Tuesday, November 30, 2010

Welcome to the war

Those of you watching the news feeds this week will have noticed intensified pressure on Portugal, Spain and Italy from financial markets. This is the same pattern of rising interest rates that occurred to Greece before it was unable to borrow any more, and to Ireland as well. Governments feel this incapacity quickly because unless they are paying down their debts, they are rolling them over--issuing new debt to cover the old debts, and now at a much higher interest rate. What is happening to these countries is much the same as happened to homeowners in the United States with adjustable rate mortgages. They're all unable to pay.

These three countries have different debt structures and their governments have managed their economies differently. Portugal has never really had a handle on its public finances and pretty much enjoyed a free ride on the credibility of being a euro zone member until recently. It will probably be hit the hardest. Spain was a poster child for a catch-up economy that could manage its finances reasonably well--until the financial crisis burst the property speculation bubble on which all of its growth ultimately depended. Italy had a brief period during which it managed to pare down public borrowing, but has a deserved reputation for being as profligate as Portugal. Yet none of this matters at this moment. The markets are treating them as more or less the same.

They can. What is so important is not Portugal, but Spain and Italy, which are too large to save under the existing resources of the European Financial Stability Facility unless its resources are expanded, either directly, or by floating its own bonds on the market. A final alternative is that the ECB intervenes in a long-term way to purchase government bonds.This would be a new step in the institutional reform of monetary union to watch if it happens.

It should be clear by now that the small countries in EMU were but the first battles in what could turn out to be a much more wide-ranging war on the euro. Small countries are an excellent place to target. It is more likely that a change in policy will be dramatic enough that investors can bet on it and get a decent return on their bets. And investors can use these skirmishes to test how public authorities react before they consider when, how, and whether to go after the bigger targets on the battlefield. When confronted with an opponent, one may choose to deter (before hostilities resume) or to counterattack (wisely deploying the limited resources one has to protect one's most prized assets), but letting one's opponent set the pace and location of battle, where and when one uses one's capabilities, is always a losing strategy.

Yet that is precisely what has happened until now, to the detriment of EU governments. Until now, the desire of those who saw the poor fiscal discipline of small countries as the only real problem to be tackled led EU governments to hesitate when it came to fully appreciating that the ultimate targets of speculators are not small countries, but big ones. The absence of haircuts in the Greek and Irish battles simply provided further encouragement and resources to those who will take the next bets against Portugal, Spain or Italy. The result will be that unless EU governnments reform the EFSF further, and move toward some kind of fiscal union in name or in practice, the EU's money will run out before it can protect all of its targets.

The EU has less freedom of manoeuvre now. It could have previously decided to have a stronger bailout fund to deter attacks from the private sector, and to weaken the private sector with haircuts, but it didn't. It could have, alternatively, let a small country fail at an 'acceptable' cost relative to the collapse of a large state--the overall impact on the eurozone economy and on international migration would have been less--but it didn't do that either.

In short, the EU has been wasting its precious, limited resources on small battles that seemed more important to politicians than they were at the time. Now it is backed into a corner. The resulting fight will be messy, and nothing will be the same as it once was when it is over.

Whatever the outcome, politicians' understanding of how to deal (collectively) with speculative attacks in the future will change as a result of the lessons they learn in the time to come.

What the course of the war suggests so far, however, is that they would do well to gather together experts on military affairs, people with a good grasp of strategic issues and the impact that technology has on them, to advise them on how to wage and win the financial war they face.

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