Gwyn Morgan is a Canadian business leader and a director of two global corporations.
We all know that individuals and corporations can spend more than they earn only as long as others continue to lend them money. And when debts exceed ability to pay, bankruptcy follows.
The same financial reality applies to countries, where bankruptcy is known as defaulting. The largest defaults in recent memory were €64-billion ($79.5-billion) by Russia in 1998 and €66-billion by Argentina in 2001. (Amounts converted from national currencies.) While these defaults roiled global financial markets, they pale in comparison to the euro zone debt crisis.
Tiny, teetering Greece has a national debt of more than €360-billion. Portugal and Spain owe €170-billion and €740-billion, respectively. Then comes Italy at a staggering €2.3-trillion. Given the huge struggle to prevent a Greek default, it's clear that the so-called European Financial Stability Facility is ill-equipped to stop a Spanish default and would be virtually helpless in the face of an Italian default.
Even at the height of the pre-2008 economic boom, euro zone countries were borrowing to pay for extravagant social entitlements. Rather than pulling back on spending as the recession diminished revenues, trillions more were borrowed to finance "stimulus spending." A sovereign credit crisis loomed. Then, rather than cutting Greece loose after it was revealed that the country had gained membership by fraudulently hiding its true financial position, the euro zone poured €250-billion into bailouts.
Now, after what some label as draconian austerity measures, almost all euro zone countries continue to run deficits. Financing those deficits, along with renewal of expiring debt, requires a continuous stream of new bond issues. Interest rates on Spain's bonds have jumped to record levels and Italy's borrowing costs are rising dangerously.
Survival of the euro zone requires investors to gain confidence in its ability to protect its beleaguered members from default. But how? It's clear that Germany is not going agree to the "euro bond" proposal wherein all members assume liability for the massive bond issues that may be needed. The IMF is trying to raise more funds to shore up the euro zone, but the U.S. and Canada are understandably reluctant to send taxpayer cash .
And it's highly unlikely that economic recovery will shore up euro zone balance sheets. Recovery from business cycle recessions has always been private sector-driven, as businesses invest in cost efficiencies and pursue changing market opportunities, putting people back to work and strengthening consumer demand.
But this is not a business cycle recession. It's a sovereign debt crisis the likes of which the world has never seen, a massive mountain of debt crushing prospects for a private sector-driven recovery. And as each day goes by, program deficits and rising debt service costs make that mountain more insurmountable. Is there anything that can prevent a chain reaction of sovereign debt defaults that would see the collapse of living standards and foster dangerous degeneration of social order?
Clearly, the euro zone needs to regain investor confidence in its ability to protect beleaguered members from default. But without euro bonds or massive IMF support, how could that be done? The only remaining way is to increase European Central Bank (ECB) reserves by radically increasing money supply. Methods of increasing money supply include lending more to the banking system at attractive rates, which the ECB has already been doing. But the most powerful way of increasing money supply is purchasing private sector financial assets with electronically created money. This policy, known as quantitative easing, has recently been employed by the U.S. Federal Reserve. But building enough reserves to shore up the finances of Spain, Portugal and Italy would require the creation of more new money than in recorded history, driving down the euro and triggering high rates of inflation.
The consequences would be profound. High inflation brings with it a huge moral hazard in that the value of personal savings and pensions collapses, while those who have lived beyond their means are rewarded by the reduced value of their debts. There are many other negative consequences and risks, and getting runaway inflation back under control is extremely difficult. Given these unfair and uncontrollable effects of high inflation, it is understandable that the singular mission of central banks around the world has been to control inflation. But for euro zone countries teetering on the brink of economic disaster, the dreaded devil of inflation may seem like an apparition offering salvation.
© The Globe and Mail