Europe’s sovereign debt crisis continues to roll from one country to the next. No sooner than Ireland accepted a $112 billion financial rescue on Nov. 28, after Greece’s $102 billion bailout package back in May, the markets zeroed in on the troubles in Portugal. Fears are growing that much larger problems loom for Spain and Italy. There are new signs of contagion across Europe’s bond markets, as government bond yields in these most vulnerable countries have soared to record levels. Where and how does it all stop?
So far, Europe’s strategy has been more ad hoc than comprehensive, addressing problems from one nation to the next as they approach a flash point. Europe has failed the first rule of crisis management, PIMCO’s CEO Mohamed El-Arian told CNBC on Tuesday, and that is “to get ahead of the crisis.” The problem is that markets are forward looking, and they are now moving on, testing the next weak link in the Euro Zone’s chain of 16 nations. The country that poses the biggest test is Spain. The growing question is whether Europe can muster the foresight and resources to prevent the Euro Zone’s fourth largest economy from requiring financial assistance.
“We believe that policymakers need to shift from a purely reactive stance—in which packages are quickly cobbled together under severe market pressure—to a proactive policy that provides clarity and assurance,” economists at Barclay’s Capital said in a Dec. 1 note to clients. The economists believe that Spain’s government can remain solvent even after significant loan losses in the banking system. If so, pre-emptive action by policymakers to close failing banks weighed down by problem loans, while supplying the necessary liquidity to hold down financing costs for viable banks, could greatly ease market fears of contagion and sovereign default.
But will policymakers get ahead of the curve? Somewhat disappointing to the markets, the European Central Bank today didn’t announce new measures to address current debt worries, although it did extend its emergency loan program at least through mid-April 2011. Contrary to expectations, the ECB did not commit to additional government bond purchases, which had been aimed at supporting the fiscal positions of the Euro Zone’s peripheral economies.
Europe’s challenge is both immediate and longer-term. Over the next year, the $1 trillion program of backup credit facilities, bond purchases, and liquidity injections hammered out earlier this year between the European Union and the International Monetary Fund will mean nothing if policymakers can’t halt the contagion that threatens the Euro Zone’s major economies in Spain and Italy.
In the meantime, between now and expiration of that $1 trillion backstop in 2013, Europe will have to work out the thorny details of the European Stability Mechanism, a permanent program for resolving future crises, the broad outlines of which were approved by European finance ministers on Nov. 28. The plan did little to calm the markets. The biggest issue is the extent to which private bond holders would be vulnerable in the case of a restructuring after mid-2013.
The bottom line is that policymakers in the EU and the ECB will do everything within their power to assure the viability of the Euro Zone’s single currency. Right now, though, their success depends on getting out in front of the potentially calamitous events they are trying to forestall.