Editor's note: This column updates the column originally posted on 8 August 2011.
The glass is now a quarter full. This Sunday, Europe’s leaders accepted two of the three steps that are necessary to bring an end to the crisis. They know what they have to do when it comes to putting Greece on a sustainable path, and when it comes to backstopping the banks. On the third necessary step – backstopping sovereign debt to avoid contagion – EZ leaders have not yet realised the magnitude of the problem – they are talking of billions when they need to be talking of trillions. Most depressing of all is the fact that they have explicitly ruled out the ECB’s full involvement.
Necessary steps on Greek debt and growth
Since early 2010, we have known that Greece would have to default on a substantial part of its public debt. With access to borrowing on the market essentially closed, the Greek government must do something; it is now caught in an austerity vortex. Cutting spending and raising taxes is self-defeating as it only worsens the recession and thus the deficit. Writing off some of the debt is the only solution, but this carries consequences.
Because Greek banks hold so much Greek government debt, any serious restructuring will bankrupt the Greek banks. To avoid an economic meltdown, the Greek government will have to step in and recapitalise the banks, but this will raise its debt-to-GDP ratio. All this means that only a very large write-down (or ‘haircut’ as they call it in the markets) will work. For example a 60% haircut would, after the bank recapitalisation (which could cost 20% of GDP), bring the debt burden down to a level where it is bearable – where growth-enhancing policies might work. Anything less will leave Greeks facing an interminable prospect of austerity and recession. In the face of such a bleak future, young people and pensioners are likely to revolt and force a disorderly default akin to the one that happened in Argentina in 2002. In short, the choices are a big, well-managed write-down now, or a disorderly write-down next year.
On this point, EZ leaders have understood the problem and are pursuing the right ideas. Indeed, they are almost there but the bank-lobby is actively trying to avoid such losses. Recalling how this lobby spectacularly captured the July 2011 summit, we cannot be sure that the necessary will be accomplished.
Recapitalising the banks
After ignoring the obvious for months – and explicitly turning on IMF Chief Christine Lagarde when she dared speak truth to power – EZ leaders finally see that the Emperor’s new clothes for what they are. The Summit endorsed the view that banks need to be recapitalised. But in keeping with the track record they have established so convincingly since May 2010, the steps they are reportedly considering are too little too late.
The amount announced (€108 billion) is far short from independent estimates of what is needed. Reassuring markets and other banks that health has been restored requires enough capital to weather a really severe crisis – one that includes recession and contagion to other sovereigns. According to news reports, the €108 billion comes from a stress test that focuses only on a Greek restructuring. This is clearly insufficient since the goal is to assure markets that EZ banks will be safe even if the crisis spreads. (The idea, of course, is that the crisis won’t spread if the banks and sovereigns are backstopped, but the size of the confidence-building backstopping must rule out even the worst case scenario.)
Worse yet, the way the recapitalisation occurs may undermine its purpose. According to news reports, the Summit agreed that banks would first have to try to raise their capital ratios themselves. Here they have two options; raise new capital via new issues in the markets (or retained earnings), or brutally downsize their loans books. If these options prove insufficient, the banks can turn to their national governments. If that option fails (since their national governments cannot assume the extra debt without turning into another Ireland) the European Financial Stability Fund can be tapped. All this is supposed to happen in the next 6 to 9 months. This is where the EFSF would be helpful but, apparently, there is no agreement yet on what conditions would be applied. The whole project is in doubt, however, if the EFSF lacks the spare billions since it has had to use its money backstopping sovereign debt to avoid contagion.
The missing role for the ECB
The worst result, however, is that the Summit has rejected any major role for the ECB. This means that public debt prices cannot be backstopped. As long as the ECB, directly or indirectly, does not explicitly commit to some floor value for public debts, the crisis will fester and deepen. Banks will become exposed to increasingly large losses and their own market access, already flimsy, will be shut.
The rest of the scenario is painfully familiar. After announcing what they claim to be the definitive solution, EZ leaders will again find themselves in emergency meetings next spring. Policymakers still don’t grasp the risks ahead. They keep moving in the direction but at glacial speed, which means a continuous worsening of the situation and, eventually, much higher resolution costs.
Updated original column
22 August 2011
In this crisis, Eurozone leaders’ motto seems to be “too little too late”.
They got it badly wrong the first weekend in May 2010.
Having announced that they had saved Greece, financial markets said “not good enough”. The next weekend they came up with a more substantial plan, but even this proved to be too little too late.
After months of living in denial, Eurozone leaders finally recognised that Greece was not going to be able to restart borrowing on its own. They came up with another plan. On 21 July 2011, they got it badly wrong again. Financial markets are again said “not good enough”.
On August 16 Chancellor Merkel and President Sarkozy held a widely-trumpeted “summit” to announce decisions that were either irrelevant or misguided. Stock markets around the world said “not good enough”. Even more ominously, the interbank market is seizing up, as it did in 2007 on the way to the Lehman disaster.
1. Cluelessness, powerlessness, or weakness?
In contrast to the extreme clarity of the market’s message, the raft of declarations from policymakers around the world suggests:
- They still do not to understand how dangerous the situation is; or
- They do not understand what they need to do, or
- They are unwilling to do what they know must be done.
This is why words intended to be reassuring words backfire. Markets suspect that nice words are all that policymakers are in a position to offer. This prevarication by Eurozone leaders needs to change rapidly if a disaster is to be avoided.
2. A clear misunderstanding of the situation
For a year and a half, policymakers have thrown good money after bad in carefully measured doses. Whether it was due to political expediency (gambling for redemption) or due to wishful thinking (the economic recovery will fix everything), policymakers have misdiagnosed the problem.
Unfortunately, we are not in a situation where a “bridging loan” can help highly indebted nations get through a rough spot. Feeding markets a few dollops of euros is like treating a broken leg with ice; it may help for a while but it fails to address the core problem.
In short, we are not in a liquidity crisis; we are in a confidence crisis. Policymakers are not part of the solution anymore, they are the problem.
3. The danger ahead
History tells us that a loss of confidence can trigger a cyclone of doubt and falling bond prices. Once triggered, such cyclones can and have washed away even the mightiest. The mechanics of such cyclones are well understood.
When investors assign a positive probability to a sovereign default, nations must pay a risk premium to continue borrowing and rolling-over their debt. The higher interest payments raise the debt-service burden. The cyclone gains strength as this tends to undermine solvency, which in turn stokes doubts and raises the risk premium.
Fiscal austerity is needed to avoid such cyclones, but attempts to redress solvency via fiscal austerity in the midst of a crisis may make things worse. Cutting spending and raising taxes can trigger or deepen a recession that lowers tax receipts and raises welfare spending – again undermining the debt’s sustainability. When markets see this, they ask for a higher risk premium and the cyclone gains strength.
Eurozone investors’ fears are amplified by the poisonous combination of banks that are both in fragile state overall and heavily invested in Eurozone bonds. As we saw in Ireland and Iceland, governments who have to bail out their banks can find themselves drawn into a self-fulfilling confidence crisis.
Europe’s problems started in 2007 with a deep banking problem. When banks had to be rescued, at taxpayers’ expense, it morphed into a public debt problem. And now it is morphing again into a banking problem because banks are creditors of the States that bailed them out.
- We are on the verge of needing another dollop of bank bailouts.
- The problem is that governments don’t have the resources anymore,
- This time, governments must bail themselves out.
More precisely, central banks will have to bail out governments and banks. The only other option is that governments who can afford it must bail out governments that can’t. Neither option is easy but one must be chosen – a disaster worse than September 2008 is coming up if neither is.
4. The size of the problem
The real danger lies in the fact that financial market equilibria concern stocks, not flows. We are not talking about the fraction of the debt that is due in the next months – as we would be if this were a liquidity crisis. The cyclone logic gets applied to the entire stock of national debt. This involves truly astronomical sums. When we add up the public debts of Greece, Ireland, Portugal, Spain and Italy, we reach something like €3,350 billion; that is 35% of the Eurozone GDP; 130% of German GDP.
Because of the stock nature of financial markets, the EFSF as we know it is now out of the picture.
The contagion has spread, and will continue spreading until a real solution is in place.
- Italy and Spain probably passed the point of no return.
- Belgium and France could be next.
The Italian case has shown that a mundane political accident – a public disagreement between the Prime Minister and the Finance Minister – can start the cyclone turning.
What could be the next trigger?
• Further rating downgrades of Eurozone nations – an event that cannot be ruled out given the US’s downgrade; or
• Recession in the US and/or Europe; or
• The collapse of a European bank collapse (which might result in a sovereign downgrade); or
• More summits that reveal even more completely the haplessness of top leaders.
But most likely, it will be some random event that we will not even have imaged.
5. Solutions that won’t work
Plainly, we are facing a very dangerous situation. Eurozone leaders must quickly wake up and realise the severity of the threat they face. Their 21 July plan – which involved the EFSF fixing the problem defined as Greece while Italy and Spain are now the issue – is dead on arrival.
- There is no way the EFSF can deal with the amounts involved. If it tries we will have a German debt crisis.
- Banning short-selling or taxing financial transactions in a few second-rate financial markets will have little if any positive effect.
This is a continuation of the central mistake made by policymakers – the belief that it is enough to buy a little bit of debts now and then to quiet financial markets until things get better.
- Blaming markets, rating agencies, and “speculators” is like slamming a car into a wall and then accusing the car’s cigarette lighter of malfunctioning.
6. What must be done to halt the confidence crisis?
The authorities must jump ahead of the curve and put in place an arrangement that effectively stops the rot. Instead of reacting, policymakers must start acting.
There is only one way to stop the cyclone of doubt and falling bond prices. We must put a floor on public debt valuation. The stock of sovereign debt must be divided into two piles – bonds to guarantee, and bonds to default upon. This is how one jumps ahead of the curve.
New proposals for accomplishing this from academics and markets emerge every day (e.g. De Grauwe 2011). Roughly, there are two main possibilities.
The ECB route
The first solution is to rely on the ECB – the only institution in the world that can put up € 3,500 billion. (This is why central banks are lenders of last resort.) Indeed, the ECB has already taken one step down this road.
After swearing they never would, they started buying Italian and Spanish government debt last week. And guess what? Spreads immediately went down. This last-minute U-turn, however, can hardly be considered a solution.
The ECB’s Council is deeply split over the issue, so the markets have reasons to believe that it may not buy all the bonds it would take to squelch the crisis. We’ve been there with Greece, Portugal and Ireland, but that was loose change compared to what would be needed for Spain, Italy, and maybe France.
Sooner or later the markets will test the ECB’s resolve, and this would bring us to the brink of history’s biggest financial rout. But this does not have to be so, for the ECB can save the world without spending this money.
All the ECB has to do is to guarantee public debts. Such a move does not have to be expensive. The ECB can simply guarantee the rollover at face value of maturing sovereign debts. This should immediately stop the sovereign debt crisis.
The idea, which was suggested to me by David Lucca from the New York Fed, simply reproduces the classic model of bank deposit guarantees.
- In 2008, most countries guaranteed 100% of bank deposits to stem incipient bank runs and guess what? There was no bank run and not one cent had to be spent.
- In the case at hand, it is likely that the markets would challenge the ECB, so some money will be spent, but most likely very little.
Eventually, we may have to alleviate some countries’ public debt burdens, but we first need to allow governments to function, and therefore keep on borrowing without imposing the kind of suicidal austerity packages that seem all the rage among policymakers now.
The Eurobond route
The second solution is the Eurobond approach that is currently ruled out by Germany.
- Understandably, German taxpayers do not want to pay for Greek and Italian taxpayers, not anymore than people want to have their houses blown away by a cyclone.
- But the financial cyclone is circling around Germany so hard choices lie ahead.
There are many variants. My preferred one involves replacing all maturing Eurozone public debts with Eurobonds – all of them, be they German, Greek, or whatever. Each country would gradually replace its current debt with safer debt, but a ceiling would be set, say at 60% of GDP, just to make sure that it’s safe.
This would give us a few quarters of market quietness – enough to organise restructuring on existing debts where needed. This in turn would require national leaders to organise bank rescues.
What if Eurozone leaders continue to dither?
If none of the above is quickly put in place, the ECB will have to spend huge sums to buy back public debts.
- Buying back debt at distressed prices (to avoid raising their market values and therefore the cost of the rescue) is essentially a way of organising sovereign debt default. (As EU nations own the ECB, ECB debt purchases are an indirect way of EU nations buying back their own bonds at knock-down prices.)
- This will lead to bank failures, which will require more public money to be spent – again by the ECB.
(Here the ECB might ask their Swiss and Swedish colleagues how to bail banks out and make a profit on it.)
In short, markets will not quiet down until comprehensive measures are taken. The “kick the can down the road” strategy has been politically expedient, but its cost has been enormous.
7. What to do about Eurozone public finances?
All of these rescues of banks and governments are creating moral hazard problems of unbelievable proportions. The culprits here are national governments and, more widely, national politics that failed to get behind the vital need for fiscal discipline in a monetary union.
This is why we must start thinking about ways of avoiding a repeat of past mistakes.
- Myopic policymakers want to toughen up and expand the doomed-to-failure Stability and Growth Pact, and to enact strongly restrictive fiscal policies.
This is how the first Greek packaged failed, and how the new plan will fail.
Portugal, Italy, Spain, and France all want to do more to reassure the markets. This will not work. Markets understand that neither Greece nor Italy can cut their deficits in the midst of a recession. All the markets want are assurances that politicians are ready to give up the deficit game and eventually reduce debts, even if that takes decades.
On this score there may be a glimmer of hope. Portugal, Ireland and Italy are now actively preparing institutional changes in the spirit of the Swiss and German debt brakes or the Swedish Fiscal Council. (The French President has put forward his own modest – probably insufficient – constitutional amendment, but divided politics in the run-up to elections next year stand in the way.) The EU Commission has also made a similar proposal, unfortunately buried with the fateful euro-plus project of strengthening the Stability and Growth Pact.
The only reasonable statement from the Merkel-Sarkozy meeting of 16 August 2011 dealt with the fiscal-rectitude issue. But it was handled in a clumsy way because they wanted a one-size-fits-all arrangement while in reality the only thing that will work is to have each country find an equivalent solution that fits with its political institutions and rules of the game. Yet, eventually, the Eurozone must include national institutional arrangements that can effectively deliver public debt reduction. (See suggestions presented in Eichengreen et al. 2011.)
It was wrong to bail out Greece in May 2010 (Wyplosz 2011). But now is not the time for regret. It is not the time to try to correct past mistakes. We will eventually have to draw the lessons from the crisis – and governments should ask impartial experts to do that – but now we have no choice. We must follow to its bitter end the logic adopted in May 2010.
In the end, finding a good solution is technically easy, but politically difficult.
Europeans have watched the US’s conflict over the debt ceiling with awe and scorn, but their behaviour over the last year and half has been much worse.
- The French want to pour money on the problem;
- The Germans want to punish fiscal misbehaviour; and
- The ECB does not want to bear risk.
All of that is bringing the world to a new recession, which we will not be able to combat because interest rates are at the zero lower bound and governments cannot borrow much anymore.
The spectre of the 1930s, including competitive devaluations as the euro breaks up, is getting dangerously relevant.
Editor’s Note: Charles Wyplosz expands on his thoughts in a companion audio piece, the Vox Talk "The Eurozone crisis: how to get ahead of the markets and resolve the crisis".
Eichengreen, Barry, Robert Feldman, Jeffrey Liebman, Jürgen von Hagen and Charles Wyplosz (2011), Public Debts: Nuts, Bolts and Worries, Geneva Report of the World Economy 13, ICMB and CEPR, forthcoming.
De Grauwe, Paul (2011). “The European Central Bank as a lender of last resort”, VoxEU.org , 18 August.
Wyplosz Charles (2010). “And now? A dark scenario”, VoxEU.org, 3 May.