The bottom line, writes Münchau in his FT column, is that the national backstops have not removed - and have possibly increased - the total solvency risk in the system.
Distinguishing pure sovereign risk (minus the contingent liabilities for the financial and non-financial private sectors) from risks that have arisen purely in those sectors, my judgement on the solvency of various entities in the eurozone has been the following. In the first category, I consider Greece to be unconditionally insolvent; Italy and Portugal to be solvent – but conditional upon a return to sustained growth. I consider the sovereigns of Spain, Ireland and the rest to be fundamentally solvent – minus the banks, of course. In the second category, I consider the private and financial sectors in Spain, Portugal and Ireland to be insolvent.
Once you conflate sovereign and financial sector risk, the situation becomes more complicated. My bottom line is that the national backstops have not removed, and have possibly increased, the total solvency risk in the system.
Even worse, I believe the outlook for solvency has deteriorated over the past six months due to the effects of austerity on growth at a time when interest rates have hit their lower limit. The economists Dawn Holland and Jonathan Portes have pointed out one other reason why the fiscal multiplier is unusually high at the moment: everyone is pursuing austerity at the same time. We may well have crossed the line where austerity not only raised debt ratios in the short run, which is to be expected, but may end up increasing them even in the long run – so that it becomes self-defeating.
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 programme 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.
I concede that these conditions, especially the fourth, could restore solvency everywhere except in Greece. The problem is that they stand in contrast to official policy.
You have to make some brave assumptions about the future – continued rollover, separation of banking and sovereign risks, readiness for fiscal transfers, readiness to abandon austerity – all of which stand in complete contrast to officially announced policies. Solvency thus depends on the assumption that official policy is a lie. One could make that assumption, of course. I have not, and would not.
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