Wednesday, March 23, 2011

Will Portugal be the first domino?

At present there are three eurozone members who have lost the ability to access the private capital market: Greece, Ireland and Portugal. Greece and Ireland have agreed to drastic austerity in exchange for access to the European Financial Stability Facility (and the IMF and ECB).

The Portuguese government has been attempting to perform fiscal surgery on itself without a bailout. Today the Portuguese parliament rejected the government’s austerity plan; the government has resigned; and there will be an election.

A bailout appears to be inevitable. But the EFSF/IMF scheme requires drastic austerity along the lines that have just been rejected. The new government and parliament will be faced with a choice between drastic austerity or default (resulting in even more drastic austerity). There is no “Get Out of Jail” option.

I would expect the ECB to keep Portugal on life-support while a new government is elected and formed. But unless Portugal requests a bailout on Draconian terms, there will be no bailout and Portugal will descent into the abyss.

It is possible that the Europeans will blink and keep shovelling euros into the Portuguese treasury despite uncontrolled budget deficits, but I can’t see Angela Merkel keeping her government together under such circumstances; the German people are already very angry about the EFSF.

Also, the EFSF may demand that bondholders agree to rescheduling and/or take a haircut. This would foreclose market access for a long time, forcing the eurozone to refinance all of Portugal’s maturing debt, a political impossibility.

The only way that Portugal can prevent economic collpase while remaining in the eurozone is to swallow the austerity pill and become a ward of the eurozone for the foreseeable future. Can any free people vote for drastic long-term austerity? The Baltics did, but for the euro peripherals, I am skeptical.

It is unclear how long the Greek and Irish peoples can tolerate a repeat of the Great Depression.