Why It Is Still Possible to Be Bullish on Europe
Despite the expanding European commitments of aid for Greece and Ireland, accompanied by increasingly detailed pledges to set up a permanent post-2013 resolution mechanism , fears of a dreaded sovereign debt contagion have tanked European sovereign debt markets throughout the region, particularly in Spain and Italy. Never has there been more talk of doom for the entire eurozone.
Yet for all the seriousness of the crisis, and the inadequacy of the European policy responses announced thus far, I argue here that it is premature to declare the imminent demise of the euro. Stronger forces will ultimately contain financial contagion and prevent the breakup of the eurozone.
With regard to the inadequacy of policy decisions so far, there are several reasons why the announcements over the last weekend have failed in their desired impact.
First, the Irish bailout was not sweeping enough to deliver the "shock and awe for the markets" that the one announced in May 2010 did for Greece, with its headline €750 billion bailout fund set up by the newly created European Financial Stability Facility (EFSF) and European Financial Stabilization Mechanism (EFSM) along with the International Monetary Fund (IMF). Instead, for better or for worse, the Irish bailout relied on the existing policy tools created earlier, undercutting the impact. Moreover, because the policy response for Greece (a conditional bailout with official sector financing in the short term) failed to address the long-term solvency issue in the eyes of many analysts in the marketplace, relying on the same strategy for Ireland was not likely to impress them. Ireland, after all, potentially has the same long-term issue as Greece, depending on the size of banking sector losses.
Second, the announced Irish bailout is clouded by more uncertainty than the Greek rescue. Ireland's economic fundamentals outside the banking, real estate, and construction sectors are healthier than those of Greece, so Ireland doesn't have to overhaul its entire economy as Greece does. Implementation of a reform package is thus more certain to happen, at least in theory.
But Irish domestic politics are highly unpredictable, especially because of the extraordinary redistributive aspects of its banking crisis and bailout. In Greece, the government of Prime Minister George Papandreou blamed his predecessor for all of the country's problems. In Ireland, by contrast, the ruling party Fianna Fáil has been in power for nearly all the last 25 years, so everything happened on its watch. This has made it harder for Prime Minister Brian Cowen to ask for sacrifice. The next Irish election, in early 2011, is certain to produce a change in government.
Cowen will likely win passage of an austerity budget in early December, but a new Irish government will be the one to implement it. Here, the redistributive politics of the Irish banking bailout will play a potentially decisive role.
If it turns out, for example, from the ongoing IMF, European Central Bank (ECB), and European Commission inspection of the Irish banks that the cost of the bank bailout is as large as feared, using up all of its "contingent capital," the outcome will be especially explosive.1
To understand why, recall that Ireland itself is providing €17.5 billion of its €85 billion bailout, at least €10 billion of which is to come from Ireland's €24.5 billion National Pension Reserve Fund (NPRF). Earlier in this crisis, this fund was forced to purchase now worthless stock in Irish banks for €6.6 billion. As a result, about two-thirds of the country's national pension fund (which has about €115 billion in estimated future liabilities) will have been consumed to save Ireland's banks.
That is an extraordinary sacrifice for any country, especially when the goal is to avoid imposing haircuts on senior bank debt holders who are in effect dumping their private claims with the Irish government. Imagine if in September 2008, President George Bush had proposed to sell US Treasuries from the Social Security Trust Fund to pay for the bailout of Citigroup, AIG, and Fannie and Freddie.
The ECB and the rest of the eurozone have an obvious interest in haircuts on senior creditors now, because of the danger of fanning the turmoil in the bond markets. But it is far from certain that a new Irish government will feel the same way. And who could blame them?
After all their troubles, Greeks seem to recognize that their system has been dysfunctional and corrupt. In the recent Greek regional elections, there was a record low 45 percent turnout despite mandatory voting. This suggests that a "silent majority" in Greece accepts the wrenching changes under way.
But resisting a solution that saddles future generations of Irish taxpayers with unsustainable debts and an unprecedented regressive redistribution of wealth and sacrifice—all in order to pay Irish bank creditors—is likely to be less a matter of irresponsible populism than an exercise in "social and/or generational fairness" or even "common sense." The Irish may decide soon, in other words, that senior creditors must share the bill for the excesses of the past.
Thus any Irish political party that promises such a regime is likely to be quite successful. Skillful political opportunists like Gerry Adams and Sinn Féin (who won a recent bi-election with almost twice the number of voters of the governing party candidate) have a different idea about what needs to be done. As their finance spokesperson said in early October:
"Sinn Féin would have done things differently. We would have allowed Anglo Irish Bank to crash from the very beginning although we would have protected depositors. We would have allowed international bondholders to take the hit. These people are not children with piggy banks. They are gamblers that were in it for the profit and sometimes gamblers lose. It is they that should have taken the hit and not the Irish taxpayers."
From this one must conclude that despite the assurances of ECB and EU leaders over the weekend, any guarantee issued today to senior bank creditors in Ireland is not durable until it is embraced by a newly elected Irish government—an unlikely development if Irish bank losses continue to deepen.
As if these political realities were not enough to rattle the markets, the new bank restructuring measure adopted in Germany last week—and certain to be proposed at the EU level, too—is also making senior bank creditors in Europe increasingly fearful and for good reasons. The German measure would force senior bondholders into debt-to-equity swaps and big potential losses before taxpayers' money is spent on future rescues.
Another reason why European markets have not been persuaded by any of the steps so far is that eurozone leaders have continued to mishandle the issue of the permanent crisis mechanism originally proposed by France and Germany on October 18. Some useful "clarifications" were offered on November 28. Among other things, there will be a permanent European Stability Mechanism (ESM) that can approve financial assistance packages to euro area member states under strict conditionality similar to the temporary EFSF. In addition, ESM loans will have preferred creditor status (although junior to the IMF). There will be no automaticity in "private sector participation" (PSP) in a package of shared sacrifice. Instead such participation will be determined on a case-by-case basis, and only when decided by unanimity—eliminating the potential for credit default swap–based speculation against sovereign bonds that would materialize if haircuts were automatically imposed as a condition for a bailout. All eurozone countries will begin to include collective action clauses (CACs) in their bonds in June 2013, enabling creditors to approve, with a qualified majority vote, a legally binding change to the terms of payment. Crucially, there will be no private sector participation in haircuts for debt issued before mid-2013.
The package amounted to a remarkable climb-down by Germany (which could cause problems for Chancellor Angela Merkel), and it fails to address the most important issue concerning potential PSP—namely that this option affects clearly solvent and risk-free countries very differently from potentially insolvent, not quite risk-free countries. In essence, PSP works as a deterrent only for evidently solvent countries, while accelerating the descent toward insolvency for countries at risk.
It is not credible for Greece, for example, to shelter its pre-2013 debt from haircuts. In any potential future debt restructuring, the assumption must be that holders of pre-2013 debt will also be affected. Alternatively, investors in new debt with CACs issued after 2013 will understand that this debt is functionally subordinate to the "old debt," driving yields to prohibitive levels and dooming the country to restructuring.
Fundamentally therefore introducing PSP will be a self-fulfilling prophecy unless eurozone leaders are willing to address solvency issues for any participating member.
It is never wise for policymakers to try to solve two problems with only one policy instrument.2 They should concentrate on today's (sovereign debt) crisis and refrain from trying to prevent the next one, as Chancellor Merkel has tried to do.
PSP is a good and indeed necessary idea. In the absence of a credible Stability and Growth Pact in Europe, the European Union is wise to mobilize vigilant fiscal oversight by self-interested investors (and quite possibly to preempt the German Constitutional Court). But if implemented before every eurozone member is on a sustainable fiscal path, enacting a mechanism for the future will continue to worsen financial market conditions today until the underlying solvency concerns are forcefully addressed. No amount of clarifications issued by eurozone leaders will change this dynamic.
But will all these shortcomings in Europe's latest policy response inevitably lead to an endless spread of financial market contagion and ultimately the breakup of the euro? The answer is no—for several reasons.
The contagion was prompted, first, by factors that were driven by both rational and limited considerations. True, EU policymakers blame (usually Anglo-Saxon) speculators for betting against the sovereign debt of even healthy countries. But while speculation might be a factor in the thinly traded market for sovereign credit default swaps, it is not an important contributor to instability in the market that actually matters, namely the very large and generally liquid eurozone sovereign bond markets.
In these markets, most participants are conservative investors like pension funds or insurance companies with little or no leverage, subject to many restrictions and guided by a long investment horizon. Sovereign bond investors generally have a limited upside, but also next to no downside from the "risk-free assets" that they hold. Correspondingly, a very powerful "herd-like" response from such a group of risk-averse investors can be expected to any uncertainty about potential defaults or restructurings, such as what is implied with PSP in the eurozone.
Add to this that the supply of sovereign bonds for eurozone investors has grown sharply since 2008 because of rampant government deficits. At the same time, the average quality of their bond holdings has suffered from downgrades. The end of the calendar year3 typically prompts investors to reconsider their risk-outlook further. As a result, they are now sitting on the sidelines and not purchasing any non-German eurozone sovereign bonds.
Consequently there are several reasons why this "buyers' strike" may not deteriorate further or even remain as bad as it is. Some traditional bond market investors are likely to become bigger buyers in early 2011 as a new bonus year begins. In addition, at a time of extremely low rates for the sovereign bonds of the United States, the United Kingdom, and Japan—as they engage in more monetary stimulus—investors may be looking soon for the higher yields available in parts of the eurozone, even on a properly risk-weighted basis. This will particularly be the case for debt from systemically important large eurozone members like Spain and Italy, for which outright default will never be permitted by eurozone authorities. Spanish bonds with far sounder economic fundamentals trading even close to current Greek or Irish levels is an obvious buying opportunity. Another factor could come as austerity measures begin to work across the eurozone, and net new issuance of sovereign debt declines.
In sum, there are reasons to believe that the yields for many eurozone countries will decline in the first half of 2011. Whether this effect will allow Portugal to escape a bailout package is far from certain, however.
Those predicting an end to the eurozone fail to appreciate the costs of leaving it. Many commentators draw erroneous conclusions based on the experience of Argentina, which repegged its existing physical peso to the US dollar before a historic boom in its main commodity exports. No eurozone member will have that much dumb luck.
Whatever the lure of leaving the eurozone, weak member states will face domestic economic collapse, devastating capital flights, and regional political and economic isolation if they choose that course . Equally important, no credible political or economic case for the net benefits of ditching the euro can be made for the strongest member, Germany. Creating a "new deutschmark" or even a "northern euro" would entail sacrificing everything that Germany has politically stood for since 1950 in Europe. It would further undermine not just the euro, but the internal market and the European Union itself. Germany's export industries would face a rapidly appreciating "new deutschmark" and renewed competitive devaluations in neighboring trading partners, while its banks would be confronted by having more than €1 trillion in loans repaid in "new drachma, lira, or escudos" or other depreciating currencies.
For sure, life inside the eurozone for peripheral members will no longer be bliss. It will instead get a lot harder. But life outside the eurozone, and getting there, would be worse. Democratic governments in Europe understand this.
Finally, while it is clear that the currently available policy tools in the eurozone are insufficient to provide credible financial assistance to any large member state, it is erroneous to believe that such tools could not be created in the future or that the political will to do so inside the eurozone is lacking.
Recall the assertion of Jean-Claude Trichet, president of the world's most independent central bank (the ECB), that observers "are tending to underestimate the determination of [eurozone] governments." Certainly, the ECB Governing Board has plenty of additional policy tools at its disposal, ranging from pumping enough liquidity into any eurozone bank to keep it afloat or buying up hitherto unimaginable amounts of financial assets. It is capable of counteracting uncontrolled financial contagion.4 We are likely to see this in practice soon.
The issue is not so much whether the EU policymakers can contain contagion or even have the will to do so in extremis. Rather the issue is which policy tools to rely on and who should take action—the ECB or eurozone governments. That much was revealed by the comments of Axel Weber, when he proposed that EU governments rather than the ECB, on whose board he has so often been outvoted, take the next set of extraordinary measures by doubling the scale of the current EFSF (enabling it to lend more and/or at lower rates). Weber clearly understands that the political will to act exists in the eurozone. By dissenting in May and suggesting governments act now, he has signaled that he doesn't feel that the ECB is the right entity to act.
The determination of the European Union to stanch the flow of crisis was further illustrated when it extended the maturity of Greece's official sector debt substantially at the end of November, in return for only a small increase in Greek interest rates, which ironically makes it even less likely that Greece can ultimately repay. With that action, the European Union took a large, if stealthy, step toward outright debt forgiveness, amounting to an ad hoc de facto fiscal transfer in a region beset by asymmetric shocks and economic crises. Note further that an ECB accepting the idea of conducting monetary policies with clear fiscal policy implications (like buying up a lot of bonds) amounts to another stealth step toward an "ad hoc common fiscal policy" in Europe.
The potential for new editions of the "eurozone rule book" to be written by member states willing to impose or accept dramatic pain on middle class citizens is what will sustain the common currency for the future.
That remains true, even as the euro gets less overvalued by the day.
1. It is not certain that the ultimate costs of the Irish bailout will be catastrophic. See Goldman Sachs' "Handbook on Ireland," November 18, 2010, for a smaller loss estimate.
2. I am indebted to my colleague Ted Truman for reminding me of this law in this context.
3. I am indebted to Ted Truman again for pointing out the particular risk aversion exhibited by financial markets close to the time at which bonuses are determined.