Evercore Pan Asset

Each time the EU draws up a bail out agreement for a wayward Euro member, we are told they are drawing a line in the sand. Each time so far it has turned out to be a line in the sand which soon gets erased by the incoming tide of problems. The Greek line was washed away by the Irish crisis. Now the Irish line is eliminated by the Portuguese request for a loan. We now know these loan packages do not stop contagion, the passage of the debt problem from one Euro state to another.

We also should know that lending more money to a country with too big a debt or too large a deficit is not the answer to the underlying problem. If a country has too large a debt, it needs to sell some assets to pay off some of the borrowing. Alternatively, it needs to stop borrowing any more at all, to reassure its creditors. If a country is seeking to borrow too much additional money year by year, it needs either to raise more revenue in taxation, or reduce its spending. Borrowing more makes the problem worse. The deficit starts to rise under the power compound arithmetic, as the interest rate bill spirals upwards. The easiest way to raise ore tax is to promote more growth, so revenue rises with increasing activity. Unfortunately some of the policies which go alongside EU bail outs make growth more difficult, not more likely. Higher tax rates and spending cuts without devaluation can lock a country into low or no growth, the opposite of what is needed.

We now know from experience of this rolling crisis that a loan package does not necessarily buy much time to sort out the underlying problem. Greece had to come back for a renegotiated loan package towards the end of 2010, just a matter of months following the successful completion of the rescue package. The new Irish government wishes to renegotiate the interest rate on its loan agreement. If the outgoing Portuguese government signs up to a rescue package, the incoming government may have different views.

The best you can say for a rescue package is it buys time to sort out the excess spending or the deficient revenue. It allows the state in trouble to borrow for a longer time period at a cheaper rate than the markets would allow. It is therefore a subsidy from the other member states to the state being helped. If that state then gets on with cutting its deficit and borrowing requirement in a way which restores the confidence of the markets, the EU members will get their money back or will not have to pay up under their guarantees. In due course the state at risk can borrow the money more cheaply from the markets and repay the EU assistance. If the distressed state does not succeed in cutting its deficit and reassuring markets, the EU and IMF assistance has to be rolled over or revised to allow the country to continue, or else there has to be some default on some elements of the state’s debts.

Countries like Portugal need a credible programme to stimulate private sector growth and to reduce public spending sensibly. If they had those they would find it easier to borrow from the markets. If they do not develop them, the EU assistance will prove a temporary respite. Like Greece, there will be need for renegotiation of the rescues.