Eurozone Debt: Chickens Come Home to Roost

All eyes are on the euro-zone leaders as they huddle to craft a solution to the sovereign debt crisis –one that international financial markets will find believable. On Friday, the leaders reached an agreement that would penalize member countries whose annual deficits exceed 3% of their GDP. They will be exempted if the excessive deficit is caused by recessionary pressures, but not if government spending and tax policies are the cause. The agreement also calls for the establishment of a quarter trillion dollar bailout fund that would make loans available to member states whose local banks are facing runs on liquidity and the threat of bankruptcy.

Major countries of the euro zone, such as Greece, Italy, Spain, Portugal, and Ireland are beginning to more closely resemble breadbasket economies than once historically potent civilizations. To be certain, it would be foolhardy to write them off economically. Yet for those of us who are old enough to remember, one cannot help but recall how many of the current euro zone countries once condemned nations of Latin America and Africa for having high rates of sovereign debt.

What sticks out in my mind most is how ugly the condemnation was. In the late 1980’s more than two dozen deeply indebted countries asked Europe and America to reschedule their debt so that they could pay the interest and principal on time. Brazil, Argentina, Venezuela and Mexico were the biggest culprits. Following the oil embargo and recession of 1973 – 74, the indebtedness of those countries increased from around $15 billion to over $500 billion in 15 years.

Their request for help did not receive empathetic responses. Instead, Latin American and African countries faced the wrath of European and American politicians and investors. They charged that the leaders of the debt-ridden countries were ill-equipped to govern and had gluttonous appetites for corruption. Reducing their debt, it was asserted, would only encourage a “moral hazard” by rewarding people for engaging in bad habits. Furthermore, there was loud opposition to providing them additional loans because it was felt that the assistance would simply help line the pockets of corrupt leaders and reward unproductive civil servants.

Today, how the chickens have come home to roost. This time, it is Europe, not Latin America or Africa, that is threatening to implode because of its sovereign debt crisis. Greece’s debt is 161% of its GDP, Italy’s debt is 123%, and both Portugal and Ireland have debts that exceed 90% of GDP. Those countries are so deeply in debt that a default among them now threatens to engulf the entire world’s economy in stagnation. While no one knows for sure how deeply the US banks are linked to euro zone sovereign debt, it is estimated that Bank of America, J.P. Morgan and Citigroup each hold about $15 billion of the increasingly worthless bonds of the five most indebted euro zone countries. This helps explain why the Federal Reserve was willing to provide liquidity to these countries through currency swaps. Should they default on their debt; the ripple effect will be felt on Main Street in America.

Fortunately, the threat of a European default has not derailed US economic growth. However, just as in the Latin American and African crisis, the euro zone must eventually fish or cut bait– specifically they must either provide a rescue fund that is large enough to cover the liquidity needs of the countries that are deepest in debt, or they must begin systematically writing down those debts in recognition of the inevitability of a default.

The world is hopeful and confident that the euro zone will find a suitable path out of its current paradox. When it does however, it might also be wise if it would learn to treat other indebted nations more kindly in the future, than it treated Latin American and Africa nations in the past.

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