How Euro Brinkmanship Is Beginning To Succeed
European Union leaders had the umpteenth euro crisis summit at the end of January. Indeed the EU Council meets so often that the descriptions of these gatherings should be changed from "yet another summit" to "back in session." The slide to near-permanent policymaking has occurred as the EU Council begins to resemble a sitting parliament. But on January 30, 2011 the leaders made tangible progress on several fronts, though not necessarily on the stated goal of the summit—job creation and growth. Most importantly, at German insistence, they cleared the political and institutional way for an increase in European bailout funds.
EU official statements are often a steady source of diplomatically phrased compromises and non sequiturs. The summit communique, Towards Growth-Friendly Consolidation and Job-Friendly Growth, was no exception. The term "growth-friendly consolidation" is of course a watered down version of the infamous and self-contradicting "expansionary consolidation" doctrine espoused by European institutions earlier in the crisis. (Mario Draghi, president of the European Central Bank, has recently distanced himself and the ECB from it.)
On substance, however, EU leaders are on the right path. No one can oppose the three main subject areas singled out for action: (1) Stimulating employment, especially for young people; (2) completing the single market; and (3) boosting the financing of the economy, in particular small and medium enterprises (SMEs). Each category encompasses many new initiatives, almost all to be carried out by the European Commission. None will do harm and several will even be useful, such as finally completing the new common EU patent law by June 2012. In fact, one must ask, why has it taken so long for these common sense proposals to be enacted?
Of course, Southern Europe and many other European countries require not simply some additional European Commission initiatives, but the implementation of far-reaching labor market reforms. These reforms must undo the web of restrictive practices that give Spain and Italy their distinct insider-outsider job markets, in which a few (typically prime aged men) have heavily protected jobs and everyone else (especially youth) are marginally attached to the workforce. Such deep and (until now) politically unpopular structural reforms are more feasible because of the financial and economic crisis.
The summit's most important accomplishment, as mentioned, centered on two new treaties—the new fiscal compact and the European Stability Mechanism (ESM) Treaty.
The fiscal compact, or Treaty on Stability, Coordination and Governance in the Economic and Monetary Union, outlines new fiscal rules for 25 of the European Union's 27 members (the Czech Republic and the United Kingdom will not join). A lot of nonsense has been written about its provisions—for example, that its budgetary constraints enshrine "pro-cyclical fiscal policies" and even outlaw Keynesianism. In an editorial betraying its ignorance of the treaty, the New York Times asserted that the treaty "will legally restrict [European governments] from fighting recessions with robust fiscal stimulus." Actually, Article 3 states that euro area members "may temporarily deviate from the medium-term objective[a structural budget deficit of 0.5 percent of GDP]or the adjustment path towards it only in exceptional circumstances." The rules thus concern the "structural budget deficit," not deficits driven by cyclical economic trends. This provision is thus not comparable to the balanced-budget requirements in many US state constitutions.
A "structural budget deficit" is defined in the treaty as the "annual cyclically-adjusted general government budget balance net of one-off and temporary measures." Contrary to the Times' assertion, euro area government can therefore implement a "robust fiscal stimulus."
Moreover, "exceptional circumstances" can include an "unusual event outside the control of the[euro area government]concerned which has a major impact on the financial position of the general government." Such circumstances could also include "periods of severe economic downturn"causing a "temporary deviation" in the budget that "does not endanger fiscal sustainability in the medium term." Accordingly, the treaty permits a euro area member hit by an earthquake, natural disaster, or a severe economic blow to undertake temporary fiscal stimulus.
The treaty notes further that under the revised Stability and Growth Pact, a "severe economic downturn" occurs "if the excess over the reference value[the 0.5 percent of GDP in structural deficit]results from a negative annual GDPvolume growth rate or from an accumulated loss of output during a protracted period of very low annual GDP volume growth potential relative to its potential." In other words, if a euro area has a large output gap, it can implement a fiscal stimulus to reduce it.
Thus whatever one thinks about the appropriateness of current fiscal policies in the euro area, they are driven by a host of political and market factors, and it is indisputable that the new treaty will permit robust future fiscal stimuli. What it will hopefully achieve, however, is a requirement that euro area members consolidate government sectors and reduce structural deficits in good times.
A more valid criticism of the fiscal treaty is that it fails to address the biggest current obstacle to a lasting stabilization of euro area crisis—the construction of a large and credible financial "firewall" to prevent contagion from the periphery to the core of Europe. The new ESM treaty1 holds the key to this issue, though inexplicably the text is not yet available. EU leaders are reserving judgment on the central issue of the ESM—its size—until the next EU Summit in March.
To some—like the New York Times editorial page again—the failure to boost the size of the European bailout instruments represent an abject failure. Such a judgment is simplistic. As C. Fred Bergsten and I have written, the key decisions in the euro crisis follow a pattern of happening only at the last minute, after the various actors have wrung the best deal possible from daunting circumstances. The ECB, for example, backed a full-scale banking bailout (through their three-year Long-Term Refinancing Operations) in December only after reform-friendly governments were in place in Spain and Italy and after it was clear that the euro area would accept the new fiscal compact. At the same time, the euro area governments offered €150 billion to the International Monetary Fund (IMF)—rather than the ESM and its predecessor European Financial Stability Facility (EFSF)—to placate German domestic political concerns2 and also to get other G-20 countries hurt by the crisis to contribute their share. The G-20 turned around and told the euro area (particularly Germany) that they might contribute more—but only after Europe comes up with more money itself.
The same pattern applies to decisions on the size of the ESM. Euro area leaders (again especially Germany) will wait until March (rather than January 30, 2011) to raise the current €500 billion limit to the ESM/EFSF vehicle in order to exert maximum leverage in the negotiations. The players include private Greek creditors (whose haircut grows ever higher), the Greek political class (where the main parties are expected to support further reform commitments) and the other G-20 nations (who understandably wish to see Europe enhance its financial commitment).
Here is what is likely to happen in the euro area under a very tight timeline, with each step depending on the previous one to be taken:
- The Greek government will shortly reach a "voluntary" shotgun agreement with private creditors, resulting in a nearly 75 percent loss from net-present-value (NPV) on privately held debt. The ECB will not participate in the deal. In the future, bonds held by the ECB may be retired by the Greek government (or bought by the ESM/EFSF) at the (distressed) prize the ECB paid for them. For political reasons, any such transactions involving the ECB's holding of Greek bonds will not occur simultaneously with a bond swap involving private creditors. Simultaneity dilutes the political capital that German Chancellor Angela Merkel and others gain by "punishing bankers" and shielding taxpayers3 in such a debt write-down. But there will be backroom promises by EU leaders to assist Greek debt sustainability in this way in the future through a "stealth fiscal transfer." The euro area will try to invoke these promises to convince the IMF to declare Greek debt sustainable.
- A new IMF program is likely between the Greek government and the Troika (the ECB, the IMF and the European Union), outlining austerity and reform requirements for Greece. A drastic debt write-down (or PSI, which stands for "private sector involvement") is a precondition. Without such an agreement, Greece cannot be declared solvent by the IMF even under its most heroic economic models. Prime Minister Lucas Papademos and most Greek party leaders will promise to implement the new program regardless of the outcome of the Greek elections in April. The euro area and IMF will initially declare themselves satisfied with this "political outcome," enabling Greece to receive the required funding and avoid defaulting by mid-March. A minor upward revision of the euro area contribution to Greek funding of currently €130 billion (which politically amounts to a fiscal transfer) may be required for the IMF to sign off. More likely, various "stealth transfers" to Greece will be promised by the euro area instead. These would include the kind of future ECB bond swap described above, along with even lower interest rates on euro area loans, and extensions of repayment schedules into the distant 21st century. In other words, various ways will likely be found to restructure the increasing part of Greek debt held by the euro area governments and the central bank.
- Political agreement on additional contributions to the IMF by other G-20 nations is likely at the G-20 Deputies' and Ministerial Meeting on February 24–26, 2012 in Mexico City. No hard figures are likely to emerge until EU leaders' public declaration on the size of the ESM the following week. The euro area can probably convince other G-20 countries to support a broad based IMF capital increase of roughly the $500 billion already requested by the IMF leadership, however, even if the United States does not directly participate. Hopefully, potential Asian contributors to the IMF will press the European members to pledge further transfers of IMF quota shares from Europe to the large emerging-market countries, consolidating European representation on the fund's board.
- EU leaders—at their next summit in early March in Brussels—will likely commit themselves to raising the current €500 billion ceiling on the combined ESM/EFSF resources to as much as €750 billion. Implementation will consist of transferring the remaining uncommitted resources of the EFSF (€250 billion) to the permanent ESM. The structure of such a transfer is uncertain, but the permanent resource ceiling of the ESM will be raised substantially. Since the recent downgrade of France and other euro area members has eroded the credibility of "sovereign guarantees," the increase in total ESM resources will probably have to be accompanied by increases in the paid-up capital of the ESM. The timeframe of such transfers might be quite extended. In the end, Germany's (and the other Northern AAA-rated members') parliaments will accept this increase in ESM resources, knowing that Berlin has extracted the maximum political mileage. Among these are the new fiscal compact and the general shift of euro area policies during the current crisis. As a result, Merkel can now find it politically expedient to "write the check," knowing that she has won concessions for the leveraging of "European resources" to build a "firewall" to prevent contagion. Moreover, an increase of €250 billion euros will take the ESM to €750 billion—or roughly $1 trillion. Combined with an additional $500 billion in new money to the IMF, this would construct the "total firewall" for Europe along the same two-to-one ratio between the euro area and the IMF that applied to Greece, Ireland, and Portugal. Of course, the $500 billion for the IMF would not be earmarked for Europe. But it would certainly be seen as most likely to be used in Europe. In political terms, pouring more money into a permanent ESM facility can be sold to the Germans as a part of Merkel's goal of "strengthening Europe" and bringing about a new "Stability Union"—rather than simply approving another bailout of Greece.
- During the April 20–22, 2012 Spring Meetings of the IMF/World Bank in Washington, DC, actual new money will be mobilized for the IMF and the ESM treaty, which should be ratified by a sufficient number of euro area members to come into force in July. As a result, toward mid-2012, an official sector insurance policy of perhaps $1.5 trillion will be in place for the euro area. Combined with reform progress in Spain and Italy, the amount should be sufficient to restore a degree of confidence in the common currency.
Many readers will undoubtedly say that this is a hopelessly optimistic scenario. It obviously requires many coordinated actions by many actors in a short time. The reason for this author's optimism now and in the past stems from a belief in a highly effective doctrine of policymaking—"brinkmanship."
Many definitions exist for "brinkmanship," which describes the political strategy of deliberately pushing a dangerous situation to the "brink" of disaster to compel concessions from an opponent. Thomas Schelling, in his 1966 classic Arms and Influence (page 99) describes it as "manipulating the shared risk of war" and "exploiting the danger that somebody may inadvertently go over the brink, dragging the other with him." Brinkmanship is risky, but consider Schelling's comments on page 96:
The essence of the crisis is its unpredictability. The ‘crisis' that is confidently believed to involve no danger of things getting out of hand is no crisis; no matter how energetic the activity, as long as things are believed to be safe there is no crisis. And a ‘crisis' that is known to entail disaster or large losses, or great changes of some sort that are completely foreseeable, is also no crisis; it is over as soon as it begins, there is no suspense. It is the essence of a crisis that the participants are not fully in control of events; they take steps and make decisions that raise or lower the danger, but in a realm of risk and uncertainty.
Schelling's words certainly evoke the euro area crisis so far. Take the ill-timed and ill-conceived imposition of a debt write-down on Greek private creditors in July 2011, which unleashed a host of adverse developments unforeseen by the German policymakers who pushed hardest for it. The biggest of these was the market contagion to Spain and Italy, which European leaders are now scrambling to reverse.
The risk of accidentally triggering a "nuclear war outcome" that Schelling cited in his analysis of the Cuban Missile Crisis does exist in the euro area crisis, where a collapse of the euro could happen in spite of everyone's best intentions. But the Cuban missile crisis analogy should not be taken too far. The US naval blockade did avert disaster in 1962. But even if euro area policymakers miscalculated by imposing PSI without a firewall in place first, the euro has survived even as the cost of bringing the euro crisis to an end and the size of the required firewall have gone up, as discussed above.
Engaging in brinkmanship to compel the Greek political elite to reform is not likely to produce a catastrophe. Rather the risks entail a higher cost of achieving ultimate reform. Note also that brinkmanship had some positive benefits. Had there been no Greek PSI and no associated contagion to Spain and Italy, Silvio Berlusconi would likely still be prime minister of Italy!
A collapse of the euro currency would certainly bring turmoil in regional and global securities markets. Acknowledging that uncertainty is inevitable, European leaders have demonstrated the will to take alternative paths of action and frequently reverse earlier positions to avert such a disaster. Considering how often they meet, there is reason to believe that they can manage sufficient coordination to continue this pattern.
Ironically, brinkmanship could have a surprising impact on the biggest longer-term unknown in the euro area, namely Greece's inability to deliver on its pledges to reform.
Since early 2010, Greek governments have promised more than they delivered. One might even ask if the real problem facing Greece is its governing capacity, which is more akin to that of a developing country than a modern European nation state. But despite its failure to comply with IMF demands, the Greek political elite has so far managed to secure international aid to avoid collapse. Everyone involved has wanted to avoid the consequences of an uncontrolled Greek default and exit from the euro area.
Can a new Greek government taking office after scheduled elections in April do better? Current polls suggest another likely "grand coalition" similar to the current "unity government" between the New Democracy Party and the Socialists, or PASOK, though both parties have lost support to fringe parties on the left and right. Whether such a government will have more success is questionable. We might be back at the brink in the fall, with the euro area wondering what to do about a member that seems "unreformable."
That prospect is the final reason why it is in Germany's interest to approve the beefed up ESM in March. In essence, Germany faces the choice between pouring more money into Greece, or into an enhanced euro area firewall. Greece's own brinkmanship of demanding help and threatening to default, and bring down the euro, could by then fall on deaf ears. Once a combined ESM-IMF firewall of roughly $1.5 trillion is operational in the fall, and up to 75 percent of private sector losses are distributed, a Greek default and possibly even voluntary exit from the euro area might be a risk worth contemplating. There would still be risks. But a European decision to abandon a recalcitrant Greece (undoubtedly letting the IMF pull the trigger) might be the only effective threat the euro area has left. The mutual threat is all the more credible because both Athens and Brussels know that a firewall is in place and the rest of the euro area periphery has made enough progress to reduce contagion concerns. To further insulate the rest of the euro area banking system from potential bank runs in Portugal, Ireland, Italy, and other countries—arising from any "voluntary" decision by Athens to leave—the euro area would be well advised to create a unified euro area banking guarantee scheme. This would avoid potential bank runs following a departure of Greece from the euro area. Otherwise bank deposits in other peripheral members could be viewed as less safe and possibly even subject to redenomination into new domestic currencies weaker than deposits in German banks. The euro area requires not just an increased firewall, but a US-style Federal Deposit Insurance Corporation (FDIC) to up the ante and credibly threaten the Greek political elite with the ultimate sanction of expulsion from the euro.
Such an escalation has a better chance of securing Greek program compliance than the recent still-born ideas of putting Athens under direct euro area administration. After all, the era of gunboat diplomacy is long over, and Europe has only brinkmanship left.
What if Greece decides not to tough it out inside the euro area and chooses instead to chase the rainbow of a new drachma and depart? Chances are good that the rest of the euro area will gladly accept the Greek offer to decamp. The self-initiated exit of Greece would serve two political purposes in the euro area. For Spain, Portugal, and others on the periphery, any ensuing economic disaster in Greece following its exit would serve as an example that no other euro area member would want to follow. In Germany and elsewhere in the core, a euro area without Greece would facilitate the political acceptance of eurobonds, since the weakest link of the chain would be gone.
1. http://www.european-council.europa.eu/media/582311/05-tesm2.en12.pdf. In an inexplicable example of lack of transparency in EU policymaking, the final ESM treaty text was only made available to the public, after it had been announced that it had been signed by member states' representatives (it still needs ratification to become law of course). See http://www.consilium.europa.eu/homepage/showfocus?lang=en&focusID=79757
2. In Germany, the new money to the IMF comes from the Bundesbank rather than the German government, making it important that the independent Bundesbank will not lend directly to the ESM/EFSF (as it regards it as monetary financing), but can accept lending to the IMF.
3. Note that this does not mean that PSI was ceteris paribus a cost-effective idea to begin with.