Yes, the headlines from the euro area are discouraging. The region’s Purchasing of Managers Index (PMI) is falling again—to 45.9 in May, with even German levels down. The European stock markets are down. The euro has slid to 1.25 vs. the dollar, accelerating preparations for a Greek euro exit. No resolutions of the political crisis came from an acrimonious if informal EU Council meeting. To paraphrase Charles Dickens’s famous comment about America’s propensity to declare doom, it seems as if the global media, financial markets, and pundits are to be believed, the euro area is always depressed, always stagnated, and always in an alarming crisis—and never was otherwise.
The future of Europe, however, will not be determined by the poor 2012 euro area second quarter economic performance. The drop in the euro’s value is good for external demand, and the likelihood of an actual Greek exit from the euro is much overblown.1 The “informal EU Council” was never expected to produce “deliverables.” In other words, as usual, the euro gloom is exaggerated. In fact, the last week brought several encouraging developments.
Bankia’s Failure: A Manageable Problem?
First, the Spanish government is finally owning up to the full scale of its banking crisis. The new capital requirement of troubled Bankia is estimated at €23.5 billion (including €4.5 billion of government loans previously converted into equity). This number is well within the legislated financial capacity of the Spanish government’s domestic bank bailout fund, the Fund for Orderly Bank Restructuring, or FROB. The question is whether Spain will raise this new government-guaranteed debt quickly. No wonder the Spanish Prime Minister Mariano Rajoy sounded eager to get the European Central Bank (ECB) to resume purchases of Spanish government debt.
Bond markets took the news of these losses relatively calmly, however, even though new rumors circulated concerning poor provincial government finances in the economically important region of Catalonia. Spanish government bond yields were up around 30 to 40 basis points across the 2 to 10 year spectrum for the week, and 10-year rates once again approached the 6.5 percent of late last year. On the other hand, such secondary market yields may not accurately reflect the market appetite for sizable new primary bond issues by the Spanish sovereign.
The calm market reaction likely reflects its expectation of Bankia’s losses, despite earlier denials, and an appreciation of the financial system’s new transparency. But the delayed admission of Bankia losses undermined international confidence in the Spanish government and the hitherto respected Bank of Spain. Covering up banking problems is always the wrong strategy for regulators and political leaders. Assuming the economy will eventually turn around, denial prolongs the agony.
Several options are available for the Spanish government. It can try to issue additional debt in the markets and use the FROB to inject the money into Bankia and probably other Spanish banks. From the perspective of Spanish sovereignty and political pride, this would seem to be the preferred option. That is undoubtedly why Rajoy called for more ECB market interventions to help. Securities Market Program (SMP) interventions do not come with explicit policy conditionality (although in 2011 SMP purchases of Spanish debt were accompanied by a secret letter of conditions accepted by Prime Minister Jose Luis Rodriguez Zapatero). Rajoy probably thinks today that he has done his part by firing Peoples Party bigwig Rodrigo de Rato (a former head of the International Monetary Fund) as president of Bankia and finally owning up to the extent of its losses. Consequently Madrid now expects the ECB to reciprocate by restarting the SMP program for Spain.
The SMP is unlikely to come to the table today, however. The ECB will almost certainly resist restarting its SMP purchases of Spanish debt. The reason is that euro area institutions have evolved since 2011. The new European Stability Mechanism (ESM) backed by euro area governments is scheduled to become operational by July 1, pending various national ratification processes (of which more is said below). It will then be able to purchase Spanish government debt directly at primary auctions to help keep Madrid’s funding cost down. As a result, the ECB will not likely want to restart its SMP program to help Spain. Instead the central bank will see aiding Spain as a task for the euro area’s new institutions and euro area governments.
The ECB will certainly remain the ultimate euro area firewall and intervene with overwhelming force if necessary. But from its perspective, the ESM is there to be used to provide financial assistance—and impose the policy conditionality that the ECB felt reluctant to demand itself. Any purchases by the ECB will simply be symbolic—a signal that it is still there and only side-by-side with direct ESM primary market purchases.
Another option for Rajoy would be to ask for a loan under the ESM Treaty’s Article 15, earmarked to recapitalize Spanish banks. Conditionality would again be explicit, calibrated to economic conditions and —as the treaty’s Article 12 states —“appropriate to the financial assistance instrument chosen.” A third option would be to have the ESM recapitalize Spanish banks directly. But that choice is politically unpalatable without a broader integrated euro area banking sector resolution and regulatory union. That project is moving along, but setting it up may take more time than Spain has at its disposal.
Thus if the markets continue to make the cost of a bank cleanup unaffordable, all roads point to the ESM. For now, a full-fledged IMF program, removing the Spanish sovereign from the markets for years, remains unwarranted.
On the other hand, the Spanish government could issue additional debt for bank recapitalization at historically high—but not necessarily ruinous—yields. Several reasons might make such a route possible. First, many euro area fund managers ought to be willing to take a chance on long-term Spanish debt yielding around 6 percent, or around 3 to 4 percent in real terms. After all, the investment alternative would be German debt, with its negative real interest rates guaranteeing destruction of wealth. Germany’s ability to issue debt at coupons so low—when the Bundesbank is accepting higher inflation and workers are getting the highest wage increases in decades—is an indictment of the efficient market hypothesis. This German anomaly should certainly fuel demands for restrictions on financial markets’ remuneration.
Second, unlike standard deficit spending, expenditures devoted to bank nationalizations shift assets, however impaired, on to the government’s balance sheet. As a result, net Spanish government debt levels may not go up as much as gross debt levels. The worth of nationalized banking assets will not be known for many years, when presumably the Spanish government will want to sell their bank shares.
Third, it is not clear if current Spanish yields have already priced in the worst case scenario for the cost of bailing out the banking system. Markets have been concerned about that cost for months. If yields at more than 6 to 6.5 percent already reflect a market estimate of banking cleanup costs, the perception of risk for Spanish debt may not rise.
Finally, the cost of bailing out Bankia will be determined by the implications for the health of the rest of Spain’s banking system. We will not know the extent of the problem for months, when Oliver Wyman and Roland Berger publish their independent audit of the entire system. If Bankia turns out to be the most rotten apple—then Bankia’s nationalization and cleanup should be affordable. If Bankia is indicative of the entire apple barrel of Spanish banks, then surely the ESM awaits.
Germany’s Politics: A Step Toward One Form of Euro Bonds?
The second piece of positive news last week was the first harbinger of a likely new German “Grand Coalition” after the next federal elections in 2013, and how such a grouping will respond to the euro area challenges. As Chancellor Angela Merkel begins the political horse trading necessary to pass the Fiscal Compact and ESM treaties with a super majority in the full German parliament, her Christian Democrats and the Christian Social Union allies engaged for the first time with the Social Democrats (SPD) over a proposal from last year for a European Redemption Fund (ERF) as proposed by a team of German “wise men.” The fund would convert euro area government debt in excess of 60 percent of GDP into de facto eurobonds. These bonds would be senior to the remaining 60 percent of national sovereign debt, creating €2.3 trillion of such securities. Member states would be obliged to redeem the ERF bonds over 25 years.
The ERF has recently become an official SPD proposal . Some version of it may become the official German response to the renewed calls for eurobonds from other states. More discussions are planned for mid-June, but a big announcement would speed ratification of the Fiscal Compact/ESM treaties in Germany—a major development for the euro area!
The SPD’s embrace of the ERF sets the German Social Democrats apart from President Francois Hollande and his Socialists in France, with their call for eurobonds now. Hollande is unlikely to moderate his rhetoric until after the French parliamentary elections in a few weeks. But economic realities in the euro area are likely to compel him to work with the SPD, perhaps embracing its approach.
Many advocates of eurobonds will see the ERF as a poor substitute—too little too late to secure long-term stability. Recall, however, that many of these same pundits declared in 2011 that the euro area would be crushed by its imminent bank and sovereign debt rollovers and cease to function by mid-2012. In fact, while an ERF might be temporary, it would create a permanent new de facto joint liability of eurobonds. The reality is that the euro area will not abandon the economic benefits derived from this large pool of senior joint liability bonds. Together they will make up a new risk free benchmark asset for the banking system and a pool of debt to rival the US Treasury market for liquidity. No less important, they will serve as coercive political instruments to force—or provide incentives for—member states to implement structural reforms and sound fiscal policies to retain access to the ERF.
Twenty-five years is a long time in European politics. In that timeframe, treaties can be changed and institutions can be created to secure a stronger political integration of Europe and pave the way for actual euro bonds. An ERF would therefore constitute the ultimate example of the euro area buying time to sort out the messy politics of continental integration.
The European Council: Heading to More Integration?
Third, the informal European Council session last week marked another policy step towards integration similar to the signing of the Fiscal Compact Treaty earlier this year. Many will ridicule the reports prepared by Herman Van Rompuy, the European Council president, for the heads of state and governments to discuss further. That would be a mistake. The reports should be viewed as a scaled-down and expedited “crisis version” of the policy process with which the EU changes its treaty, known as the European Intergovernmental Conferences (ICGs).
The last time Van Rompuy was charged with preparing such a report was at the EU Council on October 23, 2011 , when the purpose was to “reflect on further strengthening of economic convergence within the euro area and on improving fiscal discipline and deepening economic union.” The intention then was to change the EU Treaty, although that was thwarted by the myopic opposition of Prime Minister David Cameron of Britain. The outcome was the inter-governmental Fiscal Compact Treaty.
Van Rumpoy was directed to “report [at the EU Council] in June, in close cooperation with the President of the Commission, the President of the Euro Group and the President of the European Central Bank, on the main building blocks and on a working method to achieve this objective [the need to strengthen the economic union to make it commensurate with the monetary union]. Colleagues expressed various opinions on issues such as eurobonds in a time perspective, more integrated banking supervision and resolution, and a common deposit insurance scheme.”
This is how policy is made in Europe these days. Considering how the ECB has begun to campaign for a “European Banking Union,” it is a safe bet that its president, Mario Draghi, will ensure that it is on the agenda at the next EU Council. The ECB has been direct in its demand for more integration. Draghi has been relatively opaque in his calls for a “10-year plan for the euro,” but other ECB executive board members have been more clear. Jörg Asmussen, on May 24, said: “We have to move closer to a financial markets’ union. A European bank resolution authority and a European deposit insurance scheme are two elements that could be used to address the nexus between sovereigns and banks.”
The next day, May 25, Peter Praet was similarly unambiguous: “Europe needs to move towards a ‘financial union,’ with a single euro area authority responsible for the supervision and resolution of large and complex cross-border banks. This authority should also be responsible for a euro area deposit insurance scheme. With bank resolution and deposit insurance funded primarily by private sector contributions, taxpayers would be shielded from picking up the bill for future banking crises. Essentially, I envision an authority similar to the Federal Deposit Insurance Corporation in the United States.”
The ECB’s record in securing the financial stability of the euro area—and its willingness to extract political concessions from elected leaders—have made progress on integration of the euro area banking system increasingly likely.2 Doom will get the headlines, but this is a more important development than whether the ECB must undertake another Long Term Refinancing Operation (LTRO) or other new emergency measures in coming months.
As for the role of the International Monetary Fund (IMF), the recent, perhaps impolitic comments by the fund’s managing director, Christine Lagarde, could roil the waters by stirring fresh resentment in Greece. In a wide-ranging interview with the Guardian, she said: “I think more of the little kids from a school in a little village in Niger who get teaching two hours a day, sharing one chair for three of them, and who are very keen to get an education. I have them in my mind all the time. Because I think they need even more help than the people in Athens…. Do you know what? As far as Athens is concerned, I also think about all those people who are trying to escape tax all the time—all these people in Greece who are trying to escape tax."
Such blunt words, especially for an IMF managing director, are sure to figure in the upcoming election campaigns in Greece and Lagarde’s native France. But it would be unfortunate if they dominated the news story, because she pointed her finger to two important but overlooked issues. Greece has indeed received more economic support per capita than probably any program recipient of the IMF, when the regional support from the euro area is also included. Second, as Dimitris Drakopoulos of Nomura in London has pointed out to me, Greek tax revenues indeed remain a key policy problem. The revenue intake has again collapsed in recent weeks, raising doubts about whether any Greek government can continue to finance itself after the Greek elections on June 17.
Beyond the troubles of Greece, however, the bigger picture of the outlook of the European currency union remains. It is often said that the long-term viability of a political entity is dictated by the vigor of its arguments over fundamentals, including the design and role of its government institutions and the directions of its values. That is often said of the United States.
A closer look behind the surface squabbles, at what is actually going on in the euro area, makes this author optimistic over its future.