EZ rescue or recession: Fallout of the October 2011 package

Richard Baldwin 28 October 2011

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Almost nothing decided at the latest Eurozone Summit was a surprise. For many months, economists on Vox have identified six elements that are essential to turning the Eurozone into a sustainable endeavour (see Wyplosz 2011, De Grauwe 2011, Baldwin and Gros 2010, etc).

Three measures were urgent and necessary to rule out the possibility of a catastrophic explosion of Europe’s banks and sovereign debt markets – or to put it colloquially – to defuse ‘the bomb’. These are:

  • Fix Greece
  • Backstop the banks
  • Backstop the sovereigns

This is what Thursday morning’s package addressed. With the bomb finally off the table, markets soared.

How to defuse a ‘bomb’ with a detail-free package

Despite the many meetings, critical details of these three elements are missing – left to be worked out over the coming weeks. As the enormous pressure to deliver a comprehensive solution has been defused, we can be sure that politically expedient backsliding will now be the modus operandi on all three elements.

Yet despite its shortcomings, the package did defuse the bomb.

Greece: The only hard parameter decided was to get Greek debt down to sustainably levels by the end of the decade. This gives Greece a light at the end of the tunnel and thus makes political chaos and a disorderly default much less likely.

Banks: The bank recapitalisation is missing most important details, but it is good enough for the moment. Bank failures would have been the key mechanism for translating any number of shocks into an economic catastrophe. Thursday morning’s package tells us that EZ leaders are at ‘battle stations’; it makes us believe that that they are ready and able to do whatever is necessary to stop a bank-sovereign-debt vortex from developing even if the agreed package is insufficient.

Sovereigns: Here the package was completely inadequate both in terms of detail and ambition – but it doesn’t matter. Given its size, EFSF (leveraged or not) could never have been more than political coverage for future ECB actions. The ECB is the one that backstopped big EZ member debt in early August. For the same reasons and in the same way, the ECB can be expected to stop any fear-driven sovereign debt vortex in comings months.

Pyrrhic victory?

But not all is for the best in this best of all possible worlds. Short termism again won the day. Here are the problems.

Shoring up the banks was the key to defusing the bomb. Boosting capital buffers is the way policymakers decided to solve this.

A European-wide mandatory recapitalisation – the sensible, far-sighted solution – was ruled out by Germany on the basis of narrow domestic political concerns. The fall-back option (national plans) was embraced instead. But these face devilish political problems. The banks most in need of the more capital:

  • Cannot raise money in the markets;
  • Are in nations whose governments can ill afford to borrow money for them (or guarantee their debt);
  • In extreme cases, the EFSF can be tapped but only under conditions that banks and their governments would abhor.

This political conundrum was solved by tacitly allowing banks to deleverage their way to higher capital-asset ratios. There was some hortatory language at the summit about national regulators preventing this. But such provisions are neither practically nor politically credible, especially given the harsh conditions tied to the alternative of EFSF funding.

  • Thus the short-term solution – raising bank capital ratios – will create a credit crunch making recession more likely in early 2012.

The reaction of bank share prices is very telling here. Any recapitalisation without leveraging would dilute current shareholders and reduce profits – both should have hit bank stock prices. Instead, bank shares rocketed suggesting that little new capital will be raised in meeting the higher ratios.

In effect, the banks will act in a way that mimics a substantial tightening of monetary policy. One way of thinking about this is in terms of the equivalent interest rate rise that the ECB would have had to make to reduce credit by as much. The ECB has a couple of percentage points on interest rates to cut, but if banks are busy downsizing, slightly cheaper money will not stimulate lending.

The fourth unwritten pillar of the EZ Summit was a reinforcement of the austerity imperative.

  • Euro-using nations – most notably Italy, France and Spain – are about to embark on a sharp fiscal contraction; again making recession more likely.

In summary, the October package will – from a marcoeconomic perspective – look very much like a monetary and fiscal policy contraction on the eve of a recession.

The recession will bring us back to the same crisis

All of the EZ’s interlined problems – weak banks, weak sovereigns, and a desperate Greece – could be solved by a few quarters of really good growth. But likewise a recession will completely undo the October package’s progress. Recession will:

  • Worsen the fiscal position of EZ governments, making their debt look riskier;
  • Worsen bank’s balance sheets, making them look riskier; and
  • Make Greece’s future look bleaker, making a disorderly default more likely.

The centrality of recession is illustrated in the diagram (see Baldwin 2011 for details).

 

Beyond fire fighting

The urgent measures decided early on 27 October 2011 do not address the underlying factors that brought the Eurozone to this perilous state. Getting the Eurozone onto solid ground requires:

  • An EZ-wide bank regulation and resolution regime.

As European banks lend heavily to their own governments, instability is baked into the system. When – as is now the case – banks’ ultimate backers are their own governments, the system is unstable (ask Ireland and Iceland what I mean here). Before the euro, central banks were playing on the national side so their limitless balance sheets were the ultimate backers, not the government’s ability to borrow.

  • An EZ-wide backstop for sovereign debt (via the ECB or a Eurobond-like construct).

EZ nations are like Latin American nations in the 1980s – they issue debt in a currency they cannot print so default is always a possibility. Market panic over default possibilities raises interest rates that make default more likely which in turn stokes the panic. Before the euro, nations could print their way out of any hole thus transforming default risk into inflation risk. Critically, inflation risk does not have the fear-inducing, line-in-the-sand feature that can turn concern into panic when investors see things going wrong. By removing this safety value, the euro baked instability into the system.

The Growth and Stability Pact was the proposed replacement, but France and Germany destroyed its credibility in March 2005. Until a substitute is found, the EZ will be vulnerable to self-fulfilling cycles of fear and rising yields.

The stopgap measure to date has been the ECB’s willingness to stretch its mandate, but this is not a permanent solution. The ECB will need more substantial political coverage.

  • An EZ-wide plan to maintain each nation’s competitiveness.

The ultimate solution to debt problems is growth. EZ leaders know what they have to do to get back on the growth path, but the entrenched special interest that have blocked pro-growth reform for decades (remember the Lisbon Strategy?) are still at it. The current crisis atmosphere must be used as leverage against these special interests. The key is to make markets and wages more reactive to macro conditions. Better integration of service markets would also help.

Conclusions

The EZ Summit is short-term good news – it defused the bomb that threatened Europe with a generation-defining economic catastrophe. That’s why markets liked it. But the solution relied on short termism. Two features of the rescue make a recession much more likely.

  • The voluntary, ad hoc nature of the bank recapitalisation will induce banks to engineer a massive credit crunch.
  • The renewed emphasis on national austerity will induce EZ members to engineer a massive fiscal contraction.

All of this is to happen over the next six to nine months regardless of deteriorating macro prospects. The EZ is headed for a recession.

This recession will undo all the October packages work – weakening banks, sovereigns and Greece.

Expect another EZ crisis Summit before Spring 2012 

References

Baldwin, Richard and Daniel Gros (2010). “Introduction: The euro in crisis – What to do?”, in Completing the Eurozone Rescue: What More Needs to be Done?, Baldwin, Richard, Daniel Gros, and Luc Laeven (eds). VoxEU.org eBook, June.

Baldwin, Richard (2011). “Welcome to phase 2 of the Eurozone (EZ) crisis”, VoxEU.org, 5 September.

De Grauwe, Paul (2011). “Managing a fragile Eurozone”, VoxEU.org, 10 May.

Wyplosz, Charles (2011). “They still don’t get it”, VoxEU.org, 25 October.

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Topics:  EU institutions Financial markets

Tags:  EZ crisis, October 2011 package, EZ rescue