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After a couple of good weeks for the euro area, the inevitable question has arisen over whether the gains can be sustained, or if another cycle "one-step forward, two-steps back" is in the offing. On the positive side have been actions to shore up finances by the European Central Bank, a favorable German Constitutional Court ruling, and a vote for the euro in the Netherlands. But risk is ever present in the euro area. Overcoming political obstacles to implanting fiscal sustainability and structural reform in Europe's troubled countries—and transferring sovereignty to Brussels across the region—will require "crisis pressure" on recalcitrant politicians. Recent positive market "relief rallies" and declines in peripheral bond rates could breed complacency and sow the seeds of future market instability. This precarious situation will persist until the euro area restores its elusive and evanescent market confidence. Only then will short-term policy setbacks no longer result in bond market convulsions.
How close is the euro area to restoring its credibility? Spain now poses a crucial test. It is eligible to take advantage of the ECB's new program of sovereign debt purchases—known as outright monetary transactions (OMT)—and also the central bank's potentially unlimited secondary market purchases, not to mention the possibility of market assistance from the European Financial Stability Facility and the European Stabilization Mechanism (EFSF/ESM). But such actions are subject to "strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) program." At last an adequate firewall is there for a big member state. In theory, its mere availability should be enough to restore calm in euro area bond markets. With the bazooka now there for all to see, the chance of using it should decline.
Spanish bond yields have indeed declined following the initial encouraging words from the ECB president, Mario Draghi, in London in late July. But this market reaction probably cannot be sustained without an actual Spanish application for assistance. Investors want to see euro area policymakers put their money where their mouths are before recommitting to Spain. Distasteful as it might be politically, Prime Minister Mariano Rajoy will therefore have no choice but to approach the EFSF/ESM, sooner rather than later.
Make no mistake, it will not be an easy political task. Requests for outside financial assistance have provoked brutal voter hostility. Incumbent governments in Greece, Ireland, and Portugal were decimated in elections after they sought aid, and Rajoy faces regional elections in Galicia and the Basque country on October 21. No wonder he continues to dither.
Yet his concerns may be overwrought. The Basque country and Galicia are small autonomous regions, where Rajoy's Peoples Party (PP) has not been strong in the Basque region, so it is not obvious what the party has to lose. The PP may lose control of the Galician government, but the effect of such a loss seems limited. Rajoy's government has already tried to kick the political can down the road until after a regional election, however, when it postponed publication of its new austerity budget until after the voting in Andalucía in late March. The trick didn't work then. The PP failed to win a majority.
The downside of seeking help may be overstated as well. Going to the ESM will not be the watershed it was for Greece, Ireland, and Portugal, when they approached the Troika (the European Union, the ECB, and the International Monetary Fund) earlier in the crisis. After all, Spain has already applied for and been granted a bank bailout of up to €100 billion from the euro area in return for far reaching reforms of the Spanish banking sector. Approaching the ESM would be a similar step.
In the end, Rajoy's most realistic path to re-election in late 2015 is to take the painful decisions as soon as possible, and trust the economy to begin to recover beforehand.
Financially, the Spanish government does not have much time. It faces about €32 billion in bond redemptions in October and perhaps €75 billion to €80 billion in total financing needs for the rest of 2012. This schedule will likely force his hand.
Rajoy's fear is that Spanish voters will punish him for signing over sovereignty to the ESM, and even more if he goes to the IMF and ECB. Yet no country in the euro is even remotely "sovereign" today. Monetary policy resides with the ECB, and perhaps half the recent legislation passed by national parliaments has been based on previous EU decisions. Elected leaders need to appear to be sovereign and able to exercise free will in front of their electorates, of course. For the Spanish government, it is critically politically important that national leaders announce their austerity programs and reforms to the public themselves, rather than the ESM and/or IMF. The content of the message matters less than who presents the bad news to the public.
Rajoy has a window of opportunity to mitigate the political costs of approaching the ESM. Given the macroeconomic situation and earlier announced spending cuts (including four previous austerity packages since he took office), further short-term austerity steps are unnecessary. Rajoy is therefore now trying to boost his domestic image by publicly rejecting a straw man—i.e., turning down new austerity measures that come with ESM or Troika conditionality.
Expect Rajoy to adopt the same strategy on structural reform issues. Last week the Spanish Economic Minister, Luis De Guindos, announced at the meeting of European finance ministers that his government would soon present new structural reform measures in line with earlier EU policy recommendations. The intent was to preempt any ESM conditionality by preannouncing additional structural reforms—and subsequently claim that ESM assistance was being granted without further tough conditionality. The Rajoy government's goal would be to project the image that it has things under control and can be trusted to manage the Spanish economy, even if it takes outside money. It remains to be seen, of course, whether the government's steps will anticipate the ESM demands or follow Rajoy's political agenda. It will take a few weeks to implement this political ploy, but Spain looks set to continue its path of adhering to a shadow IMF program.
Outside of Spain, among those countries lending a hand to Spain, the political optics of getting help will likely improve this week when the actual costs of the Spanish bank bailout become known. They are likely to be substantially below the already politically approved ceiling of €100 billion1. Money is fungible also when countries are coming from the ESM. A Bundestag approval of another ESM commitment to Spain will thus probably be politically easier for German Chancellor Angela Merkel, when it has become clear that the previous bank bailout was cheaper than feared. The real reason that the German finance minister, Wolfgang Schäuble, called on Spain not to rush to the ESM immediately was probably to time it for a smooth passage in the Bundestag.
All these factors add up to the likelihood of Spain approaching the ESM for assistance no later than mid or late October. As Rambo was told by his Russian torturer in First Blood II: "Pride is a poor substitute for intelligence."
Another concern in the markets after recent euro area events is whether the ECB would walk away from an OMT program if an aid recipient lags on meeting its commitments. More specifically, would the central bank risk making a crisis situation worse if, for example, Spain or Italy refuses to go along with the ESM/Troika conditionality? Put in another way, doesn't the OMT program expose the ECB to unbearable political pressures, jeopardizing its independence and forcing it to provide de facto monetary financing to a recalcitrant government in Madrid or Rome?
Maybe. For the Bundesbank, which opposed the OMT, that was the fear. But the concern is probably overblown, as is the concern that beneficiary euro governments will have the ECB over a barrel.
First, recall that the ECB was more than willing in November 2011 to cut Prime Minister Silvio Berlusconi of Italy loose and deny him securities market program (SMP) support because of insufficient progress on reforms. Its action set a precedent for even large euro area member state governments.
Second, unlike the case of Lehman Brothers and other systemic banks, large industrial countries do not go bankrupt overnight. Rather they run the risk of sliding into it over time. Thus in the fall of 2011 in Italy, political and economic pressure increased gradually. Fear of a sudden "nuclear option"—a large industrialized country government declaring unilateral default—is not credible. No elected government in Spain and Italy could credibly threaten to destroy its domestic banking system and savings base (the result of such a move) without facing dire electoral consequences. Scorched earth is not a viable electoral platform in rich and ageing European countries. If a political leader tried such an approach, he or she would end like Berlusconi—booted out of power by their own parties.
This would matter for any ECB exit strategy, as the bank has wisely resisted setting any quantitative targets for OMT programs. As with Italy, a policy of refraining from market purchases would gradually ratchet up the financial pressure on Madrid or Rome. The amounts of bank intervention are to be published regularly by the ECB, so the domestic political system (and other euro area governments) would have ample opportunities to respond to a passive aggressive suspension of ECB OMT purchases and increase the political pressure.
Finally, if domestic political and economic pressure is not adequate, the ECB Governing Board has plenty of scope to enlist the other euro area governments to help coerce program compliance. Frankfurt can explicitly force the ESM (i.e., the euro area governments) to take the political responsibility for any termination of ECB OMT purchases of Spanish or Italian debt. The process is simple and mirrors the developments surrounding the ECB's continued acceptance of default-rated Greek bank collateral after the Greek debt restructuring last spring. In order to continue its acceptance of such collateral—without which the Greek financial system would have collapsed—the ECB demanded sovereign insurance from the euro group in the form of €35 billion of temporary EFSF bonds. The euro area governments' agreement to this ECB demand of "collateral enhancement" to protect the bank's balance sheet on February 21 enabled the ECB to keep the Greek banking system and economy afloat.
The potential termination of an OMT program would occur in a relatively similar manner. The ECB has wisely insisted that any OMT program must be associated with an ESM/EFSF program that would include the possibility of ESM/EFSF primary market purchases. Thus in the event of non-compliance by Spain or Italy, the ECB would insist that the ESM/EFSF enter the primary market to provide direct financial support before any further ECB OMT support. Direct ESM financial support for a recalcitrant euro area member would thus be required before the ECB intervened. This arrangement would leave it to other euro area governments (who make up the ESM board) to bless a lifeline for another euro area member state perceived to be in breach of its ESM/EFSF program obligations. Euro governments, with their taxpayers' money on the line, would hardly keep the assistance going in the absence of Spanish or Italian cooperation. The ECB would shift the onus of cutting off the OMT to the political leadership of the euro group.
In the end, the ECB can continue to leverage market volatility to force euro area politicians to take responsibility for enforcing conditionality on errant member states.
Note
1. I am indebted to Huw Pill of Goldman Sachs for pointing this timing issue out to me.
