Sunday, November 4, 2012
Why I remain a pessimist on Europe’s solvency
November 4, 2012
I should have known what would happen when you pose a question at the end of a column. Last week I asked how it could be, that somebody who was pessimistic about the eurozone six months ago could be optimistic today? If you always thought it was just a liquidity crisis, you should not have been worried then, and you would be right to be optimistic now. If you thought of it as a solvency crisis, as I did, you should still be worried now.
Several readers pointed out to me, quite rightly, that I offered only an extreme choice. What about a solvency crisis that is not inherent but caused by a liquidity squeeze – a self-perpetuating insolvency crisis? Solvency is, after all, an analytic concept. It depends on the level of debt, future growth, ability to tap private sector wealth through taxation, ability to raise funds through privatisation and, of course, future market interest rates. Reasonable people could disagree on all of these. Even Germany could be considered insolvent if you assumed a sufficiently high interest rate.
Distinguishing pure sovereign risk (minus the contingent liabilities for the financial and non-financial private sectors) from risks that have arisen purely in those sectors, my judgment on the solvency of various entities in the eurozone has been the following. In the first category, I consider Greece to be unconditionally insolvent; Italy and Portugal to be solvent – but conditional upon a return to sustained growth. I consider the sovereigns of Spain, Ireland and the rest to be fundamentally solvent – minus the banks, of course. In the second category, I consider the private and financial sectors in Spain, Portugal and Ireland to be insolvent.
Once you conflate sovereign and financial sector risk, the situation becomes more complicated. My bottom line is that the national backstops have not removed, and have possibly increased, the total solvency risk in the system.