Analysis Brief

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The Eurozone Debt Conundrum

Author: Roya Wolverson
May 26, 2010


Europe's spreading debt woes, coupled this week with tensions on the Korean Peninsula, continue to feed uncertainty and upheaval in global financial markets.

Spain's weekend seizure of a small, failing savings bank, Germany's plans to broaden (WSJ) its short-selling ban, and a failed German bond auction (FT) have added to deepening skepticism about a spreading eurozone crisis. And in the United States, political horse-trading (WashPost) on the measures to be included in financial reform legislation are stoking fears of a double-dip recession.

Clarity on U.S. and German financial reforms in the weeks ahead may alleviate some market jitters. But there are other bearish indicators. Particularly troublesome is the continued rise of the inter-bank lending rate--the rate banks charge to lend to one another--which in turn augurs poorly for businesses' ability to borrow. This rate has risen particularly among European banks, fueling suspicion that those banks may be overexposed to risky Greek, Portuguese, or Spanish debt. New research by Royal Bank of Scotland economists found that (FT) financial firms outside Europe are also more dangerously exposed to eurozone defaults than previously thought.

Other drivers of high bank-to-bank lending rates include (FT) the Fed's move to roll back its liquidity programs implemented during the financial crisis, which -- along with increased demand for the safehaven U.S. dollar -- has tightened the supply of easy money. Pending regulatory changes also threaten to reduce banks' liquidity, including an SEC rule change next month that will require money-market funds to hold more cash and limit them to only top-rated securities. The U.S. Senate's financial reform bill could also put a damper (WSJ) on big U.S. banks' credit ratings, futher limiting their borrowing options. The Carnegie Endowment's Uri Dadush warns that bank borrowing constraints fueled by high market volatility will ultimately do more damage to the U.S. economy than reduced trade and investment from Europe.

Government borrowing, meanwhile, has already fallen prey to market uncertainty, notes the Centre for European Policy Studies' Daniel Gros, as economists struggle to separate fears about eurozone debt from economic realities. Although debt-wracked European countries require reform, he says only Greece is in serious financial trouble, despite "the collective judgment of financial markets." That judgment has forced governments to pay (WSJ) higher risk premiums on their debts while increasing the EU's bailout tab, which can be a vicious cycle. More analysts are questioning whether the monetary union can survive (Bloomberg), with no answer in sight. Although the European Council created a task force for reforming the union, says Gros, there is no way for EU leaders (Moscow Times) to assure markets that the framework will work.

The good news, by some accounts, is that a weaker euro could help boost the competitiveness of stodgy eurozone countries like Greece. MIT's Ricardo Caballero and Francesco Giavazzi note (FT) that similar currency devaluations proved successful in remedying past fiscal crises in Ireland, Italy, and Argentina.

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