The rescuing authorities (Northern Europe and the European Central Bank) cannot agree on the most pressing priority – to exact a price from those who imprudently lent to Greece and other sovereign debtors or to instil confidence that a line has been drawn under the losses.
If Greece was a company, its banks would probably have withdrawn support by now. However, countries are not companies; they can still influence the political consequences of financial actions imposed upon them.
Failings
The banking crisis escalated because one bank having failed, the markets turned their attention to the next weakest. Europe has a number of countries with fiscal problems so the lack of closure on the Greek financial rescue has resulted in markets imposing punitive interest rates on others.
Otherwise manageable problems have been exacerbated by the market’s lack of confidence in the European authorities’ ability to restore normality to government bond markets. A debt burden that would be perfectly sustainable with 4% interest rates could be insupportable if markets impose rates of 8%.
Whatever deal is finally struck to solve (or defer) Europe’s sovereign debt problems, it has to address the need to boost confidence that the resulting process is both agreed and sustainable. Germany, in particular, seems insensitive to this need and intent on “creating a drachma out of a crisis”.
Concerns
In recent months markets have also worried about slowing growth. This has renewed concern about stagflation, though equity markets have responded more calmly than a year ago. The oil price has fallen back since April and there are signs that the worst of the disruption from the Japanese earthquake is over. Yet other factors still wield the potential to undermine. The upward pressure on interest rates from the rise in inflation in emerging economies has not yet reached a turning point.
Left to economics, the current slowdown in growth and consolidation in equity markets would probably be viewed as a mid-cycle transition period holding relatively few fears for investors. The bugbear is politics. Much depends on Europe resisting the temptation to turn crisis from an event into a way of life.
The European financial system’s heavy investment in the eurozone’s sovereign bond markets means that it is vulnerable to multiplied losses if the European authorities fail to put a cordon sanitaire around the unavoidable losses from a small number of minor economies. Such a failure would aggravate the erosion of market confidence, but a decisive outcome would remove a key headwind from equities.
