This time last year, I wrote a Vox column wishing us all a better year than the previous one. Alas, 2011 was worse than 2010 and things don’t look good for 2012. The new year will see the Eurozone relapse into recession with a probably that approaches 100%. Is there is any reason to be hopeful?
Why does the crisis linger, deepen and spread?
The crisis is, first and foremost, the result of policy mistakes. The authorities have never articulated a clear diagnosis. They cite a long list of woes. Some are correct but obvious, for example, the absence of fiscal discipline in the Eurozone and the associated moral hazard inherent to rescues. Others are sideshows, for example, large current-account imbalances. Most are deeply misleading, for example, blaming financial market speculation and rating agencies pessimism or worrying about inflationary risks and about widening budget deficits. To round up this depressing list, some problems are conspicuously ignored or played down, for instance, the sorry state of commercial banks, the need for serious debt defaults, and the absence of growth prospects.
It would have been a miracle if policy decisions drawn up without a clear diagnosis had been adequate. This is why 2011 was a rerun of 2010. And looking forward, heightened austerity in virtually all Eurozone countries is taking us straight into recession. Fanciful proposals for “voluntary” debt reduction – a.k.a. public sector involvement or PSI – have been on and off the table; they block any possibility for an increasing number of Eurozone countries to recover market access.
Because of the focus on moral hazard, comprehensive solutions remain elusive. Proposals to strengthen the Stability and Growth Pact keep piling up, each one aiming at more automaticity and tougher sanctions. Yet it was only at its last meeting in December 2011 that the European Council recognised that the Pact cannot work when nations are sovereign. A new treaty that would allow for a suspension of sovereignty is now being proposed. A safe bet is that this will not happen.
It is not surprising, therefore, that the situation has considerably worsened. By end 2010, three countries (Greece, Ireland, and Portugal) were facing mounting borrowing costs. During 2011, two of the largest Eurozone countries (Italy and Spain) joined the list. And now two more (Belgium and France) are slowly but surely sliding into the same bad equilibrium. Recession will seriously worsen the debt arithmetic.
Do governments and the ECB learn?
It is no surprise, either, that virtually every summit – each one presented as “decisive” – produced “comprehensive” solutions that crumbled in a matter of days. The real surprise is that markets started to buy into the official declarations and that it took them a number of days to reach the obvious conclusion that the proposals were neither decisive nor comprehensive. In the end, each summit has made the situation worse because it showed that policymakers were not able or willing to arrest the crisis.
The amazing sight of policymakers apparently overwhelmed by the problems that they face is undoubtedly the most worrisome aspect of the crisis. There is little doubt that financial crises are complex events. They require an understanding of financial markets and of multiple equilibria. No one expects politicians to spontaneously master this kind of knowledge, but we would hope that they are adequately briefed and that their proposals are thoroughly evaluated before they are put forward. Unfortunately, this has not been the case, and the question is why.
One interpretation is that the Commission, which has the technical resources, is kept out of summit preparations. A related interpretation is that the Commission at its highest levels is unwilling to be critical of governments. Either way, this would represent a tragic under-utilisation of resources that are sorely needed if we ever hope to solve the crisis.
Another interpretation is that the French President and the German Chancellor are not seeking out technical support because they are convinced that politics can solve any problem. Both are known to have such an inclination. Yet, they must have been repeatedly surprised that their “comprehensive solutions” promptly fizzled out. One would expect that these sobering experiences eventually lead them to accept that the laws of economics cannot be discarded.
Is policymaking captured by special interest groups?
This observation raises another, most disquieting, interpretation. Are the politicians captured by special interests?
A common thread of many decisions is that they aim at protecting banks. Clearly, no one wishes to see a banking collapse but if, as many believe, some deep bank restructuring is unavoidable, forbearance is highly counterproductive. The capture interpretation rests on a web of signals: the initial refusal of contemplating any sovereign debt restructuring, last summer’s row with the IMF Managing Director, pressure on the European Banking Authority to conduct gentle stress tests, and the negotiation of PSI with the world banking lobby leading to solutions that protect banks while providing little debt relief.
The ECB’s actions have been equally disquieting, raising all the same questions (understanding of the phenomenon, access to technical support, capture). The small-scale bond purchases of the SMP have repeatedly failed to quieten markets down. Tactically, the presence of the ECB in the market provides temporary relief. Yet, official statements that the latest intervention was a one-off have systematically undermined any strategic benefit that could be reaped. Most disturbing is continuous insistence on the primacy of the price stability objective, as well as concern with the transmission channels of monetary policy at a time when bond markets are in panic and the interbank market has stopped functioning. As he left the Executive Board, Lorenzo Bini-Smaghi has evoked “quasi-religious discussions” within the Eurosystem. This would confirm the impression that the central bank is not focused on hard-core economic analysis and would explain why it does not seem to learn from past mistakes either.
The only kind interpretation is that the ECB and some politicians shrewdly want to use the crisis to achieve lasting fiscal discipline throughout the Eurozone. One idea is that acute pain will teach a lesson to countries that have always thought little of fiscal discipline. A better one is that we need to go to the brink to make serious changes politically acceptable.
Can we agree on a diagnosis?
The crisis is complicated because it combines financial turmoil with governance issues under challenging macroeconomic conditions. The truth is that the economics profession has not converged on a shared diagnosis, which undoubtedly contributes to confusion among policymakers. Here is a proposal, stated as simply as possible.
Markets fear that some countries will not be able to grow out of their public debts. This leads to a vicious circle, with a number of possible outcomes, where either governments lose market access or have to pay unsustainable interest rates on their new borrowing. There is no point in debating about solvency – a government is insolvent when it loses market access.
To make things worse, any sovereign default stands to lead to bank failures because banks hold large amounts of public bonds. This is an additional vicious circle because governments would then have to bail their banking systems out, meaning an increase in their own indebtedness. Government and bank bailouts further raise a moral hazard issue. While banks can be socialised or dismantled, no such solution to moral hazard is available as far as governments are concerned. Yet, moral hazard needs to be dealt with.
Necessary conditions for ending the crisis
This diagnosis implies that the crisis will not stop until the following actions are taken:
1. Governments that lose market access must be bailed out in one way or another.
For "effectiveness" and "moral hazard" reasons, the bailout should not be complete; instead it should encourage debt restructuring.
- "Effectiveness", because countries with large public debts are unlikely to grow and, therefore, unlikely to be able to run down their debt to GDP ratio.
- "Moral hazard", because defaults simultaneously reduce the debt burden and give incentives to governments to do what it takes to recover market access.
Defaults would also help with another moral hazard, this time borne out of investors’ beliefs that Eurozone governments never default (investors have been receiving large yields since the start of the crisis).
2. The bailout must be carried out by the ECB because the required amounts are unknown and could be very large.
The total value of Eurozone public debts is about €9,000 billion. The European Financial Stability Facility (EFSF) can mobilise, at most, €200 billion, and the IMF can be expected to put up a similar amount. “Friends” such as China will not add that much. Only the ECB can mobilise any amount of money as it becomes needed.
3. Banks must be recapitalised, if possible before some sovereigns default.
The amounts needed are not based on the previous crisis – the consequence of the subprime disaster – but on the future crisis once defaults occur. If the banks cannot raise sufficient capital, the EFSF can provide the funds.
4. Addressing moral hazard requires the firm establishment of fiscal discipline throughout the Eurozone – and quickly. The treaty route is unlikely to lead anywhere.
Alternative to a new treaty: ‘Fiscal Discipline Board’ and ECB collateral rules
The current proposal for a new treaty that would allow suspension of sovereignty is extraordinarily intrusive. The proposal is for some European authority (the Commission? Or some other body?) to take over fiscal policy in a country that runs afoul of the Stability and Growth Pact. The idea that a country loses fiscal policy sovereignty is inspired by IMF programmes. These programmes, however, are never imposed from outside. Countries apply to the IMF, on their own, and they negotiate conditions. This makes a huge difference.
A much better arrangement is possible without a new treaty. Currently, in its routine refinancing operation, the ECB accepts as collateral a wide range of assets. Most central banks accept only – or mainly – treasury bonds. The unusual arrangement of the Eurozone is an artefact of history – because practices differed considerably among future Eurozone countries, the ECB decided to accept every asset that was previously accepted. The ECB has the authority to decide what collateral it accepts and it could decide to only accept treasury bonds issued by governments that exercise fiscal discipline. It would work as follows.
The ECB would ask an independent body to examine the fiscal policy framework of each member country. The body, call it the Fiscal Discipline Board, would look for arrangements that adequately constrain member governments, for example the German debt brake or the Dutch coalition agreements. The ECB would bind itself to follow the Board’s judgment. A country that has not adopted arrangements deemed adequate, or that does not abide by its own arrangements, would face the consequences: high borrowing costs, possibly loss of market access. The presumption is that the situation would be promptly corrected.
Details need to be worked out: Who would appoint the Fiscal Discipline Board? What means would the board have? Would there be a possibility of appeal? These are fairly simple issues, much simpler that the new treaty proposal. The key point is that this procedure does not call for a treaty, it does not tread upon sovereignty (fiscal discipline arrangements are left to each country, there is no threat of outside intervention or fine) and it should reassure the ECB, which is currently rightly concerned by moral hazard. By relying on an independent Board, the ECB would not have to pass judgement that can be construed as political. It would also reassert its independence, as it can decide on its own to adopt such an arrangement.
Moreover, all this can be done virtually overnight.