Sovereign debt crisis: hasn't gone away you know.

   The sharks are circling again. The cost of debt rising inexorably in the Club Med countries.  After a couple months of respite, the spectre of sovereign debt is again casting a shadow over Europe.     I was in Portugal recently, on the eve of the biggest general strike  since that country became a democracy after the ‘Red Rose Revolution’ in 1974.  The  show of strength by the trades unions was impressive though largely futile.  Following Greece and Ireland, Portugal will almost certainly become the latest  victim of the sovereign debt crisis that is rocking the EU to its very foundations. 

   Outside Lisbon, there was an eerie calm. The Algarve is now one long housing estate punctuated by golf courses.  In Albufeira I marvelled at the endless estates of candy coloured holiday homes, all empty.   It’s like being in one of those post-apocalyptic video games where all the people have all been killed by a mystery disease.  You half expected to see a crowd of zombies.  What I did see was a guy in a hat trotting along in a cart drawn by a donkey.  You see rather a lot of blokes on donkeys here, if you hang around long enough.  For, beneath the veneer of prosperity brought by tourism, Portugal is a low-growth, low-tech, essentially agricultural economy.  Nothing wrong with that.  Except that dozy Portugal is harnessed, via the euro, to the the most technologically efficient and productive manufacturing force on the planet: Germany.  And that’s the problem: it’s a donkey yoked to a race horse . 

      Portugal's bonds are being shredded on the financial markets, confidence has collapsed, the vultures are circling. With the cost of paying the ever rising interest on the country's debt becoming a crippling burden, the only sensible solution is some form of debt default.   But there is an understandable sense of bewildered hurt in Portugal.   Public borrowing here isn’t nearly as bad as in Greece, or Britain for that matter, and nor was there property madness on anything like the scale of Ireland.    In fact, until recently, Portugal was regarded as a model of fiscal prudence. Between 2005 and 2007, when countries like Britain were spending like there was no tomorrow, canny Lisbon actually cut its budget deficit in half, from 6% to 3% of GDP.  It is one of the few European countries which has taken the Eurozone’s Growth and Stability Pact seriously. There are no too-big-to-fail banks in Portugal because there are aren’t any big banks. Financially speaking, it is a wholly owned subsidiary of Spain. 

     So, why has this rather unflambuoyant and cautious country become the next domino to fall?  And why should we care?  Well, for one thing because, as with Ireland,  we will almost certainly end up paying for it., if only through Britain’s contribution to the International Monetary Fund and the eurozone’s rescue fund.   Since it joined the euro, Portugal’s export markets have collapsed because its currency, denominated in euros,  is massively overvalued.   Portuguese labour costs are actually higher than in Germany.  That guy on his donkey is probably earns as much as a Bavarian car worker, statistically speaking,  but his productivity is back in the last century, and falling.   Yet, until about six months ago, Portuguese bonds were rated as being as safe as German bunds.  They were clearly built on sand.   Now the bond speculators have decided to blow them away.  

   Portugal will now go through the same agonies as Ireland.  There will be more big cuts and further civil disturbance, then things will go quiet as the sovereign debt caravan moves on, probably to Spain.  But the problem is that this isn’t a one off event.  Being rescued doesn’t solve the problem of unsustainable debt; without growth the debt just gets bigger.  The recent austerity budget in Ireland may have sounded tough - more cuts in wages, water metering, new housing taxes, lots of jobs lost - but hardly anyone thinks it will be enough.  The growth forecasts were highly optimistic, and if they undershoot, the ECB and the IMF will be at the door again.  Ireland has borrowed a huge sum, 85billion euros, but analysts believe it will end up borrowing anything up to 130billion. 

   So, is this the long-awaited collapse of the euro?  Won’t the PIIGS (Portugal, Ireland, Italy, Greece and Spain) have to leave and devalue their way back to health?  Just like Britain?  I don’t think so.  Indeed, far from being the end of Europe, this is almost certainly the beginning of a new phase of European economic integration.   Germany has no choice but to salvage the PIIGS, because the break up of the EU would create such economic dislocation - import tariffs, currency wars, competitive devaluation deflation - that its own export markets would be destroyed.  German banks would crash.  

   For their part, the PIIGS can’t afford to leave the euro because  their humungous debts, denominated in euros, would be doubled over night.  They would have to go to the expense of restoring their old national currencies, which would prove to be largely valueless as soon as they hit the currency markets.    The euro may be a devil’s bargain, but it isn’t one that can easily be broken. The structural problem is that Europe has a single currency, but it isn’t a fiscal union, like the USA, or the UK.  There is no central mechanism for transferring wealth from the poorer areas to the wealthier.  There is no federal apparatus with the political legitimacy to levy taxes and create a uniform economic zone.  France and Germany will now have to build a fiscal union on the foundation of the European Financial Stabilisation Mechanism.  There is no alternative.  The ad hoc rescuing of Mediterranean economies is wasteful and divisive. Nearly a trillion euros has already been devoted to the collective rescue and much more will almost certainly be needed before the year is out. 

    And here’s the twist: Britain will also have to contribute to the cost of building the greatest fiscal lifeboat in history.  Our banks are heavily invested in Europe and European banks are all over our high streets.  The Spanish bank, Santander, has 1,500 branches in Britain and it is our second biggest home loan lender.  And since Spain has already been lined up as the next domino to fall after Portugal, we are up to our necks in Europe’\s sovereign debt crisis. There’s no way out.  It may seem preposterous now, but once this crisis is done,  the chances of Britain ultimately joining the euro will have greatly increased. Obrigado.