Resolving the current European mess

Charles Wyplosz 25 October 2011

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Editors' note: This column forms part of a VoxEU.org eBook 'The Future of Banking', to be published on Tuesday 25 October.

Invariably, policy mistakes make a bad situation worse. The May 2010 rescue package was officially designed to prevent contagion within the Eurozone, but the crisis has been spreading ever since, as evidenced by the interest spreads over German ten-year bond rates (Figure 1). Unofficially, a number of governments were concerned about exposure of their banks to Greek and other potential crisis-countries’ bonds. Banks are now in crisis, a striking blow to the July stress tests that were officially intended to reassure the world and unofficially designed to deliver reassuring results. This is not just denial; it is an attempted cover-up.

Figure 1. Ten-year bond spreads over German bonds (basis points)

The debate is now whether it is more urgent to solve the sovereign debt crisis or the banking crisis. The obvious answer is that these two crises are deeply entangled and that both crises must be solved simultaneously. Debt defaults will impose punishing costs on banks, while bank failures will require costly bailouts that will push more countries onto the hit list. Spain, Italy, Belgium, and France are on the brink. Quite possibly, Germany might join the fray if some of its large banks fail. This should dispel any hope that Germany will bankroll governments and banks. German taxpayers are revolting against more bailouts, but they may not realise that they cannot even afford to be the white knight of Europe. From this, a number of conclusions follow.

Conclusion 1 is that current policy preoccupation with widening the role of the EFSF and enlarging its resources is bound to disappoint and trigger yet another round of market panic. Unofficial estimates of how much more capital the banks included in the European stress test need to restore market confidence (ie aligning their Tier 1 capital to banks currently considered safe) range from $400 to $1000 billion. Even if the EFSF can lend a total to $440 billion, with some €100 billion already earmarked for Ireland and Portugal, this is not enough to deal just with the banking crisis.

The current plan is for banks to seek fresh capital from the markets, with EFSF resources as a backstop. Conclusion 2 is that this plan will not work. Markets are worrying about the impact of contagious government defaults on banks. They will not buy into banks that are about to suffer undefined losses. Somehow, a price tag, even highly approximate, must be tacked on sovereign defaults for investors to start thinking about acquiring bank shares. They need to know which governments will default and in what proportion. Since this will not be announced ex ante, market-based bank recapitalisation is merely wishful thinking. Much the same applies to the much-talked-about support from China, Brazil, and other friends of Europe. They well understand that they stand to throw good money after bad and will not do so unless they can extract serious political concessions. One cannot imagine how much several hundred billions of euros are politically worth.

Assuming that, somehow, bank recapitalisation and debt defaults can be handled simultaneously (more on that later), how to make defaults reasonably orderly? Last July, the European Council set the parameters of an orderly Greek default. Hau (2011) shows that this agreement, dubbed voluntary Private Sector Involvement (PSI), has been masterminded by the banks and only aims at bailing out banks, not at significantly reducing the Greek public debt. Conclusion 3 is that there is no such thing as a voluntary PSI. Banks are not philanthropic institutions; they always fight any potential loss to the last cent. If not, they would have bailed out Lehman Brothers without the US Treasury guarantee that they were denied.

This brings us to Conclusion 4 – in order to avoid a massive financial and economic convulsion, some guarantee must be offered regarding the size of sovereign defaults. Crucially, the country-by-country approach officially followed is unworkable. The current exclusive focus on Greece is wholly inadequate. Markets look at Greece as a template. Whatever solution is applied to Greece will have to be applied to other defaulting countries. Adopting an unrealistically short list of potential defaulters will only raise market alarm and result in failure. Such a list is difficult to establish on pure economic grounds (should Belgium and France be added to Italy and Spain?) and politically explosive (governments cannot provoke a default by including a country in a near-death list). The only feasible solution is to guarantee all public debts, thus avoiding both stigma and lack of credibility. Finland, Estonia and Luxembourg would do the Eurozone an historical service by requesting to be part of a debt guarantee scheme.

What kind of guarantee scheme is needed? An example is provided in Wyplosz (2011). In a nutshell, all sovereign debts must be partially guaranteed (eg up to 60% of each country’s GDP, or up to 50% of the nominal value). The scheme would backstop debt prices by setting a floor on potential losses. It would lead to less panicky debt pricing by the markets. In turn these market prices would serve as a guide to debt renegotiation between sovereigns and their creditors. By depoliticizing the process, it would make defaults as orderly as possible under the circumstances.

Who can offer such a guarantee, which is effectively a price guarantee? A price guarantee only operates if markets know beyond doubt that the guarantor can and will buy any bond that trades below the announced target (which in this case is a floor). The total value of Eurozone public debts stands at some €8300 billion (more than three times the German – or Chinese – GDP). This is beyond any enlargement of the EFSF. This is beyond current and future IMF lending resources, currently some €400 billion. The unavoidable conclusion is that the ECB is the only institution in the world that can backstop public debts and make reasonably orderly defaults possible. The current ECB position – “we have done what we can, now it is up to governments” – dramatically misses the point. Of course, the ECB may be concerned about taking on such a momentous task; an imaginative solution is for the ECB to provide the commitment through the EFSF, as suggested by Gros and Maier (2011).

Finally, how can the two rescues – of sovereign debts and banks – be carried out simultaneously, as required? If Greece defaults, its banks, pension funds, and insurance companies will fail in large number. It seems that Greece will not be able to bail them out. Assume, just as an example, that Greece defaults on half of its public debt (about 70% of its GDP). Assume that bailing out its banks, pension funds, and insurance companies costs 30% of GDP. The government can do the bailout and still come out with a debt that is lower than now by 40% of GDP. Greece can afford to borrow what it needs to bail out its financial system. The solution then is that the ECB – directly or indirectly via the EFSF – partially guarantees the existing stock of debts and fully newly issued debts simultaneously. Obviously, the guarantee of future debts cannot be given without absolute and verifiable assurance of fiscal discipline in the future. Proposals to that effect are presented in Wyplosz (2011).

References

Gros, Daniel and Thomas Maier (2011) “Refinancing the EFSF via the ECB”, CEPS Commentaries, 18 August

Hau, Harald (2011) “Europe's €200 billion reverse wealth tax explained”, VoxEU.org, 27 July.

Wyplosz, Charles (2011) “A failsafe way to end the Eurozone crisis”, VoxEU. org, 26 September.

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Topics:  EU institutions EU policies International finance

Tags:  ECB, eurozone, sovereign debt, EFSF

Professor of International Economics, Graduate Institute, Geneva; Director, International Centre for Money and Banking Studies; CEPR Research Fellow