Hopes that a solution to Europe’s debt crisis will be found this weekend have subsided once again, after Wolfgang Schauble, the German finance minister, moved the goalposts by saying a package would not be complete until the Cannes G20 summit in November.
“The situation remains highly unpredictable and markets will remain highly sensitive to random headlines over the coming days,” Deutsche Bank credit strategist Jim Reid wrote in a note to clients on Tuesday, reflecting that the appearance of a coherent response to the crisis tends to prop markets up briefly, before dissent inevitably takes the crutch away.
The basic elements of a plan outlined by the European Commission are well known, but each solution fractures into many new problems.
Greece needs debt relief in the short term. This means that a “haircut” crystallising the private sector’s losses on Greek issuance and reducing its overall debt levels by anywhere from 20 to 60 per cent. Some form of bond-swap deal, where Greek debt is exchanged for bonds backed by the European Financial Stability Facility (EFSF) might also be possible.
Any such plan has to be watertight, as whatever deal is done with Greece will inevitably be taken to be a template for other countries struggling with their insurmountable debt piles. Getting it wrong by making it too easy for countries to “get away” with their debt problems would introduce too much moral hazard to satisfy the market.
Taking too much of a haircut on Greek debt means introducing large losses into the financial sector, with banks, pension funds and insurance companies potentially suffering dramatic write downs on their holdings. This would mean that banks, already trying to come up with capital to boost their balance sheets to meet increasingly strict requirements from the European Union, would face very real solvency issues.
Protecting the banking sector is critical, despite the popular distaste for more bailouts.
When policymakers talk of “contagion” of the Greek debt crisis, it is usually the banks that are assumed to be the vector of transmission.
Banks are big holders of Greek, Italian, Portuguese, Irish and Spanish debt. Should that debt be devalued, they face losses. If they are unable to cover those losses and either go bust or have to rein in their own lending, they can transfer the loss to the real economy. Enterprises that rely on bank lending face shortages of credit, causing them to cut back on spending and hiring. In extreme scenarios, consumers risk losing access to their deposits.
That fear has led the European Union to ‘stress test’ the banks to make sure that they have sufficient capital to absorb these losses. The last round of stress tests are now widely considered to have been too lenient. Dexia, the Franco-Belgian bank, passed the tests but came close to collapse earlier this month as rumours over its exposure to sovereign debt swirled. The bank’s Belgian operations were eventually nationalised.
There is now talk that the amount of capital that banks are required to hold will also be increased, in order to prevent contagion from becoming a credit crisis.
However, getting capital is not cheap, and there is a concern that solving the problem could cause credit to dry up in the near term, as banks cut back on their lending to shore up their balance sheets.
To help banks achieve this quickly, the EFSF is in the process of being reformed to allow it to directly participate in bank recapitalisation, giving institutions a cheaper way to prepare themselves for a default.
Of course, this means more money out of the EFSF, which also has to be ready to bailout other countries. This is why it might need more firepower.
That might mean “leveraging” the EFSF’s resources – i.e. using a variety of financial engineering techniques to increase its deployable capital. That itself is controversial, and there is considerable disagreement within the eurozone over whether that is necessary or desirable, but the German and French governments are believed to be close to an agreement on the issue.
Currently standing at €440 billion, there has been speculation amongst analysts and economists that €2 trillion would be needed to fully reassure the markets that the worst case scenario could be dealt with.
Reassuring the markets is important, as without investors becoming confident enough to accept reasonable interest on future bond issues from peripheral euro zone countries, those countries will be unable to finance their restructuring at sustainable rates.
However, the structure of the EFSF, which is backed by the eurozone’s higher rated countries, means that giving it too much firepower could in fact dent confidence in the markets, because it would increase the liabilities that those core countries have in the event of rolling defaults in the rest of the euro area.
The eurozone has few good options in the short term, and no easy ones in the long term. As George Magnus, a senior economic adviser to UBS, wrote in a paper on Monday:
“Even if the details to be announced in the next one to two weeks pass muster with global financial markets for now, more financial engineering is never going to be as effective as up front money, which is politically contentious,” Magnus said.
“And it will not substitute for broader political agreement to re-design the euro zone so as to strengthen its existential claims.
“The acid test for the eurozone remains the willingness of all member states to give up considerable sovereignty as they advance steadily towards greater fiscal and political integration.”
This long term Gordian knot has to be cut somehow, if the summit’s plan is anything more than just a temporary response.
The immediate cause of the eurozone crisis was that a number of countries within the single currency area built up unsustainable debt levels, and that their economies would not grow fast enough for them to be able to repay. Those countries are going to have to go through a painful period of deficit reduction and structural reform of their economies.
What this exposed, however, was that running a monetary union without the accompanying economic union is unsustainable. While it has a central bank and a number of other federal institutions, the eurozone does not have a finance ministry and is not able to deploy the kinds of policy tools that a single national government can.
It is also unable to force fiscal discipline on its member states in the way that it needs to be able to in order keep a supra-national group composed of diverse and multi-speed economies running.
To make this work would require a considerable degree of sovereignty being abandoned by national governments, who would give up some of their ability to make economic policy. This would be a huge political step, and could require many of the union’s rules to be re-written.
As Magnus wrote: “Real fiscal integration means the eurozone will have to abandon the no bail-out rule, and adopt jointly and severally issued [euro bonds], cross-guaranteeing all member states’ debt issuance, in order to wrap any debate about national sovereign debt. It means … a European Treasury and Finance Minister. The European Council might have to be given veto power, or at least much stronger authority over national Treasuries, and budget planning and execution.”
Many early critics of the euro pointed these structural problems out, but its supporters hoped that the reality of the single currency would force the eventual economic consolidation. It might yet, albeit not in the smooth way the euro’s architects hoped.