The financial community claims nearly unanimously and somewhat vociferously that the eurozone is suffering from a confidence crisis that can only be solved by wielding a "big bazooka." If the rescue fund is large enough, goes the argument, markets will be assuaged, interest spreads will shrink, and the distressed countries will manage to refinance their public debt. But as popular as this view may be, it is far too optimistic.
Of course markets are jittery, and the risk of self-reinforcing runaway processes is real. However, markets have every reason to be nervous. There is not just the self-inflicted instability of mutually infecting speculators, but a fundamental distortion of prices for goods, labor, and capital that would need a currency realignment that is impossible within a currency union. Whoever offers his guarantee for the funds powering the big bazooka should know that such a guarantee will be drawn eventually, given that the debtor countries lack the competitiveness to be able to redeem their debt.
The distortion of prices stems from the bubbles that built up in the eurozone's periphery in the years before the crisis. The rapid interest convergence that took place from 1995 to 1997 in anticipation of the euro induced governments and private agents to overborrow and overspend, making their respective economies overheat. In Greece and Portugal, the borrowed funds went largely into the wages of government employees, and in Ireland and Spain largely into the wages of construction workers. As construction workers paid more taxes, and government employees bought more homes, they pulled each other along into the bubble. At the end of the day, whoever borrowed the cheap funds from abroad made little difference. From 1995 to the crisis year 2008, the GIIPS countries (Greece, Ireland, Italy, Portugal, and Spain) appreciated against their eurozone trading partners by 30 percent. By contrast, Germany depreciated against its eurozone trading partners by 22 percent, which translated, for instance, into Italy appreciating by 50 percent against Germany. Increasing wages, prices, and nominal incomes in the GIIPS undermined their export competitiveness and boosted imports, driving all countries into current account deficits: 2.2 percent of GDP in Italy, 3.5 percent in Ireland, 7.7 percent in Spain, 10.9 percent in Portugal, and 12.5 percent in Greece over the past five years.
The most recent estimates for 2011 show that the combined current account deficits of the GIIPS will be on the order of 127 billion [euro], and their net foreign debt position will have risen to l,620 billion [euro]. Italy's net foreign debt amounts to only 26 percent of GDP, but that of the rest to a staggering 95 percent (95 percent for Greece, 86 percent for Ireland, 105 percent for Portugal, and 95 percent for Spain). No less than 52 percent of the total net foreign debt of the GIIPS, or about 1,021 billion [euro] in absolute terms, lies in Spain, with 417 billion [euro] or 21 percent in Italy, and the rest shared among the other GIIPS countries. (Surprisingly, even France had a net foreign debt position of about 215 billion [euro] in 2010, the eurozone's third-largest in absolute terms. In relative terms, however, that amounts only to 11 percent of French GDP.)
A net foreign debt position on the order of 100 percent of GDP is extreme by any standards. Greece, Ireland, Portugal, and Spain will therefore have a hard time repaying their foreign debt, to put it mildly. There is every reason for the current holders of the respective government bonds to be frightened.
The only chance to repay the debt is to become competitive enough to earn a current account surplus. That, however, requires becoming cheaper. The terms of trade must deteriorate in order to stimulate exports and redirect import demand towards the purchase of domestic goods. That is easy if a country exits from the euro, but difficult if it …