Body
The euro area faces an existential crisis. After almost two years of drama, European sovereign debt problems and associated threats to the stability of European financial institutions continue to build. The euro and the European integration project confront "catastrophic risks," in the words of US Treasury Secretary Timothy Geithner, and time is running out. A failure to decisively address those risks would be catastrophic not only to Europe but also to the rest of the world. The appropriate prescription is to apply overwhelming force via two channels: economic policy and financial support.
The basic content of the policy channel is clear. The crucial question, however, is whether a mechanism can be utilized in a timely way for the financial-support channel.
Recent discussions about such a mechanism suggest that Europe can mobilize the European Financial Stability Facility (EFSF)—with its expanded powers that are expected to be approved by mid-October—and the European Central Bank (ECB). Acting together they have the scope to provide the kind of overwhelming financial force to stabilize the situation and to support the required economic and financial reform (see the PIIE-Bruegel conference and Jacob Kirkegaard's most recent Real Time pieces, What Tim Geithner Should Tell the Europeans about Collaborative Crisis Solutions, The German High Court, Eurobonds—and a New Euro Area Treaty?, and Europe's Made-in-America Tools to Deal with Its Financial Crisis).
The United States in 2008-09 used the Treasury, via the Troubled Assets Relief Program (TARP), and the Federal Reserve in an analogous manner. By combining the potential loss-absorbing capacity of the EFSF with the ECB's capacity to provide liquidity, these approaches can provide substantial financial means for Europe to confront skeptical market forces.
The details about how the final structure would work, while important, are secondary at this stage. What is required is for the European authorities to decide to use the resources and authorities of the existing institutions in conjunction with each other to supply the firepower to governments implementing credible economic and financial policies. In other words, policy conditionality would not be relaxed. Those governments, in turn, can then use those resources to address various manifestations of the crisis. Once a commitment is made credibly to do everything that it takes to save the euro, and the authorities demonstrate they have the resources to back up that commitment, the details can be worked out. But until the markets believe that the resources are there, they will assume the worst. This is one of the essential lessons of the US experience.
One structure might involve the ECB or the EFSF setting up a special purpose vehicle that would be capitalized by the EFSF and financed by the ECB. Another possible mechanism would be for the EFSF to buy bonds from a euro area country—presumably starting with Greece—providing that country with the resources to buy back its debt, recapitalize its banks, or implement some other agreed program. The ECB, in turn, would buy the bonds from the EFSF via a repurchase transaction at an appropriate discount—say, 10 percent. In the process, the EFSF would restore most of its capacity (90 percent in the example) to engage in additional transactions with other governments or institutions. The result would transform the €440 billion endowment of the EFSF into financing potentially amounting to several trillions euros, while limiting the risk to the ECB's balance sheet. The fundamental point is that there are many ways Europe can structure its official financial support on a sufficient scale to do the job. It is neither necessary nor desirable to further transform the EFSF beyond the measures agreed to on July 21st that are in the process of being approved by participating countries. What Europe needs is action!
Three years ago, Ben S. Bernanke, the Federal Reserve chairman, was widely quoted as saying that the US federal government should do "whatever it takes" to stabilize the situation. Now the EFSF should be mobilized by the euro area authorities to convince markets that they will themselves do "whatever it takes" to support credible economic and financial policies of its members that are convincingly implemented. Only in this way will market participants, citizens in the affected countries, and global public opinion be convinced that the euro crisis is over.
Without overwhelming financial support for credible economic and financial policies, market participants will remain skeptical that economic and financial reform programs will work. Consequently, the citizens in the affected countries will lack the incentive to implement the needed policies, and global public opinion will not swing around to believing in the success of the overall effort. The unpleasant fact of life is that global markets can mobilize almost unlimited financial firepower to communicate their skepticism. The European authorities must respond commensurately. Moreover, the European authorities do not have the leisure to invent new institutions or further transform existing institutions. They must work with the institutions, tools, and instruments already available to them.
They would do well to look to the EFSF the ECB to do the job. They do not have much time.
