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What has austerity wrought? We know it has sent the jobless rate soaring in the hardest-hit European countries, triggered the downfall of more than a few governments and deepened recessions, all in the name of trimming budget deficits, which were indeed trimmed.
What it hasn't done is crunch sovereign debt levels; in fact, the opposite is happening. In the 17-country euro zone, the ratio of debt to gross domestic product was about 70 per cent in 2007, the year before the financial crisis. Today it's about 90 per cent – and climbing – in spite of savage reductions in public spending. We remind you that the Maastricht Treaty calls for a debt-to-GDP ratio of no more than 60 per cent.
If sovereign debt loads were unsustainable a few years ago, they are even less sustainable now. No wonder debt ratings are not improving. Last week, DBRS slapped a CCC rating – rotting, smelly junk to you and me – on Greece with a "negative trend," meaning the danger of default is rising. The trend line is the same in Italy, Spain and Portugal; that is, more downgrades are likely even though the euro zone is now officially out of recession.
You can be forgiven for thinking that the worst of the debt crisis is over. In the last year, 10-year bond yields – the cost of long-term borrowing – in Italy and Spain have fallen by 1.5 and 2 percentage points, respectively. Portugal's is down 3.4 percentage points and Greece's is down a formidable 14.7 percentage points. That's the good news. The bad news is that the yields are still atrociously high compared to benchmark German bond yields. Italy is paying 4.2 per cent to flog 10-year paper; Germany can sell the equivalent for a mere 1.9 per cent. Spain has to pay almost 4.4 per cent. The high yields, of course, translate into painfully high financing costs for corporations.
The even worse news is that the falling yields in Italy, Greece, Spain and Portugal have almost nothing do with sound fiscal performance and almost everything to do with the European Central Bank. A year ago, ECB boss Mario Draghi promised to do "whatever it takes" to keep the euro zone intact. His commitment translated into a plan, not yet used, to buy the sovereign bonds of countries that have trouble financing themselves.
The mere existence of the program, known as Outright Monetary Transaction, has been enough to hammer down bond yields. Without OMT, there is a good chance Italy and Spain would be teetering on the fiscal cliff. If either of them were to be shut out of the bond markets – as Greece, Ireland and Portugal were – the euro zone would break apart. There is simply not enough financial firepower in the system to save either, let alone both. The permanent rescue fund (the European Stability Mechanism) has access to €500-billion ($690.11-billion). Italy's debt alone is more than €2-trillion.
The debt-to-GDP ratios are unsustainable in some cases, and approaching unsustainability in others. Greece's debt is expected to reach a ridiculous 176 per cent of GDP this year, even though its public debt was whittled down in 2011, when private holders of Greek sovereign debt (mostly banks) were frog-marched into the barbershop and given a "haircut." Italy's ratio is almost 130 per cent and rising. With Italy's growth firmly in negative territory, the ratio will get worse as the denominator shrinks. "These economies are just not growing fast enough," says Fergus McCormick, DBRS's head of sovereign ratings.
So ignore the blathering that the debt crisis is over because bond yields are no longer at crisis levels. Debt is rising almost everywhere in the euro zone, and growth, where it exists, is anemic.
The ugly truth is that without strong GDP growth, debt levels will have to come down by unnatural means. The uglier truth is that each of the debt-elimination options is a primed landmine. Privatizations and other government asset sales would seem the easiest solution. The reality is that such sales are agonizingly slow to organize and could result in fire-sale prices if done too quickly. Smacking the private holders of sovereign debt would cripple the banks and unleash contagion. The ECB says the restructuring of official holders of sovereign debt (that is, the ECB itself) is off the table, though DBRS thinks a fiddle will be found for Greece, such as an extension of debt maturities or a reduction in interest rates.
Writing in the Voxeu.org economists' site, Pierre Paris, of Banque Paris Bertrand Sturdza, and Charles Wyplosz, economics professor at the Graduate Institute in Geneva, think debt monetization is the least evil way out. It would see the ECB buy sovereign debt and, in effect, convert it into interest-free loans that would never be paid back.
It's impossible to tell which option will be chosen, but there is no doubt that, absent a miraculous return to growth, debt will somehow have to come down, potentially unleashing a political and economic firestorm. "The Eurozone's debt crisis is getting worse despite appearances to the contrary," conclude Mr. Paris and Mr. Wyplosz.
Eric Reguly