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Greece Bailed Out, Banks Bailed In: Is Fiscal Union Becoming a Reality?

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The European visionary Jean Monnet once quipped that “people only accept change when they are faced with necessity, and only recognize necessity when a crisis is upon them.”  This sentiment was clearly at the special euro area summit in Brussels on July 21, as European leaders again showed their far reaching pragmatism in reforming the unique hybrid entity that is the European Union and euro area.

Major decisions were taken on several fronts1:

First, the euro area agreed, together with the International Monetary Fund (IMF) and “private sector involvement,” or PSI – the euphemism for concessions by creditors -- to cover Greece’s funding gap until 2014.

Second, the euro group agreed to make the European Financial Stability Facility (EFSF), and later the permanent European Stability Mechanism (ESM), far more flexible and helpful  as instruments seeking to solve this and future crises in Europe. EFSF/ESM lending will now be at the much lower rate of the European Balance of Payment facility at around 3.5 percent and at a maturity of 15 to 30 years (with an additional 10-year grace period). They will also be able to act (with the appropriate conditionality) in a precautionary capacity, i.e. without a country being under an IMF program. They will further be able to finance recapitalizations of financial institutions through earmarked loans to all euro area governments. Finally they will be able to intervene in the secondary bond markets on the basis of a European Central Bank (ECB) analysis and based on the “mutual agreement” of the euro area governments.

The reduction in EFSF loan rates, along with the maturity extensions, amounts to a sizable “stealth fiscal transfer” from the core to the periphery of Europe. Greece, Ireland and Portugal will now enjoy  lower costs of their official funding. This will aid debt sustainability and obviously provide additional incentives for recipient countries to implement their IMF austerity programs.

The immediate extension of the lower rates to Ireland and Portugal, moreover, illustrates a powerful attempt by euro area leaders to ring fence Greece and prevent the contagion that markets have been fearing in recent weeks. The method behind that effort is to direct substantial “stealth transfers” to these two countries, aiding their debt sustainability and just maybe pushing them over the hill to fiscal health. In other words, euro area leaders have put a lot of money on the table up front. The goal is to help ensure that “Greece requires an exceptional and unique solution.” This proactive decision making by EU leaders has frequently been missing since the spring of 2010.

Equally important, euro area leaders state that they “are determined to continue to provide support to countries under programs until they have regained market access, provided they successfully implement those programs.” This commitment is potentially far reaching, especially considering that the debt sustainability or market access of Greece, Ireland and Portugal is far from secure at the end of their current programs. The Greek example shows more specifically how IMF programs are generally extended until market access is restored. Taken literally, the statement amounts to an open-ended commitment of support and the birth of what I am ready to label a hybrid euro zone “conditional fiscal union.”

What does “market access” mean? The ability to place debt at 100 basis over Germany? At 6 percent? At rates a country can afford? It is not a clearly defined threshold.

But imagine the likely scenario that Greece – still with a huge debt load of over 100 percent of GDP – falls short of market access in 2014, despite a primary surplus derived from implementation of its IMF obligations.  At that point, Greece would not, as now, be financing deficits. Instead it would mostly need to roll over or retire its existing debt. The euro area commitment opens the door for the continued rollover of outstanding private sector debt into the public sector on an ongoing basis, provided that Greece adheres to any “euro area political conditionality.” In principle, given how Greece’s still huge total debt load might make private investors reluctant to provide any parri pasu (on an equal basis) finance for the foreseeable future, the vast amount of Greece’s remaining privately held debt stock (outside the debt transacted under the PSI agreed this week) could therefore be gradually rolled over into the public sector of the EFSF/ESM. That would be the case unless, of course, the euro area at some point decides to evoke the ESM’s provisions for PSI after 2013.

A very large amount of Greece’s outstanding public debt could thus end up in the EFSF/ESM – i.e., converted into conditional eurobonds. This way, provided Greece adhered to programs and other political conditionality, the euro area will gradually slide into owning the vast majority of Greek debt. Commonly funded eurobonds could consequently become the principal credit vehicle for several peripheral euro area nations.

This wouldn’t quite be the huge common pool of highly liquid bonds like the U.S. Treasury market right away. But in the distant future, when the euro area’s new fiscal sustainability initiatives have potentially succeeded in reducing the debt stock differences among the member states, euro members could well agree to pool their outstanding bonds into a single debt instrument. Such a step would be aimed at improving liquidity, market size and credibility as one of the world’s anchor currencies. Stronger euro area members like Germany would not, under any circumstances, agree to this -- unless the debt profiles of individual members were far more similar than they are today, and fiscal policies much more aligned. Pooled bonds among a smaller sub-group of likeminded euro area members might be a multi-speed euro area” precursor to eurobonds. Euro area-wide regular eurobonds are not around the corner, on the other hand.

Nonetheless, the type of conditional eurobonds that the EFSF/ESM represents does in the short term overcome the prohibitive democratic deficit inherent in eurobonds among diverse euro area members. The disparate populations of Europe still overwhelmingly identify themselves with their home countries, and their home countries’ taxing authorities. Despite obvious financial market advantages, populations in Germany, for example, will not accept liability for the fiscal decisions of another government – like Greece. This week’s euro area decisions, however, clearly show a willingness by elected officials to accept liability for the actions of their peers, provided that these peers “do as they are told” in the goal of achieving austerity. Conditionality provides accountability, which can substitute for direct democratic legitimacy through a common identity/election process. Large-scale conditional eurobonds as they have now been created are a big step forward in the hybrid euro area.

In addition, the euro area – in collaboration with international banks in the International Institute of Finance (IIF), the leading association of the banking industry 2 – agreed on the precise outline for bank haircuts in conjunction with the new financing for Greece. The euro area went to great lengths to underline that this sets no precedent. “Greece requires an exceptional and unique solution,” they said, in a statement that, along with the pre-emptive transfers to Ireland and Portugal, should mitigate the much-feared contagion. It will be interesting to see Moody’s reaction to this. The world is watching to see whether Moody’s reverses its recent junk-rating on Ireland and Portugal, which it justified by citing earlier versions of PSI mooted by the euro area leaders. It probably won’t do an about-face, however. The credit rating agencies seem likely to declare Greece in selective default, since all the voluntary options in the suite of measures prepared by the IIF3 indicate losses for bondholders. It is unlikely, on the other hand, that the International Swaps and Derivatives Association (ISDA) will declare the new accord to be a “credit event,” triggering payouts for sovereign credit default swaps for Greece.

The ECB, which has resisted PSI for months, got a lot in return from euro area leaders for going along with this version of debt restructuring. The central bank has rejected default-rated collateral in its regular repo-operations. As a result, there has been abnormal importance attached to the credit rating agencies’ declaration with respect to Greek PSI, because Greek banks remain totally dependent on access to ECB liquidity. While the ECB failed to dissuade euro area governments from imposing PSI, it has forced euro area governments to insulate it from any risk transfer to its balance sheet from a Greek default.

As laid out by the ECB president Jean Claude Trichet at his press conference in Brussels4, a Greek default declaration from the credit rating agencies would require euro area governments to recapitalize the Greek banks to make them “sound counterparties” eligible for regular ECB repo transactions. Such a step would involve granting default-rated Greek collateral an additional euro area guarantee, turning it back into “sound collateral” in the eyes of the ECB. Following the completion of the outlined PSI transactions, Greece would almost certainly be lifted out of its temporary default by the ECB. This would allow the country’s collateral to be used by the ECB as collateral, as before. In other words, euro area governments ended up doing what they ultimately wanted to do on PSI, but with protections for the ECB from the consequences of their actions.

Combined with the euro area endorsement of several of the ECB’s long-held position on the secondary market access for the EFSF and euro area governance, the overall outcome in Brussels will broadly have pleased the ECB. In the end, the central bank and the euro area governments managed to remove the economic importance for Europe of credit rating agency actions. That is a good thing.

With their call for a “comprehensive strategy for growth and investment in Greece,” and their instructions to the European Commission and European Investment Bank to work towards this goal, the euro area governments have for the first time outlined a direct initiative to restart economic growth there. Combined with the far-reaching pro-growth structural reforms outlined for Greece (and Portugal), Europe is gradually moving beyond the required goal of austerity.

In sum, this was a big leap forward for economic integration in Europe. Many doubters will remain in financial markets and the punditocracy, with some justification. Many – among them quite likely most macro-economists – will continue to see the euro area in black and white and conclude that without a fiscal union like the one in the United States, or a regular eurobond analogous to a Treasury bond, the euro is doomed. Fortunately, however, the real world is more complex than macro-economic theory dictates. The Manichean declarations on the euro zone can largely be dismissed.

Even if Greece’s ultimate solvency was not secured this week, if Europe’s leaders retain the pragmatism exhibited this week, financial markets may gradually realize that just because the euro is a novelty and a hybrid, it can still be viable.

Notes

1. http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/123978.pdf

2. http://www.iif.com/press/press+198.php

3. http://www.iif.com/download.php?id=rPiz9R7SVQ4

4. http://video.consilium.europa.eu/index.php?pl=5&sessionno=3522&lang=EN

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