is of the whole Eurozone expedition tumbling into oblivion.

But the very nature of the euro makes it very much harder for struggling countries to climb out of debt and deficit problems, because they cannot devalue their currency to create economic growth, nor can they cut interest rates. Right from the outset, it has been obvious that the euro’s biggest flaw is the flip side of its greatest advantage: the fixed exchange rate and interest rate regime among member states.

Britain’s advantage

Contrast Britain and Spain, both struggling with huge debts caused by the global financial crisis, both with banking sectors obsessed by lending on overvalued property, both with big trade and current account deficits, but one out of the euro and one in.

Sterling has on a trade-weighted basis fallen 25% since the start of the financial crisis in July 2007, and exporters’ confidence is now at a 15-year high because the goods that Britain makes and the services it provides are now much more price competitive. However, for Spain that route to growth is choked off. It was the last major European economy to emerge from recession, and still has a staggering 20% unemployment.

Why Greece just cannot make it

Greece, with €300 billion of debt, has worse problems than any of its neighbours, The national debt is expected to reach 120% of GDP this year, compared with 62% for the UK.

There’s a simple rule of thumb which shows the power of debt once it matches income. Lets say an economy owes a trillion on which it pays 3% interest. If it only earns a trillion in GDP, then it needs 3% economic growth just to service the debt. Everything extra you earn goes on interest not repaying capital, so you’re running just to stand still.

Coming an Acropolis?

In fact, the Greek economy isn’t  expected to grow at all until 2013, and then just by 1% according to the IMF. Its debt is expected to peak at 150% of GDP in 2013 according to ratings agency Fitch, and its average cost of existing debt is 4.5%.   

Clearly Greek debt will continue to worsen for years as it borrows to pay interest. Though the government will undoubtedly chop back its spending deficit  from its current 13.6% of GDP, its target of knocking 11 points off it by 2013 is “historically unprecedented” according to Fitch. In the meantime, Greece will still have to borrow to fund spending too.

 As Thomas Mayer, chief economist at Deutsche said last month,  Greece has entered "a death spiral of government insolvency."

Likely scenarios

Greece is going to be okay for a couple of years. The European support package, of which €110 billion was in loans to avoid Greece seeking new debt, won’t run out until 2013 or so. That’s when the problems will really begin.

The most likely scenario, and a most damaging one for the eurozone, is that Greece finds it politically impossible to meet its deficit cutting commitments and defaults on its debts. European banks alone have €272 billion tied up in Greece, according to the Bank of International Settlements, so the financial and political fallout across the European economy would be enormous.

Exit sign for the euro

It gets worse, though. By 2013 there is a good chance that eurozone interest rates will be edging higher to deal with the inflation that has always been the European Central Bank’s primary concern. That won’t be any help to Greece, which will want to boost its economy at any cost.

Though Athens would be reluctant to leave the Eurozone, it restores the two key tools of economic policy – interest rates and exchange rates – and would be domestically less painful than further squeezing a restive population who are already furious with proposed cuts.

However, by leaving the euro and returning to the drachma, Greece would point the way to the exit for any other economy which in the future doesn’t like the medicine which euro membership might force upon it, not to mention leaving a gigantic loss for those who had lent it money.

As German chancellor Angela Merkel said yesterday, when introducing a ban on trades which could be used to undermine the euro: “It is a question of survival. The euro is in danger. If the euro fails, then Europe fails.”

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