Eurozone Debtor Members Will Change the Structure of the Euro

There’s not much else in the news today except the European Monetary Union’s (Eurozone) debt debacle.

Greece is off the front page, overtaken by Italy. Spain and Portugal are closing in on Greece, while Ireland seems to be holding its own, even meeting its commitments made to receive the bailout package last winter from the European Central Bank (ECB), the IMF and the European Commission.

What is the real problem? It’s not so complicated. Greece has a national debt that is about 140% of its annual gross domestic product (GDP). It also has a history of poor economic performance, and with the restrictions being placed on it by the Eurozone in order for it to receive its bailout package, the unemployment rate has skyrocketed and young people, especially, are unemployed and angry.

This combination makes it next to impossible for Greece to repay its bailout loan or, for that matter, to repay the debt holders who bought its national bonds. There is also the problem of Greek’s creditworthiness, which is so bad that most bond purchasers want huge interest rates (15%) just to buy Greek national bonds.

Portugal is trying to correct its financial house and for the moment seems stable, if very weak. Spain’s national debt is only 80% of GDP, but its unemployment rate is above 25%, causing tax revenues to be lower than needed to repay bondholders. But, unlike Greece, Portugal and Spain are still able to borrow money in the open markets.

The international ratings agencies, such as Standard & Poors and Moody’s, are organized to evaluate companies and countries in order to rate their debt as a function of their ability to repay. High ratings mean low interest rates (1-3% average in the US, depending of the term of the bond). Low ratings mean high interest rates (Greece’s 15%), or the decision of potential bond buyers to back off and look for less risky places to put their money.

The Eurozone wants to “restructure” the Greek loans. But, the ratings agencies say this would be a default, much like a homeowner in default who won't continue to pay his mortgage. So, the Eurozone says, let’s call it a “rollover” and avoid the default word. No, say the ratings agencies, if it looks like a duck, walks like a duck and quacks like a duck - it’s a duck. So, rollover, like restructuring, will be equivalent to default and lead to much lower ratings.

There's the problem. How are the Eurozone, the IMF and the ECB going to help Greece recover without putting her in default and forcing all her bondholders to ask for immediate payment of the money they lent, as well as the interest.

There are two possibilities. One would be to let Greece, and eventually other similar countries, leave the Eurozone and return to their original currencies. But, that would require a renegotiation of their debt to put it into the country’s original currency, and since the country is not solvent, the payment schedule would be long and the interest rates would be high, and the currency itself would probably be devalued (by decree or by printing a lot more of it). So, large German and French banks would be stuck with bonds of a weak country which will probably be repaid in devalued currency over a long period. This would go onto their books and lower their capital reserves. They would have to reserve more of their money and that would mean less money to lend, i.e., a less robust recovery from the world financial crisis.  

The other possibility is for the Eurozone, IMF and ECB to continue to bail out Greece and whoever comes after her - Portugal, Spain, Italy. Greece is easy because it’s a small country with about 250-300 million Euros of debt. Ditto Portugal. But, Spain and Italy are the third and fourth largest economies in the Eurozone. Italy’s economy is almost as large as those of Portugal, Greece and Spain combined. There is not enough money to bail Italy out.

That brings us to the unspeakable third solution - let Greece default and withdraw from the Eurozone. Use the bailout funds available to make the French and German banks whole. THEN, organize a two-tier Eurozone. One for the big guns (Germany, France, and several northern European countries) and let the countries in trouble because of the Eurozone's debt rules form a second Eurozone with less strict rules and more flexibility to devalue the new common currency when debt problems arise because of economic hard times.

One thing is sure - the Eurozone and the Euro will not look the same in July 2012 as they look today.