Iceland on the Thames: Can Countries Really Go Bankrupt?

By SPIEGEL Staff

The bailout packages aimed at shoring up financial markets in Europe are getting increasingly expensive. A creeping depreciation of currency is inevitable and state bankruptcies can no longer be ruled out. Could the euro zone also fall victim to the global financial crisis?

"There's a rumor going around that states cannot go bankrupt," German Chancellor Angela Merkel said recently at a private bank event in Frankfurt. "This rumor is not true."

Of course she's right. Countries can go bankrupt if they allow their deficit spending to spin out of control and are no longer able to service their interest payments. Merkel's comments can be read as a warning that countries need to keep their deficit spending in check. The message is: If governments go too far in trying to bail out companies and the economy, they could face insolvency themselves.

Great Britain is on the brink of financial ruin.
REUTERS

Great Britain is on the brink of financial ruin.

And so far, national governments have gone very far. Be it in the United States or in Europe, the sums governments are having to cough up to prevent the financial system from collapse are staggering.

Germany alone has already provided credit guarantees of €42 billion ($52.28 billion) to prevent the collapse of Munich's Hypo Real Estate, a bottomless pit that most now believe will have to be fully nationalized. The only thing holding up such a move is a legal provision in Germany that limits state holdings in banks to 33 percent. Meanwhile, Germany's second-largest consumer bank, Commerzbank, has been bailed out, with the state taking a one-quarter stake in the company. And the recent fourth-quarter loss of €4.8 billion at Germany's leading financial institution, Deutsche Bank, suggests that it too may ultimately require state assistance.

From Inconceivable to Inevitable

The image is even bleaker in the United States, where economist Nouriel Roubini estimates that losses in the financial sector will total $3.6 trillion. In the United Kingdom, the government has partially nationalized the Royal Bank of Scotland and Lloyds TSB -- and many experts see a full nationalization as inevitable.

There are few who would disagree with such moves. Should large systemically-vital banks go bust, the global financial system would collapse. But how much can countries afford to pay before the deficit-spending bubble bursts? An unimaginable scenario? Less than a year ago, a nationalization of banks in the US, Germany and Britain would have been inconceivable. Today, even the US -- the home of unbridled capitalism -- sees these moves as inevitable.

The borrowing being done by countries to finance the bailouts, economic stimulus programs and shortfalls in tax revenues will create a lasting burden. Worse, with the decline in the banking sector continuing, it is unclear that such massive spending will be effective. Especially when other, less economically stabile countires surrounding Germany have gone into a tailspin.

Take the example of Great Britain. The country is on the brink of financial ruin. Real estate is overvalued, private households are overly indebted and its vast financial sector has been badly hit by the crisis. Confidence in Britain's ability to overcome the economic turmoil is sinking by the day, as evidenced by the precipitous decline of the pound, which has almost reached parity with the euro. Just 13 months ago, it was worth €1.40.

A Second Iceland

"I wouldn't invest any more money in Great Britain," says American investor Jim Rogers. And economist Willem Buiter, a former consultant to the Bank of England, warns of the "risk that Great Britain will become a second Iceland."

One can also look to the example of Italy, which is on track to join a rather exclusive -- and undesirable -- club. At 106 percent of gross domestic product, Italy will have the third-largest national deficit in the world.

In a country that has long had a solid savings rate, deficit spending hasn't proven to be a huge problem in the past. The greatest challenge the government had was luring people to buy bonds at a set interest rate. The country's finance minister has described these investments as the "most solid and secure thing available." Of course, not everyone shares that opinion at the moment -- particularly not the Italians themselves. One bond that was floated in mid-January only found takers after the government markedly increased the interest rate offered.

Bond returns in the euro zone.
DER SPIEGEL

Bond returns in the euro zone.

This year, Rome has to pay back €220 billion in short-term bonds. Finance officials have been quoted as saying that were a single bond issue to find no takers, it "would be a disaster for the state." In December, Italian Labor Minister Maurzio Sacconi warned that Italy could go bankrupt if the country were no longer able to sell public bonds because of the glut of offers in other countries. "It would create a liquidity problem for paying salaries and pensions and we would end up like Argentina."

Great Britain as a second Iceland, Italy as a second Argentina. Iceland today is as a good as bankrupt, and Argentina actually became insolvent in 2001. It's no wonder then, that quotes like that from government officials are making people nervous. There has been no other time in history since the end of the Great Depression that the risk of national bankruptcies was this great in Europe as it is right now.

The national budgets in most of the European Union member states are in a miserable state. Finance experts at the European Commission in Brussels estimate that, this year alone, deficit spending in the 16-member euro zone will total 4 percent of GDP, with that figure rising to 4.4 percent next year. The euro Stability Pact, however, only allows 3 percent. The Commission estimates that in 2010, 17 EU states will surpass this total. The list includes countries like Germany (4.2 percent), France (5 percent), Spain (5.7 percent) and Britain (9.6 percent). Ireland is expected to top the list with deficit spending of an anticipated 13 percent.

These predictions, of course, exist only on paper for the moment. But Austrian Finance Minister Josef Pröll warns that "someday, payment day will come."

Euro Bonds?

Last week, Pröll and his colleagues formulated a call for a change of course, saying a coordinated fiscal stimulus was needed and that it must include a "coordinated budget consolidation" across Europe. Just how that might happen, though, is unclear.

In a hearing before the economic affairs committee of the European Parliament last week, EU Economics and Currency Commissioner Joaquin Almunia was showered with questions for which he had few answers. As a first step, he suggested that six to eight countries should reduce their deficits. But he didn't suggest how they might go about doing that.

For some governments, budget consolidation is the furthest thing from their minds at the moment. Instead these countries are doing everything they can to find ways of securing credit, which is getting increasingly difficult. "Smaller countries are being pushed out of the credit markets because the larger countries are borrowing billions," members of parliament told Almunia. His response: That's true, but you still can't "do away with capital markets."

In order to solve the problem, Luxembourg Prime Minister Jean-Claude Juncker, who is also his country's finance minister, proposed that the 16-member euro zone states should create common "Euro Bonds." Smaller countries praised the proposal, but it met with instant rejection in Berlin.

Germany, so far, has been able to borrow cheaply because it still has an excellent credit rating. If the country were to fill its coffers by floating Euro Bonds, it would have to pay €3 billion more this year. Austrian Finance Minister Pröll also seemed uninterested, dismissing the Euro Bonds as giving carte blanche for creating new debt at the expense of others.

Many European leaders have been critical of Germany's approach to the financial crisis -- it was slow to implement an economic stimulus package and some derided Chancellor Angela Merkel as "Madame Non." But in Germany, the government has been concerned about the risk of over-borrowing and burdening future generations with debt. The government has already abandoned its plan for a balanced budget by 2011, and Merkel has warned of the limits of Berlin's role in any bailout.

Merkel is concerned that the bailouts will overstrain the government. After all, if the government's debt continues to rise, at some point it will no longer be capable of paying the interest. Already, 2009's planned borrowing of €18.5 billion is higher than the previous year, and this week the government is now in the process of approving a second economic stimulus package that, combined with other borrowing, could push 2009 deficit spending past the €50 billion mark. No German government has ever had to borrow that much money.

To ensure that future generations aren't saddled with massive debt, the plan contains a provision that will funnel €1 billion a year in revenues from Germany's central bank, the Bundesbank, that previously went into the government budget starting in 2011. Currently, the Bundesbank pumps €3.5 billion a year into the budget. Until 2012, any profits at the bank exceeding €3.5 billion would go toward paying down the growing national debt.

Most experts believe the German government still has room to maneuver, but further deficit spending may be inevitable and few know how much will be needed. Berlin may soon have to establish one or more so-called "bad banks" where troubled financial institutions can park their bad loans -- a program that would require yet further government borrowing.

A Real Test for the Euro Zone

The government has exercised a degree of caution in deficit spending in recent years that has often been lacking in some other EU states. And politicians in Berlin have been reluctant to push through massive economic stimulus programs that might encourage others to abandon any sense of fiscal responsibility.

In the past, a handful of EU member states borrowed and borrowed without giving it a second thought. Now, they've been hard hit by the current downturn because their credit ratings have been lowered and they are being forced to borrow at higher interest rates. Spain, Italy, Ireland and Greece have been particularly hard hit.

Countries that have to borrow so expensively are threatened with constantly rising interest rates that in turn increase their debt. In response, credit ratings agencies further lower ratings, pushing interest rates even higher in what becomes a vicious circle.

Market speculators create additional pressures. The tensions could escalate even further and create a real test for the euro zone.

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