Last weekend the leaders of the European Union finally realized that their dithering over a financial aid package for Greece had imperiled the entire continent’s financial structure. They acted to stem the tide by adopting – subject as usual to country by country approval – a series of measures that would make up to €750 billion ($1 trillion) available to countries that find themselves in financial difficulty. How they got to that point is an object lesson in how financial crises can develop.
Delays Cause more Problems
Europe’s current economic mess can be described in clichés: “a perfect storm” – “it’s the economy, stupid” – “every man for himself” (or “sauve qui peut,” in French) – “may you live in interesting times” – ” the ‘German’ problem” – “Beware of Greeks bearing gifts,” etc. But, none of them help in finding a solution.
For most of the year the leaders of the countries that make up the Euro zone [the 16 countries out of 27 in the EU that use the euro] debated whether or not to bail out the Greeks. They finally decided to authorize a €110 billion (app. $140 billion, depending on the exchange rate) funding package.
France pledged €20 billion [$25.4 billion]; Germany finally agreed to pledge €24.4 billion [$31.13 billion], 28 percent of the total package; other countries pledged proportionate amounts. The International Monetary Fund had previously agreed to pick up the rest.
There should have been no questions, let alone the delays, in arranging this financing, once it became apparent that without it Greece would default on its national debt. That could have created a “Lehman Brothers” situation, which would probably set off another global financial crisis. It still could.
The delay has widened the scope of the EU’s financial problems considerably. Many financial commentators have expressed doubts that the money will be enough to enable Greece to avoid an eventual default. Even more seriously, it focused attention on the over indebtedness of other Euro zone members, who may need help.
The situation has been dubbed the “contagion” phenomenon. But it’s potentially more serious than bird flu. Germany’s Chancellor, Angela Merkel joined IMF Head Dominique Strauss-Kahn in warning of the dire consequences for Europe and the Euro zone if the crisis isn’t stopped in Greece.
She conveniently ignored the fact that Germany’s reluctance to bail out the bad boy, profligate Greeks, was the main reason for the delay.
One can understand Germany’s reluctance, however. The Greek government joined the Euro zone with a pledge to abide by its rules – mainly holding government debt below 3 percent of GDP – which it never intended to keep, and didn’t. To make matters worse, Greece fiddled the books to hide the fact that its debts were rapidly expanding. They’re now around 13.6 percent of GDP.
Germany was accused of being newly “nationalistic” (a term that conjures up images of jackboots and swastikas), but its intransigence is somewhat justified. Germany gave up the solid Deutsche mark to join the euro only on condition that it would be a strong and anti-inflationary currency. Two periods of hyperinflation (the 1920’s and post World War II) made this a necessity. There were also solemn promises – notably from France – that it would never be required to supply funds to bolster the economies of other Euro zone members.
Germany also produces a lot of goods, which it sells to the rest of the world. Most of that money stays in Germany, which has a healthy balance of payments. The country has no intention, as many have put it, to become “Europe’s ATM machine.”
Therefore the frugal German electorate was particularly outraged at proposals to use their tax money to bail out the miscreant Greeks, whom a majority feels should never have been allowed to join the Euro zone in the first place.
Merkel and other German leaders, however, apparently ignored the facts and the pernicious effects of any delay. To cite another cliché: “if you’re in for a dime, you’re in for a dollar.” Greece foreclosed the possibility of devaluing its currency [the preferred escape strategy for heavily indebted countries] when it joined the Euro zone. German banks have lent massively to Greek companies and have invested in Greek bonds. There never really was an alternative, except to supply the funds – with drastic restrictions – to enable Greece to continue to pay its debts.
Those restrictions are, to say the least, unpopular with the Greeks. They include lowering pensions, raising the retirement age, increasing taxes, getting rid of surplus bureaucrats in the public sector and, perhaps hardest of all, making a vigorous effort to collect taxes, which puts a pall over the national sport of evading them. Mass demonstrations and riots that left three people dead have been the result so far.
The uncertainty resulted in the precipitous slide of the euro. €1.00 cost over $1.50 last January. It’s below $1.30 today. Fears over four other Euro zone countries’ finances have finally made the EU, and the rest of the world, realize that without an effective fiscal policy and the means to implement it, the euro can only drift until a Greek-like crisis makes some kind of action imperative. Spain, Portugal, Ireland and even Italy are now seen to be at risk from sovereign indebtedness and faltering economies that could eventually require similar and even more expensive bailouts.
The economic crisis has also coincided with the fickle winds from the North Atlantic that periodically send clouds of abrasive ash from Iceland’s Eyjafjallajokull volcano across Europe’s skies, halting air traffic, as well as a cold and miserable spring, and the, until recently unresolved, outcome of the British elections.
Insurance Industry Faces the Crisis
The global insurance industry cannot afford to ignore the EU’s financial position, which has become alarmingly unstable. The steadily building crisis affects nearly every aspect of the industry from policy issuance to claims to investments.
Investment dries up in countries that are undergoing an economic crisis. That means less demand for new insurance policies and cutbacks on spending for existing coverage. A recent report from Marsh’s London office warned that “European financial institutions are buying less insurance or decreasing their sums insured in an effort to reduce costs, despite an increase in claims notifications.”
The financial uncertainties, notably the risk of “contagion,” are already having adverse impacts. In the first week of May European stock markets plunged. The Eurostoxx 50 index closed down 11.24 percent on the week. Moreover, due to globalization, the crisis has spread beyond Europe. On Thursday, May 6, the Dow Jones Industrial average plunged by nearly 1000 points, its biggest drop ever. Although it recovered to close down three percent for the day, at one point all three of the major share indexes [DJ, S&P 500, and NASDAQ] were down over 9 percent.
Even though later reports indicated that a “trading glitch” might have been partly to blame, no one can afford to ignore the interlinked character of the financial markets. Moreover, the EU’s inability to take effective economic measures to stem the crisis may be the global financial system’s weakest link.
The Problems are Systemic
To bring up another cliché, the EU, “coulda, woulda, shoulda” taken a course in risk management. As the insurance industry has learned over the years, it’s more cost effective to analyze potential risks, both local and systemic, in order to try and avoid and minimize their consequences.
The only institution charged solely with safeguarding the euro is the European Central Bank (ECB), which essentially sets interest rates and controls the money supply. Until now it has resisted any commitment to purchase Greek (or any other) government debt as a cornerstone of its independence. However, ECB president Jean-Claude Trichet was under such intense pressure from governments and European banks, that he finally agreed the bank would accept Greek obligations, even if they were “pourries” (rotten – i.e. junk).
The ECB’s change of policy has been hailed as part of the larger fund package. But it also has potential adverse significance. Buying IOU’s, especially those that may never be repaid, sets the EU on an inflationary course, as it adds to the money supply and does little to encourage a reduction in deficit spending.
It is all that the ECB can really do, however. Unlike the Federal Reserve System in the U.S., it has no real enforcement authority, which remains with individual EU governments. There is no equivalent in the EU to the U.S. Treasury. The rescue package depends on a basket of pledged loans – from the IMF, from EU emergency funds and from additional pledges from EU governments, some of whom may be the same countries that could eventually need to be bailed out. EU leaders are in the process of approving the plan.
However, even $1 trillion may be too little, too late. Two Nobel Prize winning economists, Joseph Stiglitz and Paul Krugman, who writes a column for the New York Times, apparently think so. Stiglitz prophesied that unless the EU solves its fundamental financial problems, the euro’s future “will perhaps be very brief.” Krugman said that once all the alternatives haven’t worked, which he considers quite likely, Greece would have to leave the Euro zone. What the consequences might be if countries start abandoning the euro can’t be fully calculated as yet, but, at the very least it would cause chaos in global financial markets.
Any risk analyst examining the Euro zone’s monetary system would have concluded that some form of inter-European regulation should have been put in place to deal with economic situations such as the one presented by Greece. Many EU financial experts called for this to be done, but the governments that make up the EU couldn’t agree to do so. They were ultimately unwilling to give up any of their sovereign prerogatives to assure the euro’s stability.
The crisis may have changed that. In addition to authorizing the bailout fund, EU governments are now pledging to work together towards reforming and strengthening the system. They have also been making a lot of positive noises about how they have the situation in hand, and everything will be fine.
At the same time, however, they’ve also fallen back on their old habit of blaming someone else for creating the problem. First in line are “speculators,” or as one diplomat called them the “wolf pack.” These are investors who have the temerity (or the foresight) not to believe their positive noises, so they short the stocks and the euro, betting that they will fall further.
Second in line are the rating agencies – Moody’s and S&P- who are blamed for downgrading the credit ratings of countries – notably Greece and Portugal. This is surprising, as their primary purpose is to warn investors when they might lose money. The fact they failed to do so for collateralized debt securities, should have surely reminded them of this responsibility.
The trillion dollar pledge did have a positive effect. On Monday stock markets in Europe, the U.S. and around the world recovered a portion of their losses from the previous week [See IJ web site – https://www.insurancejournal.com/news/international/2010/05/10/109667.htm]. The euro even briefly topped $1.30.
The euphoria hasn’t lasted, however. There haven’t been any severe plunges, but there hasn’t been a huge surge upward either. Most experts are taking a wait and see attitude. The rest of the world, and not just the EU, are waiting as well.
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