Country By Country Financial Analysis

European debt crisis

Throughout the last year, European debt problems have been cited as a threat to both the euro and to the American economy, among other entities. While many correct assertions have been made concerning the potential impact of a European debt implosion, there have also been many ill-conceived ones. It is often faulty economic theory that leads to faulty conclusions. This article revisits economic theory — from a free-market perspective — as it relates to the current European monetary challenges.

The cause of the European debt crisis, in its simplest form, was overspending by (mainly southern) European governments during the last decade, and especially after the 2008 financial crisis. The ECB (European Central Bank) enabled artificially low risk premiums on interest rates of government debt belonging to the so-called PIIGS countries (Portugal, Ireland, Italy, Greece and Spain). And these artificially low rates facilitated and encouraged the overspending.

CAUSES

The recognition that overspending had occurred was brought about by reduced economic growth and the subsequent reduced tax revenues, which were less than the amount needed for both expenditures and dept payments.

PRESENT STATUS:

Country By Country Financial Analysis

Against a backdrop of nationwide strikes, the government of embattled prime minister Silvio Berlusconi is scrambling to secure parliamentary backing for a revised reform package, new tax rises and spending cuts. The 20% VAT bracket will be raised to 21% and a special 3% levy will be imposed on incomes of more than €500,000 (£439,000). Berlusconi said ministers would approve a new "golden rule" in the constitution on balanced budgets and simplify local government.

A strike in Rome on Tuesday showed the strength of feeling that richer Italians had escaped tax rises and spending cuts. Analysts believe Italy could be the next Greece. Economist David Mackie at JP Morgan said: "Once you say to Italy, we will not allow you to fail, they then have the upper hand. There has been a moral hazard issue with Greece for some time. Now we have one in Italy, too."

ITALY

Despite its stellar status, Germany is far from all-conquering. The Dax share index has lost 29% since the beginning of July – significantly worse than London's FTSE 100 – while business confidence is tumbling at the fastest rate since the collapse of Lehman Brothers. New data showed a sharper than expected fall in industrial orders in July, especially from beyond the eurozone. German taxpayers are becoming increasingly sceptical about efforts to help eurozone strugglers such as Greece. That in turn has put domestic pressure on the chancellor, Angela Merkel, whose coalition government has suffered a string of setbacks this year.

Germany

Another day, another denial from Spain that it has come close to requiring a bailout. Spain's finance minister, Elena Salgado, rejected suggestions on Tuesdaythat the country nearly called in the International Monetary Fund last month, after a Spanish union leader reported that prime minister José Luis Rodríguez Zapatero had told union and business leaders he had seen "the edge of the abyss, in the form of a bailout for the Spanish economy". Whatever the truth, Spain is in deep trouble. To cut its borrowing requirement, the country has just started a privatisation programme, which includes selling a 30% stake in the national lottery, which it hopes will raise €9bn (£7.9bn), and part of the state airport authority.

The latest data has caused economists to fret that Spain may be heading towards recession.

Spain

Under heavy fire from German and Finnish politicians, George Papandreou's left-of-centre government is facing accusations of backsliding. Having committed itself to huge cuts in state spending and a €50bn (£44bn) privatisation programme to gain a second EU bailout package, the fear around Europe and the US is that Papandreou cannot force through the reforms needed to make the cuts work. The interest rate for the government to borrow for two years is now more than 50%, showing investors do not want to go near the Greek economy. Officials on Tuesday denied newspaper claims they had asked for faster bailout payments to fill the gap left by lower taxes and higher spending.

Greece

There are plenty of economists who put Portugal and Greece in the same boat. Moody's, the ratings agency, says Lisbon's attempts to cut state budgets are failing and it is only a matter of time before officials seek a second Brussels bailout – the first entailed €80bn (£70bn) of loans. Prime minister Pedro Passos Coelho says more cuts will do the trick, despite expecting the economy to contract this year and next.

Finance minister Vitor Gaspar says the Portuguese should expect to pay more taxes next year, including higher VAT and increases for higher earners and companies making big profits. Protests are likely as unemployment is set to head toward a peak of 13.2% next year.

The economy has appeared largely immune from the effects of the current crisis and grew robustly in the second quarter. GDP climbed by 2.3% from 2010 but the latest quarterly increase – 0.4% – was the lowest since 2009, causing economists to worry that the strength of the Swiss franc would put a further brake on expansion this year and into 2012. That is why the Swiss National Bank in effect devalued its currency on Tuesday. The Swiss franc, seen as a safe heaven, had moved close to parity with the euro but its strength has made the country's exports much more expensive and harmed its tourism industry. Swiss residents have been crossing into Germany to shop.

Even so, economists warned that the powers of central bankers can be very shortlived when it comes to currencies

Switzerland

Chancellor George Osborne is to downgrade his growth forecasts for the UK after a series of gloomy business surveys and sharply declining consumer confidence. Stock markets were spooked on Monday when a survey of the vital services sector was the worst for a decade. Services make up 75% of economic activity. A similar survey of manufacturing last week was dire. Constr-uction, once a booming industry, has shrivelled. A double dip recession beckons and some economists believe the economy may already be contracting. The chancellor is sticking to his austerity plan and hoping the Bank of England governor, Mervyn King, can ease the pain by maintaining low interest rates.

Britain

Ireland is in the depths of the worst recession in its history, but there are signs it may have turned the corner. Ireland was bailed out by the IMF with €85bn last year, but some economists believe the austerity measures introduced by the Dublin government are now paying off.

Borrowing costs have fallen and GDP growth is forecast at 1.8% this year. Still, while Ireland is banking on exports to return it to economic growth this year, it also desperately needs to halt the decline in consumer spending in order to meet growth targets crucial to dealing with a mounting debt pile. December's budget already promises to cut spending and raise taxes by at least €3.6bn.

Ireland

While Washington is gripped in an agonizing and potentially lethal game of chicken over the U.S. debt ceiling, the risk of sovereign defaults still remains much higher across the pond, in Europe. Sure, Europe's leaders are probably feeling good about themselves after finally cobbling together a second bailout of beleaguered greece, last week. They also made some important changes to their approach to the debt crisis that give the euro zone a bit more ammunition to combat the contagion spreading to its weaker members, especially Spain and Italy.

However, anyone who thinks Europe has solved its debt crisis is deluding themselves. Even German Finance Minister Wolfgang

schauble admitted that "it would be a mistake to think that the crisis of trust in the euro area can be solved by a single summit." In my opinion, the latest crisis-busting package lacks the muscle to bust much of anything. Here are my six reasons why the euro crisis will still be with us, for a long time to come:

Six reasons Europe's debt crisis isn't over

First, the Greek debt crisis is far from resolved. The latest deal is based on too many “ifs” and rosy assumptions that have a high possibility of disappointing. Athens will still have to implement a politically suicidal austerity plan in a politically charged climate, and based on the progress so far (not one public sector employee has been laid off) there is little reason to be hopeful the Greek government can hold up its end of the deal. The idea that Greece will be able to raise more than $40 billion from privatization over a short period is also highly optimistic. Buyers, knowing they're at an everything-must-go fire sale, will hold out for the best possible prices, and that means low prices. So the holes to plug may end up being larger than expected. And the level of debt reduction the Greeks are getting in this bargain isn't much of a bargain. It looks like Greece's government debt to GDP ratio would peak at something around 150% of GDP even after the recent agreement's debt buyback and bond swap schemes. That's still an unsustainable level. So after months of effort, the euro zone has put together a second bailout that may only lead to a third.

Second, the latest agreement has done nothing to build confidence in the other weak economies of the euro zone. Borrowing costs for Italy and Spain were back on the rise this week. The future course of the euro crisis will still depend on whether or not Ireland and Portugal can fulfill the reform pledges made as part of their EU bailouts and convince investors to start lending them money again, and even more, the ability of Spain and Italy to repair their national finances and stay out of bailout programs. There are no guarantees that politicians in any of these countries can continue to shove severe sacrifices down the throats of the voting public to preserve the euro. That raises the possibility that more bailouts may be on the horizon. New fears erupted this week that Cyprus could be the next country to require a bailout, after Moody's downgraded its sovereign rating.

Third, the second Greek bailout may make future bailouts even more likely. The decision to force losses onto private bondholders (though only fair) increases the risk of holding the bonds of other indebted euro zone governments. That means investors will likely demand even higher yields to continue to fund Madrid and Rome, making it more costly for them to maintain access to private capital. It also might make it more difficult for Portugal and Ireland to turn to private investors to fund themselves once their EU rescue funds run dry. In other words, the Greek bailout, rather than putting the brakes on the crisis, might actually have stepped on the gas.

Fourth, the euro zone still doesn't have the firepower to fight such contagion. Yes, the latest agreement allows the euro's leaders to use their $1 trillion rescue fund more effectively. But the problem is that many analysts believe it is simply not large enough to give the euro zone's bark some bite. A chunk of the money has already been committed to the Greek, Portuguese and Irish bailouts, leaving the fund depleted. And with the other troubled economies – Spain and Italy – so much larger, investors won't be convinced the current fund can achieve much of anything. By one estimate, the fund would have to expand to a lending capacity of $2.9 trillion to do that, but that capacity (net of its commitments) stands at a mere $430 billion now.

Fifth, all of these problems underscore the reality that the euro zone still has no comprehensive solution or approach to solving its debt crisis. Last week's Greek bailout agreement followed the same pattern as all of the other euro zone, debt-crisis agreements – it was made at the brink of the precipice, and promises more than it delivers. The existing system – combining liquidity support matched to austerity programs – has fundamentally not changed. Aside from tweaking the use of the bailout fund, no new methods were introduced to build investor confidence or shore up the financial standing of the PIIGS (like a Eurobond). The responsibility for saving the euro is still very much on the heads of politicians in Spain and Italy. Basically, the euro zone is fighting its debt-crisis with the same playbook that has proven a loser again and again. Is there any reason to believe that playbook will perform any better in the future?

Sixth, the real problem is that the euro zone is still not addressing its deeper problems. There is no action on the sort of wide-scale economic reform across the zone to foster the growth and investment that would help weaker economies return to health. There is still no acknowledgement that the shaky standing of the euro zone's banks is at the core of the problem. The leaders of the euro zone have to finally realize that they are not dealing with a liquidity problem, but a structural problem – that won't go away no matter how much money is dumped into bailouts.