A Drawn Out Crisis Resolution for Europe
Unrest in the Middle East, particularly in Libya, has sent oil prices skyward, rattled the markets and cast a shadow over hopes of a recovery in Europe. Possibly because financial markets can focus on only one major problem at a time, however, the Middle East crisis has lifted some of the political and market pressure on European Union (EU) leaders to deal decisively, swiftly and comprehensively with the intertwined European sovereign debt and banking crises. Perhaps inevitably, the resolve of late 2010 among EU leaders to produce such a solution by their summit later this month is dissipating fast.
This lack of resolve postpones an inevitable reckoning and will likely require more "quasi fiscal market firefighting" by the European Central Bank (ECB) in the volatile months ahead.1 But we are not back to pre-crisis "square one." There has been a marked shift toward recognizing reality since May 2010. For example:
- Spain has largely "bailed itself out" through a series of tough crisis-inspired austerity measures, structural reforms of pension systems, labor markets and, not least, though belatedly, dealing aggressively with its troubled savings bank (cajas) sector. With Spain "the domino that won't fall," the truly systemic implications of Europe's sovereign debt and banking crisis have been averted.
- Europe has put its "no bailout clause" behind it and established a set of new institutional mechanisms that follow the established guidelines and experiences of the International Monetary Fund (IMF) and bolsters its ability to deal with "asymmetric shocks" in its current form, at least for small member states2. These mechanisms, a product of political expediency to be sure, have lifted some of the uncertainty among financial market participants.
- The ECB has, in its first major test, proven itself a capable and flexible "crisis manager" for the entire euro area. The established willingness in Frankfurt to do what is necessary in a crisis, despite notable resistance on its fully federal governing board, will prove of lasting institutional credibility and outlast the term of its current president, Jean Claude Trichet.
- The nine national elections in the EU since May 2010 have established that political platforms based on credible fiscal policies and structural reforms can win favor among European voters, while economic populism remains marginalized3. This is likely a lasting political reorientation in several euro-zone countries, similar to the embrace of more market-oriented social and fiscal policies (e.g. New Labour) among Northern European center-left parties in the late 1980s and early 1990s.
In other words, irrespective of what happens at the upcoming EU summit, the last year has not been a wasted crisis.
One key point still missing from the European crisis policy response, however, is of course the issue of what to do about the clearly unsustainable level of Greek (and possibly Irish and Portuguese) debt. Here, EU leaders have evidently allowed "irrational exuberance" to develop in the financial markets with promises of a "comprehensive solution" at the summit in late March4. While important decisions will be taken at the summit, a detailed solution to help Greece achieve debt sustainability will not be reached at that session. This failure will inevitably lead to some disappointment and associated volatility in the financial markets. And with near certainty, it will send Portugal into the arms of the IMF/European Financial Stabilization Fund (EFSF) during April5.
Despite the delay on dealing with Greece, financial markets should recognize that EU leaders have not adjusted their view of what is unacceptable in this crisis. Given the obvious risk of contagion to large eurozone members' debt from any haircuts imposed on private holders of Greek government bonds, outright default remains beyond the pale for EU leaders, including German Chancellor Angela Merkel. The EU cannot allow the risk-free status of existing euro area debt to be shattered, compelling many traditional investors to turn their backs on euro area sovereign debt markets.
An expeditious comprehensive solution to the crisis would surely be in the broad interest of the European economy. Because such a solution requires substantial political horse-trading among euro area members, however, it is far from obvious that a quick or feasible solution would be in the interest of several key political players. A drawn out timetable might in fact allow some to continue to try to extract concessions for maximum political gain. The March Summit was the EU leaders' own stated political deadline for a solution, but that might change. Indeed, missing the March summit deadline would not in itself bring disaster. The issue of Greece's debt must be solved before 2013, or possibly by late 2011, if the goal is to enable Greece to gain access to debt markets by 2012, the timetable that was part of the original IMF program for Greek government financing.
Several factors point to a protracted ultimate solution to this problem. First, the German state election calendar makes it advantageous for Chancellor Merkel to postpone any detailed solution for as long as possible. It is in her interest, in other words, to prevent a backlash among her own core voters in her Christian Democratic Union-led coalition6. At a minimum, her concerns mean that little concrete will likely come out of this week's summit of the euro area on March 11, as Merkel will not likely reveal her "red lines" before required at the EU Summit on March 25, just two days before two German state elections — in Rheinland-Pfalz and Baden-Wurttemberg — on March 277. Leaving everyone guessing for as long as possible and avoiding German news headlines about concessions to Greece thus serves her direct political interest.
Second, there are several pseudo-discussions under way over what flexibility the EFSF/European Stabilization Mechanism (ESM) should have on future loan provisions. Since the ESM is to be a permanent new EU/euro area crisis response institution, EU leaders should make it as large and flexible as possible, maximizing its potential use in future crises. On the other hand, the size of the EFSF/ESM is immaterial to solving the immediate Greek debt issue as well as potential future debt crises in larger member states, which will be a matter of the political will available at the time. That is true, too, with respect to the issue of whether or not the EFSF/ESM should be able to buy government debt (or finance governments' own debt buybacks). Both abilities would – especially from the ECB's perspective – be useful tools to make available to the permanent ESM, but neither of them will play a particular role in solving the Greek debt issue. Buybacks of distressed debt typically drive up the market value of the remaining outstanding debt, and hence rarely help to reduce the market value of a heavily indebted country's total outstanding obligations8.
Third, the recent Helsinki declaration of the European People's Party (EPP) leaders (which included Angela Merkel), stated (my emphasis)
"We encourage a periodical re-evaluation of EU and international assistance, which may lead to possible amendments of the packages in place. This can be pursued upon reaching agreed benchmarks. Possible measures to ensure the continued successful implementation of the Greek and Irish programmes should also fall under this category. We recognize that measures taken as part of consolidation plans need certain adjustments at national levels." 9
This statement clearly keeps the door open to future revisions of both the Greek and Irish program. The language makes clear, however, that such changes come only in a multi-stage process and that not all will be announced at the EU summit in March. Instead, we are likely to see the March Summit embrace the broad contours of more flexible future pan-European EFSF/ESM lending policies, followed at a later stage by a Greek, Irish (and Portuguese?) solution folded into this new set of European rules.
Ultimately, the precise future borrowing conditions for Greece and Ireland may not be settled at the point of the EFSF expiration in May 2013, after which only the ESM will be available for ongoing European financial support.
It is evident from the official language that the EU— and Germany and other AAA-rated nations in particular— are determined to expand existing conditionality in the IMF/EU programs by imposing added conditions to the interest rates charged on the two-thirds European financing component of euro area rescue packages. By insisting initially that Greece and Ireland pay unsustainably high interest rates on their European financing, and now giving themselves the flexibility to change those rates, the AAA-rated European countries have bestowed on themselves an adjustable policy lever that does not require any involvement with the rules-bound IMF in Washington.
Berlin and other AAA-rated countries hence have a crucial additional condition that is almost wholly politically discretionary, which is not the case for the IMF. Its lending rates are established by a set of rules, and ultimately only restricted by the necessity to avoid an outright default of the borrowing country (e.g. "ensure the continued successful implementation of the Greek and Irish programmes").
This is what the language of "enabling future amendments to lending programs upon reaching agreed benchmarks" boils down to. Such "IMF+ benchmarks" can (and will) be dictated largely by Berlin with the goal of extracting maximum concessions in whatever political form is desired by the German and other AAA-rated governments for countries subject to the ESM.
Moral hazard can be restricted in many ways, and risking the displeasure of Berlin is probably more effective than EU rules of questionable effect. If Angela Merkel manages to pull off this strategy with Greece and Ireland, she will surely have provided a far stronger incentive for other eurozone governments to avoid the ESM in the future. The ESM could turn out to be a stronger tool for political preemption than the Stability and Growth Pact could ever aspire to becoming.
1. The ECB's preemptive tightening signal (hawkish), combined with continued lavish liquidity until at least the summer(Dovish) last week, and especially Jean Claude Trichet's subsequent press conference clearly had a certain political pre-summit signaling intent to EU leaders of "not taking ECB activism for granted forever" and hence get on with taking the necessary difficult decisions asap.
2. It is obvious that a future emergency in a major euro area- member state would require a new round of "institutional innovation", as currently envisioned institutions like the EFSF/ESM will not suffice. However, events since may 2010 has clearly illustrated that the political will for such future innovations will be there if required.
3. This week's re-election victory of the Estonian government, despite its extremely tough economic reform program to enter the euro-zone, is merely the latest example of this trend from now eight national elections in the EU since May 2010. See http://www.euractiv.com/en/elections/estonias-ruling-centre-right-coalition-wins-election-news-502787?utm_source=EurActiv+Newsletter&utm_campaign=71d44dbdca-my_google_analytics_key&utm_medium=email
6. Note that at a minimum this means that absolutely nothing will come out of this week's euro-zone only summit, as Merkel will not reveal her "red lines" be
7. Postponing any details of any compromise to March 25th would moreover push them back until after the next state election in Saxony-Anhalt on March 20th.
8. Secondary market debt buybacks by governments of their heavily discounted outstanding debt raises the secondary market value of the remaining outstanding debt, as they will be more likely to be able to service it. As such, governments are better of investing their funds in other more profitable investments. See Claessens and Dell'Ariccia (2011) for a detailed discussion at http://www.voxeu.org/index.php?q=node/6173.