The euro area's debt crisis

The Euro Zone’s bail out  strategy to tackle it’s sovereign debt crisis is failing, indeed miserably.  A scheme was introduced in order to help the countries that otherwise cannot borrow at tolerable interest rates (due to high sovereign debt), well that did lower the risk but failed to eliminate the risk that the insolvent country may default for want of short term funds.  The only viable option that can visibly have a positive impact is to restructure the insolvent country’s national public debt.  As old debts are refinanced by issuing new treasury bonds (which is nothing but a result of the increased budget deficits), it will eventually result in increase in the share of such country’s debt held by official sources.

Now economists’ and noble laureates debate amongst themselves whether to restructure the debts of insolvent countries, if so, when? Sooner or later? The right indicator to determine whether  or not actually a debt burden is too heavy to borne is the public debt-to-GDP ratio. Most (so called) rich economies in the West which includes euro area’s most troubled (Greece, Ireland, Portugal, Spain) have large budget deficits which have been ever increasing, more so because it has been the model for their economic prosperity, which is tried, tested and practiced for decades. The larger question is, how huge the debt burden would be when their respective economies stabilize, say in 5 years time.

The Economist magazine has estimated the likely burden for the four most beleaguered euro-zone countries, taking into consideration assumptions about growth and interest rates. Because of the fact that all four countries suffer from lack of competitiveness, a recovery in real GDP in the face of fiscal austerity will probably require a drop in wages and prices. For that reason, it has been assumed that nominal GDP falls before recovering to its 2010 level.

(Source: The Economist)

Experts say that it would take five years of tax increases and spending cuts for each country to reach a primary budget surplus without taking into account their interest burden on public debt. 

In the above mentioned table, we can notice that Greece ends up with a debt-to-GDP ratio of 165% by 2015. Ireland’s projected burden is 125%, Portugal’s 100% and Spain’s 85%.  Only Japan which was driven by massive Govt spending (an explicit way to copy the West model which ultimately didn’t work) has a larger burden than Greece, but Japan is comfortably placed since it sits on huge pile of liquid assets and extremely healthy domestic savings, almost 90% of its public debt is held by domestic savers.  For a small country like that of Greece, a debt-to-GDP ratio of 165% is unbearable, amidst the fact that it’s domestic savings being negligible, well, the bubble can’t grow any longer.

Spain though looks comfortable, is a probable solvent. It’s projected debt burden is comparable to that of today’s Germany and France which are considered safe. On the other hand, Ireland and Portugal look as if they are comfortable, in the sense that a public debt in three figures might be tolerable at interest rates of 4% or so, but would be too costly to bear at today’s bond yields which is somewhere in between 9% to 11%.

If we look at the debt-to-GDP ratio of Greece (165%), we could comfortably conclude that it is better to restructure or write off debts which are unbearable, sooner than later. Greece is under compulsion to halve its debt burden to say 80% from current astronomical levels in order to enter the comfort zone.

To conclude, sovereign default by a rich country like that of Greece could be shocking but feasible. Questions like when and how they would write off or restructure to bring the debt levels to halve of what it is now (projected) remains unanswered. It is for the (so called) intellectuals and economists to devise and execute strategies accordingly, who invariably happen to be the “architects” (if I could call so) of this great economic soup.