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December 7, 2011

Euro Crisis: French and German Fiscal Plan is Ambitious

Markets have been rebounding for the past week on news that the leadership in the European Union have come close to a bailout plan for the troubled countries of Greece, Spain, and Italy. The political leadership, on Monday, announced plans for a treaty that would bring the EU closer to a fiscal union, limiting each country's annual deficit to 3 percent of GDP.

The leaders will include "automatic sanctions" against countries that violate the debt rules. There is no indication this early on, if any of the EU countries (besides France and Germany) will sign on or refuse this new treaty proposal. The main challenge will be the population in each of these countries supporting austerity measures.

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While politicians may agree with the measures laid out in the treaty proposal, civilians of the governments in crisis may be less obliged. As we've seen in Greece, entrenched entitlement spending is the most difficult line item to pull away from a budget. Unfortunately, it is also the worst funded. Many countries may deal with citizens who do not want to lose their "benefits," but also at the same time, not pay for them. Governments sympathetic to these cuts may find themselves challenged or voted out by more hard line elements that will challenge EU membership.

Is 3% of GDP Enough?

There isn't a clear indication from the private markets that 3% of GDP is a manageable deficit. I believe, that in order for that to be true, countries have to grow by at least 3% each year. Europe is currently heading towards recession, which means that even with balanced budgets, some debt to GDP ratios are going to continue to rise.

Additionally, the factors of supply and demand weigh silently huge to this outcome. If the private market is over-saturated with debt, it isn't going to accept anymore, no matter what the quantities are. Additionally, if the recent rise in interest rates does enough financial damage, institutions may be less willing to purchase government bonds in the future. This would permanently lower the demand side of the equation.

If supply and/or demand are negatively altered, then these measures may not be enough from stopping a further crisis in the immediate future.

Hope on the ECB

It is becoming more widely accepted that the ECB will need to step in and buy Euro government bonds. These purchases, similar to Quantitative Easing in the United States, will be designed to ease interest rates. Unfortunately, like QE, these types of purchases lower the incentives of EU countries to be fiscally responsible. Additionally, they run both the risks of future inflation and angering the responsible nations who were responsible, yet had to watch their counterparts be rewarded for failure (similar to what Ford had to witness when GM and Chrysler were bailed out).

The ECB can (and likely will) get around this solution by buying an equal purchase of bonds in all 17 euro countries. This will equally lower rates in each of the member countries and allow for political stability to be more attainable. Unfortunately, it still does not solve the fiscal responsibility problem that it poses.

For more on the Euro Debt Crisis, check out our new Euro Debt Crisis Live section.

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