Europe’s leaders and senior officials are today trying to cobble together a last-gasp deal to save the euro. It is possible that they will fail to reach a consensus, in which case the almost certain result would be immediate market panic, renewed pressure on banks, a double-dip recession and, very likely, a disorderly break-up of the euro area.
Recognition of this fate is the reason why, at the end of the day, or more probably the night, some agreement is likely to be reached.
Unfortunately, clinching a deal is only a necessary, not a sufficient, condition for resolving the crisis. All the signs are that the nature of the package around which a consensus can be forged is such that it will not resolve the crisis, which will thus continue, the only question being, at what pace?
I would be happy to be proved wrong. Perhaps some rabbit, as yet hors discussion, will suddenly be pulled out of the collective hat. But all the signs are that even now Europe’s leaders are focusing on the wrong issues and the wrong solutions, while the crucial issues and effective solutions are not, as far as I can tell, on the table.
There is a broad consensus that a very large haircut (50-60%) must be imposed on Greek bondholders and that the banks must at the same time be recapitalised in order to avoid the haircut resulting in their bankruptcy. I stick to my long-held view that this makes no sense, at least no rational economic sense. As I have repeatedly argued, this insistence on so-called ‘private-sector participation’ has been the main channel of contagion from one country to the next and from the sovereign-debt to the banking crisis, and back again.
The recent stress tests – which did not include a sovereign-debt haircut, bizarrely so, given the views of the leading political actors on the supposed need for private-sector participation – indicated that Europe’s banks are largely ‘safe’, provided they do not have to take large losses on their most conservative investments, namely domestic and other euro-area government bonds. It makes no sense to weaken banks with one hand (haircut) and support them with the other (recapitalisation), which in the meantime creates massive uncertainty, tightening the credit squeeze, and thus driving down asset prices and weakening the financial sector and the chances of fiscal consolidation still further.
Moreover, it is very difficult to force one country into default while convincing holders of all other countries’ bonds that they are safe because a firewall has supposedly been built against future defaults by other troubled sovereigns. (Not to speak of the long-run costs of large-scale defaults, nor of the equity issues involved in treating different bondholders so differently.)
Instead, European sovereign bonds should be backed in full. Early in the crisis this could have been done by solvent Member States, with or without the support of the IMF. Thanks to political dithering, the obsession with private-sector participation, and counter-productive austerity policies, this is no longer the case (though it is important to realise that, even now, the sums involved, i.e. the annual debt-servicing payments of troubled economies, are tiny relative to euro area GDP.) The only institution that can now back sovereigns is the ECB. Its ability to do so has been shown by the limited success of its bond purchases which were correspondingly limited in time and scope. It must offer unlimited backing. This is a necessary condition for resolving the other issues.
The irony here is that the ECB has all along, and quite rightly, insisted on avoiding haircuts, so that it is contradictory of it now to refuse, with reference to its legal mandate, to provide the firepower necessary to make this possible (and not to mention the contradiction involved in simultaneously raising interest rates.) In any case, Germany, whose political class is sadly driven by a sort of modern folk mythology rather than a grasp of basic economics, seems certain to oppose any increase in the role of the ECB.
In other words, what will work is not politically feasible.
What does seem politically feasible (albeit on a highly optimistic reading) is a combination of Greek default, a ramped up collective fund as a contagion firewall vis-à-vis other sovereigns and the banks, and a diktat on other deficit countries to implement austerity policies with renewed vigour. Yet a combination such as this is highly unlikely to work. Why?
The Greek default can be imposed quickly, but the rescue of the banks is fraught with political (who pays?) and more technical-economic problems. Even if these can be overcome, it will take time. Meanwhile, confidence will fail to recover, so that the slide in lending, economic activity, asset prices is set to continue. The belief that this can be avoided if only the EFSF ‘bazooka’ is big enough is, I believe, misguided. First, there are doubts about the finances of even the AAA-rated countries that are supposed to be holding the bazooka. More fundamentally, though, as Lehmann showed, if the uncertainty about where losses are located is great, then size no longer greatly matters.
Even if the bank recapitalisation can be organised effectively, a key ‘known unknown’ is how the holders of other countries’ sovereign debt will react. As is now well understood, given the lack of monetary autonomy of national governments, bondholder expectations dance on a knife edge that can shift very quickly from a safe, low-interest equilibrium to a lethal high-interest one. There is no sensible meaning to terms like ‘insolvent’ and ‘illiquid’ in such a context, much as commentators bandy them about. After all the events of the past 18 months, and now the likely imposition of 50-60% losses on Greek bondholders, anything short of a full guarantee by the only institution credibly able to offer it, the ECB, will fail to do the trick.
Last but not least, the insistence on further radical and immediate belt-tightening in Italy and other peripheral countries is self-defeating. Yes, Berlusconi is a scoundrel. Yes, Italy is badly governed and needs structural reform. But it is a complete misunderstanding of the nature of the crisis to assume that putting a swift end to ‘southern European profligacy’ is a key part of the solution. Hauling Berlusconi over the coals may satisfy a political need, but it is actually the last thing Europe should be calling for. Already the dire effects of austerity in Greece have been amply demonstrated. If the third-largest euro-area economy embarks on a massive austerity programme, the result will be not only a sharp drop in that country’s output, a likely worsening rather than improvement of the Italian budgetary situation, but also substantial further negative pressure on the economic outlook for all other countries in Europe.
Europe needs an immediate guarantee of all sovereign debt as a necessary first step. Other steps must follow, including but not limited to the following: short-run area-wide monetary and country-specific fiscal stimulus, including faster wage and price growth in surplus countries; medium-run supportive EU-financed public investment in deficit countries, combined with genuine growth-enhancing structural reforms; and measures to strengthen countries’ revenue-raising capacity.
That always has been and still remains the only credible path out of the crisis, and I just cannot see Europe’s leaders taking it with the now requisite speed. It is mid-afternoon Brussels time and the clock is ticking. No one would be happier than I to be able to throw this post into the virtual waste-paper basket tomorrow morning. But the odds are very slim.