Portugal Plays Chicken

Minority parties within the Portuguese government have rejected an austerity program proposed by Prime Minister Jose Socrates. He stepped down. As MarketWatch pointed out, the incentives for politicians in debt ridden nations to accept harsh terms from the EU have begun to vanish.

Ireland is currently in a stand-off with its neighbors about the interest rates it should pay on 85 billion euros worth of support. The new government has resisted an increase in corporate taxes as a partial remedy to deficit growth. Ireland has decided that the problem belongs more to the EU and IMF than it does to Ireland. Minority parties which voted against austerity plans in Portugal seem to think the same thing.

It is convenient to think that the EU will rescue members at any price. Resistance to austerity among the region’s economically weakest nations will be met by a sort of economic compassion. Bailout interest rates will be lowered. The EU has created a larger European Financial Stability Facility with capital of 440 billion euros up from the previous amount of 250 billion euros. The facility also has permission to buy sovereign bonds in the open market.

Ireland and Portugal can look at the actions to increase the facility as a sign of weakness on the part of the economically more powerful nations led by Germany. That view only works if Germany does not press for austerity in exchange for support as its has in the past.

The eventual result of a long-term stalemate would be a default on sovereign obligations by Ireland and Portugal. Politicians in each country can rightly assume that the desire to keep the EU intact and the euro as a viable currency will make a rescue inevitable even under terms that Germany might find unpalatable. That assumes, among other things, that the Merkel government stays in place. Germany’s voters may reject the country’s participation in bailouts in favor of the borrower and not the lender.

Default, as inconceivable as it may seem, will be more difficult road than anti-austerity forces believe. Borrowing costs will not be capped by reasonable investors.  Instead, they will drive interest rates to unprecedented levels. Ireland and Portugal will be forced into austerity because they cannot afford to offer the most basic government services otherwise.

Portugal will have to accept austerity as the only way out of its financial trouble. It is just a question of whether it is now or slightly later.

Douglas A. McIntyre