For nearly two years, Europe has tormented itself with increasingly convoluted efforts to avoid the only cure for its countries with excessive sovereign debt: selective sovereign-debt defaults. Last week came yet another self-delusion: news reports have European leaders hoping that the Chinese government will invest tens of billions of dollars in euro debt to help distressed European nations avoid default. The money would come with strings attached. In fact, a deal with China likely would be the ultimate self-inflicted deformity: Europe would give up some of its rights to free political speech so that it could use Chinese money to hold the withering judgment of free markets at bay for a while longer.
As with everything related to the ongoing global financial crisis, the situation is incredibly complicated. Last week, Europe pretended once again to have fixed its debt problem. Under the latest plan, lenders to Greece, including big French banks, are supposed to take a “voluntary” loss of half the face value of their Greek bonds. French president Nicolas Sarkozy and German chancellor Angela Merkel have insisted on this “voluntary” canard because an “involuntary” loss would be, well, a default. Official Europe wants to avoid a default, which would mean big payouts for speculators who bought “credit-default swaps”—yes, those things again—in anticipation of such a disaster. Europe wants to punish the speculators, whom the politicians blame for precipitating the sovereign debt crisis in the first place.
But this political and financial alchemy is itself a gamble. It’s not only speculators who bought the financial instruments that were supposed to pay off in the event of default. Investors who hold Greek bonds purchased them, too, to protect their bond investments (as bond prices go down, swap prices should go up). These investors have also bought credit-default swaps as a hedge against Italian, Portuguese, and Irish debt—and now they’re wondering if such “insurance” is worthless. “If you owned a sovereign bond and you got scared because you bought [credit-default swaps] thinking [they] would pay out, you’ll realize you would have been better off just selling your bond—and you’ll just get rid of everything,” AllianceBernstein’s co-head of credit, Ashish Shah, told the Wall Street Journal.
Since nobody sells a financial instrument that hedges against the risk of political default, investors don’t know quite what to do. It’s unlikely that they’ll start putting money into the bonds of the other struggling countries. These countries need new money, though, to refinance their existing debt. Indeed, last Friday, after the latest deal for Greece was announced, Italy had to pay even higher interest rates on its own new borrowing; it can’t keep that up for long. Unless Europe inflates its way out of this crisis, prevailing upon its central bank to print money to buy up all the stranded bonds, more Greek-style restructurings on other European sovereign debt are inevitable. And we haven’t heard the last from Greece: Monday, prime minister George Papandreou said that he wants to give Greek voters a direct say—via referendum—in the budget cutbacks they must bear as a condition of European aid.
The prospect of bigger losses for investors in sovereign debt terrifies France. Sarkozy knows that French banks can muddle through the Greek mess. But to bear losses on other countries’ debt, France would need to raise capital. If the private sector won’t provide this new money, the French state would have to do so—or risk losses for the bondholders of these banks. It gets worse: France doesn’t have unlimited funds to bail out “private” financial institutions, at least not without cutting back severely elsewhere and experiencing low growth for years. France may have to decide whether it wants to be Ireland—protecting lenders to its banks at the expense of its economy—or Iceland, letting bank creditors suffer losses to protect the nation’s long-term future. To avoid having to make this choice, France is looking east. Sarkozy hopes that China will invest some of its trillions in a new fund, which Europe would manage, to prop up the bonds of indebted eurozone countries.
But China’s participation is another self-set trap for Europe. China has no willingness to throw good money after bad. “Beijing must be given strong guarantees on the safety of its investment,” the Financial Times noted, citing two Chinese sources. Europe can’t offer explicit guarantees against loss without getting each country’s permission again—permission that the Germans, Finnish, Slovenians, and other Europeans are tired of granting.
If the past two years are any guide, Europe will try to get around this problem with wink-and-nod provisions. But either something is guaranteed, or it’s not. Otherwise, Europe would have to call the new fund the “Schrödinger’s Cat” fund (after the quantum mechanics example that calls on an observer to assume that a cat is both alive and dead at the same time). If Merkel were that brilliant a physicist, she wouldn’t have gone into politics.
The bigger problem is existential. As Sarkozy’s Socialist opponent in next year’s election, Francois Hollande, asks: “Are we supposed to imagine that if China comes to the aid of the euro zone, it will do so without expecting anything in return?” China likely would want Europe to stop criticizing it for undervaluing its currency—a government intervention that makes Chinese investments more attractive globally—or for “competing” through unfair trade practices. Giving China more room to compete unfairly costs European jobs. Sarkozy disavows concern. “Our independence would not be put into question” by a Chinese rescue, he told a French interviewer.
European leaders have said many things over the last few years of crisis. Here’s what they don’t say: bad lending and borrowing carries a hefty price, for borrowers and lenders alike. Someone, somewhere, has to pay that price. It is better for the financial system—“involuntarily”—to take the hit than to force these losses onto the West’s supposedly priceless political and market freedoms.