European Debt: When Will the Brinksmanship End?

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.

Written at 13:03:27 PST on Feb. 9,2012

After months of drama, the leaders of Europe's leading financial institutions have yet to reach a deal with Greece's governing coalition to impose further austerity measures on that country in exchange for a €130 billion bailout.

The leaders of Greece's three coalition government parties, including Prime Minister Lucas Papademos, had been negotiating the deal among themselves as well as with the heads of the three supranational organizations (the "Troika") which are expected to provide the country with financing: the International Monetary Fund, the European Union and the European Central Bank.

This agreement should provide the Greek government with enough financing to pay off its upcoming sovereign bond redemptions in exchange for the imposition of new fiscal tightening measures. These include cuts in the government pension funds, a slashing of the minimum wage and enacting new taxes.

Greece's two major labor unions are already calling for a 48-hour strike beginning Friday to rally against the agreement. The leader of one of these unions, the ADEDY, told reporters, "The painful measures that create misery for the youth, the unemployed and pensioners do not leave us much room. We won't accept them. There will be a social uprising."

Additionally, Greece's politicians must now also negotiate a deal with their private creditors. These negotiations, however, are not expected to be as contentious as those with the Troika were.

The optimism is due to one of the few hopeful notes in this saga; the ECB's acquiescing to forfeit the deep discounts on the Greek bonds it bought.  This has resulted in private investors feeling more confident in regard to buying European sovereign debt. As the ECB is such a large holder of Greek debt, all other holders would have had to take a proportionately larger loss on their holdings in order to allow Greece's debt burden to be brought down to 120 percent of GDP (the level the International Monetary Fund considers the limit of sustainability). Also, private investors would be reluctant to buy the government bonds of any other troubled European nation in the future if they believe that their holdings would be squeezed whenever official bodies such as the ECB stepped into the market. Had they not done this, the first hint of bond buying by the ECB would likely prompt a run for the exits, putting future bailouts at risk.

 Most importantly, the ECB's move sent a powerful signal that it is willing to be flexible in order to keep the euro zone intact.

This flexibility will probably be tested soon, both by existing and future bailout recipients. The night before the Greek deal was announced,  the Irish Finance Minister told the local press "If the ECB are prepared to make this kind of concession to Greece it would encourage me to think that they might be ready to make concessions on the promissory note to Ireland."  This is a clear hint that Ireland will soon request either interest rate concessions or debt forgiveness from the ECB on the promissory notes it used to rescue defunct lender Anglo Irish Bank.

The financial stability of both Spain and Portugal has been brought into doubt during the crisis, but they have not reached the level where a rescue is required. Spain is not under pressure at this time, but the outlook for Portugal is tentative. Not because the right policy changes can't help overcome her debt, but because national sentiment echoes what was heard in Greece.

Early optimism was further dampened in January when the country's credit rating fell below investment-grade. Such factors make it clear that even 90 percent adherence to financial conservatism may not be enough. In this climate, even small examples of undisciplined spending will be amplified, making investors more skittish and speculators less confident. Post the Greek debt deal the 10-year bond yield for Greece is still at 29.6 percent; for Portugal, it is at 12.4 percent. But the bond yields of other seriously indebted nations (Ireland at 6.7 percent, Italy at 5.45 percent, and Spain at 5.125 percent) combined Germany's 2 percent yields prove that Portugal is in serious pain.

It comes down to this: the Greek debt crisis is being treated as a benchmark instead of an exception. Last Wednesday, the leader of Portugal's largest labor union publicly denounced proposed austerity measures, calling for the "renegotiation of debts, in terms of deadlines, in terms of interest and in terms of the amount." For some Portuguese, who are witnessing the most serious recession since the 1970s, the acute pain of tax hikes, budget cuts, and the elimination of two months of civil servant wages overshadow the threat of something worse.

In order to save itself, Portugal must go beyond merely doing better than Greece — it must, in word and in practice, be prudent. "It is painful but this pain is unavoidable," said Klaus Regling, head of the European Financial Stability Facility. "Countries that went through a bubble have to go to a new equilibrium, and that means a lower standard of living."

This should sound familiar to all of us in the USA.....