We all know that individuals and corporations can spend more than they earn only as long as others continue to lend them money. And when debts exceed ability to pay, bankruptcy follows.
The same financial reality applies to countries, where bankruptcy is known as defaulting. The largest defaults in recent memory were 64 billion euros by Russia in 1998 and 66 billion euros by Argentina in 2001. (Amounts converted from national currencies).
While these defaults roiled global financial markets, they pale in comparison to the eurozone debt crisis. Tiny, teetering Greece has a national debt of more than 360 billion euros. Portugal and Spain owe 170 billion euros and 740 billion euros, respectively. Then comes Italy at a staggering 2.3 trillion euros.
Given the huge struggle to prevent a Greek default, it’s clear that the so-called European Financial Stability Facility is ill-equipped to stop a Spanish default and would be virtually helpless in the face of an Italian default.
Even at the height of the pre-2008 economic boom, eurozone countries were borrowing to pay for extravagant social entitlements. Rather than pulling back on spending as the recession diminished revenues, trillions more were borrowed to finance stimulus spending. A sovereign credit crisis loomed.
Then, rather than cutting Greece loose after it was revealed that the country had gained membership by fraudulently hiding its true financial position, the eurozone poured 250 billion euros into bailouts. Now, after what some label as draconian austerity measures, almost all eurozone countries continue to run deficits. Financing those deficits, along with renewal of expiring debt, requires a continuous stream of new bond issues. Interest rates on Spain’s bonds have jumped to record levels and Italy’s borrowing costs are rising dangerously.
Survival of the eurozone requires investors to gain confidence in its ability to protect its beleaguered members from default. But how?
As eurozone leaders passed their 20th crisis summit, it’s clear that Germany is not going to agree to the euro-bond proposal by which all members assume liability for the massive bond issues that may be needed. The International Monetary Fund is trying to raise more funds to shore up the eurozone, but the U.S. and Canada are understandably reluctant to send taxpayer cash to profligate Europe.
And it’s highly unlikely that economic recovery will shore up eurozone balance sheets. Recovery from business cycle recessions has always been private-sector driven, as businesses invest in cost efficiencies and pursue changing market opportunities, putting people back to work and strengthening consumer demand. But this is not a business cycle recession. It’s a sovereign debt crisis, the likes of which the world has never seen.
The only remaining way for the eurozone to regain investor confidence is to boost European Central Bank (ECB) reserves by radically increasing money supply. Methods include lending more to the banking system at attractive rates, which the ECB has already been doing. But the most powerful way is purchasing private-sector financial assets with electronically created money. This policy, known as quantitative easing, has recently been used by the U.S. Fed. But building enough reserve to shore up the finances of Spain, Portugal and Italy would require creating more new money than in recorded history, driving down the euro and triggering high inflation rates.
The consequences would be profound. High inflation brings with it a huge moral hazard in that the value of personal savings and pensions collapse, while those who have lived beyond their means are rewarded by the reduced value of their debts. Getting runaway inflation under control is extremely difficult.
The singular mission of central banks has been to control inflation. But for fragile eurozone countries, the dreaded devil of inflation may seem like an apparition offering salvation.
Gwyn Morgan, former president and CEO of EnCana Corporation, is a director of two global corporations.