Thursday, Oct. 27, 2011, was a giddy day for European politicians and global investors. European Union officials announced a plan for addressing the EU’s worst financial problems. There would be a partial write-down of Greek sovereign debt—a 50 percent haircut for private bondholders, but no haircut for governmental creditors (the political class looks after its own). In addition, EU officials unveiled a one-trillion euro (approximately $1.4 trillion) bailout fund purportedly to recapitalize European banks and insure against sovereign defaults.
Stock markets on both sides of the Atlantic soared on this news. Euphoria reigned—for a few days, that is. Just three trading days later, markets gave up all of the previous Thursday’s gains and pessimism returned.
Two events in particular have precipitated this manic mood shift: Prime Minister George Papandreou announced that he will submit the EU bailout plan to a national referendum, and the financial firm MF Global Holdings, which had placed a heavy bet on European government bonds, has declared bankruptcy.
Even if these two Halloween surprises hadn’t spooked the markets, the viability of the EU bailout plan was in doubt anyhow.
Europe’s financial problems are immense and intractable. Greece is the focus of attention, but when you realize that Greece’s national debt is around 350 billion euros—its entire GDP is only about 225 billion euros, which shows how hopelessly broke the Greek government is—and the announced bailout fund was for one trillion euros, you can see that most of the bailout fund isn’t for Greece.
Spain and Italy combined are almost three trillion euros in debt and run chronic budget deficits. Significantly, since the bailout plan was announced, interest rates on sovereign Spanish and Italian debt have risen, indicating widespread skepticism that the bailout fund (if it materializes) would buy sufficient time for those governments to get their financial house in order.
While detailed specifics about the bailout plan are vague, cautious skepticism is prudent—for two major reasons:
First, where will the vast sum of one trillion euros of bailout money come from? Certainly, no European government has that kind of money set aside for the proverbial rainy day. Even Germany, the undisputed economic leader of Europe, has a national debt of 70 percent of its GDP and is limping along with a one percent growth rate.