Eoin Fahy: At least we've finally woken up to risk of EU states' debt
IN the latest round of the game of chicken between the financial markets and the European authorities, the markets blinked first, scared off by the sheer size of the rescue package that was put together last Sunday.
"Lehmans -- the Sequel" never happened as European governments, and the ECB, thought back to the collapse of Lehmans in September 2008 and decided not to make the same mistake their US counterparts did then, with Greece playing the part of Lehmans this time around.
And so this round of Europe's debt crisis ended with a decisive win for the EU. But will there be more battles, and who will win? To know that, we need to think about how we got into this mess in the first place.
There are two main reasons why government deficits have soared to such high levels that they are raising doubts in the markets about the ability of governments to repay debts. And there is a further structural problem in the EU which exacerbates the problem.
The first cause of high government debt levels is the years of very strong economic growth followed by a couple of years of weak or negative growth. In the good years, governments took the very high tax revenues that came with the boom and spent them. When growth slowed revenues fell, but governments weren't able to cut spending in parallel. Social welfare increases could not be reversed, extra public servants couldn't be fired and pay increases couldn't be cancelled -- at least until the crisis hit. So governments were left with collapsing revenues and static costs -- a recipe for very large deficits.
The second cause was the decision by many European governments to bail out their banking systems when the financial crisis hit, and the actions of a few governments to explicitly put money into the economy via tax cuts or spending increases in a bid to fend off the recession.
The effect was to add, directly or indirectly, hundreds of billions to the outstanding stock of government debt across Europe, and in many cases the cost of servicing those debts added considerably to the burden on national finances.
A third factor was the lack of a single decision-making authority in the EU, given that each country retains autonomy over fiscal policy. In the US, Japan or the UK, there is one single government. In the EU, there are 27. It could perhaps be argued that this makes key decisions 27 times more difficult.
And these difficulties matter. Time and time again over the past few weeks when EU leaders tried to put together a package to help Greece they ran into trouble. Various drafts and leaks came out and each time the package looked likely to be weaker and smaller than the markets were expecting, until eventually the authorities, last weekend, did what they should have done months earlier.
What does all this mean for the weeks and months ahead? Well, one thing is clear, and that is that the financial markets have well and truly woken up to the fact that government finances matter. A lot. This is a relatively new development as until the past few months markets essentially behaved as if the debt of eurozone member states was virtually riskless.
NOW that markets are keenly aware of this, there will continue to be pressure on all countries with large deficits to rein in spending. Finance ministers will be looking over their shoulders over the next couple of years -- not just at the European Commission, but at the financial markets. And some will be at least as interested in what the financial markets think of their budgets as what their voters think.
Another implication is that we are not yet back to "normal" economic conditions in the EU. The ECB cannot assume it can safely withdraw all its emerg-ency liquidity measures as yet, nor can it even begin to think about interest rate increases.
And the UK and US authorities will also have to think long and hard about their policies. Deficits in those two countries are certainly smaller than in Greece, but they are not that much smaller than those of Portugal or Spain, for example, and yet those economies found themselves in difficulties in recent weeks. While the US and UK economic recoveries seem stronger than the European one, interest rate increases in both of them seem much less likely now in the next few months.