While some leaders in the EU fret that a debt default by one of the sovereigns could trigger a break-up of the currency trading bloc there is a growing narrative as to how to remediate the problem.
In fact, a recent report by the American Enterprise Institute (AEI) notes that a key lesson of the recent global financial crisis was that policy makers failed to resolve losses in “financial intermediaries” (that is money center banks) in 2007 and 2008 that “aggravated uncertainty” which led to a collapse in market confidence.
Eurozone Crisis Needs Decisive Action
Now, as it relates to the sovereign debt crisis, the lesson that should have been drawn is to act decisively to maintain confidence in the global capital markets which is a key element in the current euro zone sovereign contagion, a crisis with three dimensions:
- debt sustainability problems of sovereigns
- bank solvency or capital inadequacy problems, and
- the valuation of exchange rates within the euro zone.
In short the European leaders must urgently respond by making draconian decisions like imposing austerity measures and dramatically curbing entitlements in the floundering nations of Portugal, Ireland, Greece, Spain, and Italy to keep the zone together while the EU must also work with its trading partners to protect the broader global capital markets.
Sovereign Debt is Unsustainable
The overarching problem for these nations is that the massive debts are unsustainable and must be restructured to stem the contagion from infecting the international financial system where banks in the EU, the US and across the globe face exposure and risk. One need only look at the collapse of MF Global trading and how its long positions in euro zone sovereign debt brought down the once venerable primary trader of government securities.
Further, the Basel committee has recently announced new surplus capital requirements for financial firms that have been designated “systemically important” (the so-called “SiFis”) while similar requirements under the Dodd-Frank reform measure in the US show how governments of all concerned intend to restore and maintain confidence in the global financial system.
In order for this to happen, “sufficient funding must be available from a coordinated, large, and credible source to eliminate uncertainty about the sustainability of European sovereign debts,” says the conservative think tank.
This means that the European Central Bank (ECB), the Federal Reserve Bank in the US and the International Monetary Fund (IMF), with Germany at the helm in what looks to this writer like a gambit of monetary brinksmanship, will need to pony up the cash to ensure that liquidity remains in the system in the event of a debt default by one of the sovereigns or a large bank failure. In other words, footing the bill will ultimately fall upon the shoulders of taxpayers. Meanwhile, the ECB continues to buy bonds of the floundering sovereigns (much like the Fed has been doing with Treasury securities, corporate bonds and mortgage-backed securities).
EU Exchange Rate Misalignments
Finally, leaders in the EU must get their arms around “real exchange rate misalignments” that give countries like Germany and France a competitive trading advantage over the weaker southern sovereigns. Of course, the Euro’s should have realized this in 1990 when they were cobbling together a new world to create the euro dollar in a play to compete with the US dollar and have as a wedge against America geo-politically, but what’s done is done.
The long and short of it is that the exchange rates of southern European countries are over-valued compared to the north, and this is where the fault line lays as some of the sovereigns may be forced out of the bloc, and no one knows how that will pan out at the end of the day; however, the prime directive is to keep this from happening.
This is so because global investors in the US, Latin America and Asia are all exposed and the crisis could ultimately hamper global trade meaning all the trade partners would suffer from a significant contraction in the global economy.
In the final analysis, the euro zone crisis ultimately needs to be resolved at a global level and the AEI maintains that “bank capital regulation throughout the world must be fundamentally reformed.” But the question remains as to how much austerity the people in the euro zone are willing to endure and the degree of sovereignty each nation is prepared to sacrifice to sustain global world order.
Sources
The Eurozone Crisis: A Roadmap for Urgent and Decisive Action, AEI Oct 24, 2011
Kyle Colona - Kyle Colona is a freelance writer from the New York area with an extensive background in legal and regulatory affairs.
