The most immediate task facing the new government will be to engage in the process of revising the euro-zone bailout mechanisms. There has been much ink spilled on the strategy the government should adopt, with threats versus persuasion the early dividing line.
I think it is fair to say that persuasion has won out for the moment. But the persuasion branch itself divides into those stressing a focus on European blame/Irish credit on one side, and those stressing shared interests in fixing broken mechanisms on the other. I would expect our European partners will listen (mostly) politely to our assertions on blame and credit, but those assertions will be ultimately dismissed as self-serving yapping.
The case for shared interests stands a better chance. It is becoming clear how flawed the bailout mechanisms are. I have previously referred to a “bailout trap”, whereby it is difficult to regain market access once a country enters a bailout. The 10-year bond yield shows the markets continue to place a high probability on a longer-term Irish default. But I think a “black hole” is actually a better analogy: not only is exiting the bailout a problem, but any country that gets anywhere close is at considerable risk of being sucked in, with Portugal most clearly in the danger zone, followed by Spain, Belgium and Italy.
Perhaps the most revealing news of last week was the threat from S&P to downgrade Portugal if EU leaders follow through on plans to impose burden sharing as part of the proposed ESM, as well as insisting on official creditor seniority (FT article here).
“We believe that if the source of external financing for the Portuguese economy were to remain restricted, the government would have to approach the EFSF to avoid an even more severe economic contraction,” . . . [Eileen X Zhang, S&P credit analyst] said.
S&P warned it would downgrade Portugal’s sovereign debt rating by one or two notches if European leaders decided later this month to require borrowers from the European Stability Mechanism – due to replace the EFSF in 2013 – to restructure their government bonds and make the ESM a preferred creditor.
Potential new private creditors see considerable risk of taking disproportionate losses in any future burden sharing, and stay well clear if there is a chance a country will succumb. But as these private creditors stay clear (and yields rise), the fear of entering the “bail-out” becomes self-fulfilling.
It is in no one’s interests to have this black hole spreading from the periphery of the euro zone, ultimately threatening its destruction. That is the case the new government should be making, and it should have no shortage of allies.