Body
It nearly goes without saying that Europe does not have the institutional capacity to solve all of its competitiveness, debt, banking, and political crises simultaneously. Policymakers have yet to invent the institutions to address these huge problems. But Europe does have the capacity to avoid disaster. Fortunately, its incremental steps so far have almost all been in the right direction. But another critical week lies ahead.
That is why the world now awaits the actions of the President of the European Council, Herman van Rumpoy, in particular. What additional incremental steps must he take to shepherd Europe's leaders toward an arduous exit from its crises? Two things should be at the top of the agenda of an EU summit meeting on October 17–18—bank capital and leverage for the European Financial Stability Facility (EFSF).
Perhaps surprisingly, Greece should be a relatively low priority. The Greek parliament, for example, will not have voted on the decision to lay off or retire up to 30,000 public workers by the time of the EU Council meeting. Accordingly, the euro area finance ministers have postponed the disbursement of the next Greek loan tranche to early November. As a result, detailed issues concerning Greece and its debt sustainability should not be on leaders' agenda. Euro area finance ministers appropriately refused to authorize more money to Greece until the Greek Social Democratic (PASOK) government accepts the political sacrifice of beginning to lay off public sector workers and thus alienating its electoral base.
Spanish Prime Minister Jose Luis Rodriguez Zapatero voluntarily took such a step early in the crisis and paid the political price, by announcing in April that he would not run for re-election. There is no reason to demand that Prime Minister George Papandreou and PASOK do anything less if they want to avoid the economic collapse of their country. In short, Greece and issues related to enforced haircuts for creditors should be secondary at the upcoming EU Summit.
At the Euro Area Summit on July 21, van Rumpoy was tasked to "make concrete proposals by October on how to improve working methods and enhance crisis management in the euro area." In pursuit of that goal, he must first focus on the most immediate crisis for Europe right now, which is its banking sector.
Here van Rumpoy must exploit the brief political window of opportunity that has been opened by the completion of the EFSF parliamentary approval process. Now that European leaders can publicly discuss what unpopular things like bank recapitalizations they wish to use the EFSF for, they must face certain realities. Foremost among them is the collapse of Dexia (illustrating how meaningless the second EU bank stress tests were) and the accelerating credit crunch in the euro area while growth slows down (which makes the economic costs of undercapitalized banks unacceptable). The overriding goal must be to push hard for a deal that quickly puts as much new equity capital into the European banking system as possible. Such interventions are politically feasible only during periods of acute financial market stress, so German Chancellor Angela Merkel's recent statement in favor of "coordinated bank recapitalizations" must be seized and acted on.
The fact that the European Central Bank (ECB) this week went further than expected in providing the European banking system with unlimited liquidity for up to 12 to 13 months and until the summer of 2013, as well as additional ECB covered bond purchases of €40 billion, further suggests that action is imminent. The ECB is unlikely to have taken these forceful "non-standard" measures without firm policy assurances of a quid pro quo from governments on banks' capital.
Concerns over the debt levels of several EU sovereigns make the use of sovereign bank guarantees financially unrealistic. Such guarantees would only further jeopardize credit ratings. Consequently, EU leaders have no choice but to use direct capital infusions in to their banks, which will give them bank assets in return, mitigating the net government debt effect of such interventions. The sequence seems reasonably straight forward: (1) have the European Banking Authority (EBA) issue new stress test guidelines showing more realistic capital requirements (overruling the usual captured EU national regulators); (2) issue a short deadline (say a few weeks) to raise any risk-hungry new private capital (or allow banks to sell off assets); (3) encourage national governments to step in with the EFSF available in the background if various thresholds have been reached to avoid the "Irish scenario" of a sovereign taking on mountains of unsustainable debts.
The French—with their large bank exposure and stressed AAA-rating—will obviously want as much EFSF money deployed as possible. By contrast, the Germans and the Dutch will be happy with overwhelmingly national sources. Van Rumpoy's principal task ahead of the summit will therefore be to design a political compromise over national-EFSF breakdown of the sources of required government capital. His objective will be to mobilize the maximum possible amount of new core equity capital. Fortunately, unlike in the United States, the political concerns over potentially large government ownership shares in banks will not be a particular issue—as long as such stakes are held by the national governments.
Van Rumpoy and EU leaders must also focus on getting a credible political agreement on how to leverage the EFSF. This is necessary to make the EU policy response comprehensive and sufficiently large. For reasons of financial credibility, the direct involvement of the ECB will be imperative. Van Rumpoy should act quickly and exploit the fact that this will be the last EU Council for ECB president Jean Claude Trichet, and that Trichet has more freedom to design an assistance package for Italy than his successor Mario Draghi, outgoing head of the Bank of Italy. Once installed, Draghi cannot afford to be seen as lending Italy a helping hand from the ECB Tower in Frankfurt.
What is needed is a politically credible and potentially unlimited joint EFSF/European Stabilization Mechanism (ESM)/ECB mechanism for intervening in the secondary government bond markets in the euro area. This is a tall order, but Trichet explicitly stated at this week's ECB Governing Council meeting press conference in Berlin that "no limits have been discussed on the ECB Securities Market Program." His words suggested that the ECB Governing Council is ready to stand at least implicitly behind euro area governments to avoid an economic meltdown in Europe.
Van Rumpoy should work for a political agreement laying out the "policy rules" for interventions by a joint EFSF/ESM/ECB mechanism, where the EFSF/ESM will provide the risk capital and the ECB the leverage. The rules must stipulate two things:
- When can secondary market interventions be contemplated? An intervention could be triggered, for instance, once a member state's interest rates spread to the benchmark, surpassing 350 basis points, which would provide national governments ample economic incentives to avoid "getting help," thereby reducing moral hazard;
- What kind of conditionality will be applied to countries benefitting from secondary market interventions? Various types can be imagined, but it is clear that unlike the failed Stability and Growth Pact (SGP) created at the monetary union's founding, the conditionality must be automatic. This way, access to secondary market interventions through such a mechanism will become the functional equivalent of a flexible credit line from the International Monetary Fund (IMF), available to euro area members with strong fundamentals (e.g., no solvency issues). The conditions must also include acceptance of enforceable policy adjustments to prevent a full-blown crisis.
Securing recapitalization of Europe's banks—a bigger EFSF "bazooka," in the memorable terminology of former Treasury Secretary Henry M. Paulson—will greatly enhance crisis management in the euro area. It will more specifically enhance the credibility of EU political commitments to stand fully behind Ireland, Portugal, Spain, Italy, or any other troubled country. It will bolster the July 21 declaration that "Greece requires an exceptional and unique solution." Only if the European Union can make a plausible case to financial markets that no other euro area member faces any solvency issues, will it make sense for leaders to proceed with a more thorough debt restructuring in Greece than envisioned in the July 21 deal. Only after Europe gains credible tools to prevent contagion to other countries (with a leveraged EFSF) and after euro area banks have more capital in place, should policymakers risk the additional contagion that would flow from the overthrow of the risk-free status of Greek sovereign bonds.
It makes no sense for policymakers to both recapitalize the banks directly and bail them out again through a Private Sector Involvement (PSI) scheme of haircuts that would also be beneficial to them and their balance sheets. Yet, reopening the July 21 deal on haircuts for banks before banks have been recapitalized would be extremely—and unnecessarily—destabilizing.
