Commentary: Austerity Does Not Help Euro Zone

After months of speculation, Portugal last night accepted what many had claimed has been inevitable since the fourth quarter of 2009 and went cap in hand to the European Union as its borrowing costs became unsustainable following another big jump in yields.

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The news saw the euro make further gains against the dollar as investors looked past the Portuguese decision to ask for support and instead focused on the European Central Bank, which is today expected to raise rates by 25 basis points in a bid to rein in rising prices. While the market has been pricing in the chances of Portugal asking for help for some time, the decision by caretaker Prime Minister, Jose Socrates, to ask now has been forced on him by the bond market following a raft of downgrades by ratings agencies, huge jumps in borrowing costs despite implementing austerity measures aimed at avoiding this situation.

The key questions facing investors now are whether Portugal’s caretaker government can actually negotiate a bailout and whether attempting to cut your way out of trouble will allow a national government to avoid default.

“A bankrupt and illiquid nation needs money and does not have a government empowered to ask for a bridge loan. We are in unexplored territory, and we need to wait for the political masters to figure out how to deal with it, if they can,” said Carl Weinberg, the chief economist at High Frequency Economics, following the news from Lisbon.

Having predicted that Portugal would have to ask for help months ago, Weinberg now questions whether it will simply join Ireland and Greece in the “ranks of bankrupt borrowers that have been unfixed by the largesse of the ECB and EU.”

It is likely that the EU and ECB will back the Portuguese call for help given Europe’s political elite has been calling on Lisbon to take help for some months behind closed doors, but Weinberg is not sure what the German response will be.

“It is uncertain whether Germany, for instance, will agree to disburse funds to a caretaker government without the assurance of strict conditionality in perpetuity,” said Weinberg.

Getting Out of Debt

The details of any bridge loan or bailout will trickle out over the coming days as EU finance ministers meet in Budapest on Friday.

How can Portugal, Greece or Ireland get out of the debt spiral they find themselves in? With bridging loans from the ECB and EU doing nothing to actually lconower the national debts of any of the three states, they will remain on life support until they can grow at a pace higher than their interest charges, something that could be years away.

“The EU/IMF approach is not to restructure, but rather to burden heavily indebted governments with even more loans,” he said.

The Financial Times Deutschland reported that EU leaders are no longer ruling out restructuring for Greece and it does not take a mathematical genius to look at the numbers for Ireland and Portugal to conclude that they will have to follow at some point.

Weinberg believes all this is very bad for all euro zone bonds and that France and Germany will end up supporting the fiscal woes of the weaker euro nations. He remains worried about the state of the EU’s banking system.

“We have no idea at what point a drop in euro land bond prices might start to crunch the balance sheets of the banks that are already impaired. We guess that are at least 160 of them, judging by the number of number of institutions begging for cash at the repo window each week,” he said.

Greece, Ireland and now Portugal have implemented huge spending cuts, seen growth and tax revenues collapse and ended up seeking help anyway. This message will be ringing in the ears of leaders in Spain, Italy, Britain and even America.

The Keynesian calls for more stimuli and more borrowing to fund said stimulus could begin to look like a more attractive option if the alternative leaves you with higher debts, no growth and out of power.