Dual debt crises: The abyss that awaits

A week ago last Thursday, global equity markets were sitting pretty, secure in the expectation of good US employment figures and some breathing space in the European sovereign debt saga. Now, that confidence has disappeared. In its place, investors see contagion gripping the eurozone, renewed weakness in the American economy and the looming possibility that the issuer of the world’s reserve currency will default in little more than two weeks. It is hardly the backdrop to the holiday season that policymakers wanted.

As the period of thin financial markets approaches, an August panic similar to those in 2007 and 2008 no longer appears far-fetched. Only this time, the global economy is far less well-equipped to cope.

Policymakers are worried. Ben Bernanke, Federal Reserve chairman, described a possible US default as a “financial calamity” this week, while Guilio Tremonti, Italy’s finance minister, likened the eurozone crisis to the Titanic, where “not even first-class passengers can save themselves”.

The big question is whether the jolt to sentiment is the start of a downward spiral or just a spot of inevitable turbulence in a gradual recovery.

The series of troubling events started a week ago on Friday when Italy, the eurozone’s third-largest economy, became embroiled in the European sovereign debt crisis. Long sclerotic and saddled with public sector debt well in excess of national income, Italy had escaped the attention of bond vigilantes because it shared none of the problems of other peripheral eurozone economies.

Unlike Greece, its government had not concealed its debts. Unlike Portugal, its deficits were under control. Unlike Ireland, its banks had not engaged in crazy lending. And unlike Spain, there had been no residential construction boom or bust.

But with a public debt burden of 120 per cent of national income and with €900bn ($1,270bn) of debt maturing over the next five years, Italy was vulnerable to any change in sentiment. That came on July 8, when investors fretted that political risk could be the country’s undoing.

Silvio Berlusconi, prime minister, publicly attacked his finance minister’s handling of an austerity package proposed by the centre-right government, telling a newspaper that Mr Tremonti “thinks he’s a genius and that everyone else is stupid ... He is worried about the markets ... But I always remind him that in politics the result is made up of consensus and votes.”

Investors took fright at this budgetary spat at the centre of government and sent bond yields on Italian debt to nine-year highs – undermining Italy’s credibility to the point where its debt sustainability was questionable.

On the other side of the Atlantic, US investors did not care too much about the colourful nature of Italian politics but woke on that Friday morning fully expecting payroll figures that would show the US recovery gathering steam. The previous day, a private sector survey of employment had beaten expectations. So the shock was palpable when official figures showed employers had created only 18,000 jobs in June, far below expectations. US equities fell 0.7 per cent on the day.

The descent that started on that Friday continued this week.

In Europe, finance ministers and central bankers continued to bicker over a second package of loans for Greece. With latest forecasts from the International Monetary Fund showing Greek debt is likely to rise to 172 per cent of national income, European officials began to recognise that there was little hope of being simultaneously able to generate a sustainable debt position, avoid any form of Greek default and involve the private sector in new lending to Athens. Something had to give.

But as German ideas of allowing an orderly Greek debt restructuring with private bondholders sharing the pain gained ground, so did the fears of investors in other peripheral economies that they would soon also have to take a hit on Italian, Spanish, Irish and Portuguese debt. These fears were enhanced by a statement from the eurogroup of eurozone finance ministers on Monday night suggesting, without specifics, an agreement on “enhancing the flexibility and scope” of the European financial stability facility, which lends to countries un­able to access financial markets. This was seen as a prelude to purchasing distressed peripheral debt back at knockdown prices, forcing banks to take potentially large losses.

Moody’s, the credit rating agency, responded on Tuesday by downgrading Ireland’s debt to junk status, citing, “the increasing possibility that private sector creditor participation will be required as a precondition for additional support”. By Thursday, Italy found it had to pay 4.93 per cent on its auction of five-year debt, more than a percentage point greater than the 3.9 per cent paid a month earlier.

The rise in bond yields had implications wider than for the Italian treasury. Its economy with high public debt, moderate growth and tight public finances was the model that Greece has been told to follow once it had emerged from the crisis period at the end of the decade. If yields could rise so quickly, threatening Italy’s solvency within a week, Greece would not be safe from a squall for decades.

Even the euro’s fans are worried. Willem Buiter, Citigroup’s chief economist, summarised the febrile mood: “We are talking of a game-changer and a systemic crisis. This is existential for the eurozone.” Jacques Cailloux of RBS says he expects the crisis to “continue deteriorating and threaten the entire euro area”. Policymakers, he says, “still misunderstand market dynamics”.

But fear and dysfunctional politics are not reserved for Europe. At least the continent’s decision-makers pretend to respect each other. In the US, relations between President Barack Obama’s administration and the Republican-led House of Representatives have sunk to a new low, raising the risk that negotiations on the debt ceiling will go beyond the usual brinkmanship and on to outright default.

With an August 2 deadline approaching, the full faith and credit of the US government is at stake. Priya Misra of Bank of America Merrill Lynch says the market reaction to any default – even only just temporary – would be “drastic”. The US “may also lose one of its most valuable assets – the safe haven nature of US Treasuries – which could structurally pressure [bond] rates higher”.

The risk, however small, of a default, pushed Moody’s to downgrade the outlook on its triple-A rating of US sovereign debt to negative on Wednesday as it worried that the stalemate in Washington would also prevent a credible medium-term debt reduction plan. S&P, another rating agency, followed on Thursday, warning that it was so unimpressed by the longer-term budget negotiations that there was a 50:50 chance of the US losing its triple-A status over the next three months.

The IMF and most economists have long recommended that the US should instigate a credible medium-term plan of spending cuts and tax rises, while limiting the immediate up-front austerity. Unless the politics change, the debt ceiling deadline will force the opposite: an immediate retrenchment, hitting the US economy hard, without a plan to bring deficits down in the medium term. A US double-dip would not be in the interests of any country, and the risk comes as the US economy is suffering another soft patch.

On Wednesday, Mr Bernanke acknowledged the economic weakness and committed the Fed “to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly”. His words marked the Fed’s first serious discussion of a third round of quantitative easing.

Legitimate sovereign debt fears in the world’s two dominant economic regions provide sufficient explanation for the change in sentiment of the past week. Another leg of the economic crisis which started in 2007 is a distinct possibility – and exchequers simply do not have the fire-power to offset another private sector panic.

But before pessimism entirely takes hold, there are still reasons why the slide of the past week can be halted.

Officials on both sides of the Atlantic are well aware of the risks they are running. The most likely outcome, to the US budget stalemate and the eurozone sovereign debt crisis, is that Winston Churchill’s wartime assessment of America still applies. It will do the right thing, after having exhausted every other alternative.

Second, the world economy has fundamentally changed: it is much less reliant on the traditional locomotives of the US and Europe than it was. Globally, the recovery is on track and China’s 9.5 per cent annual growth for the second quarter underlined its continued strength compared with weakness in most advanced nations.

These circuit breakers remain the central expectation of investors and officials. The strains will diminish if policymakers step back from the brink and the soft patch firms again.

But if there is any hitch – officials fail to get a grip or growth stutters – the jolts of the past eight days will appear benign.

ft.com