"Those who seek to defend everything defend nothing"
Prussian Reformer and General Gerhard von Scharnhorst.
The quote above is a fair characterisation of the policy response of European heads of state and the ECB to Europe's sovereign debt crisis. A new strategy is needed. Instead of trying to avoid sovereign default, at staggering costs to the European taxpayer, policymakers need to focus directly on capital measures for European banks – a much more credible, cheaper, and defendable policy.
The May 2010 Greek policy was a mistake
It is increasingly clear that avoiding the default of Greece and the creation of the European Financial Stability Facility (EFSF) was a big policy mistake (see Wyplosz 2010 and 2011). Some bank economists and bond investors have done their best to manipulate public opinion and, surprisingly, many confused journalists have echoed the narrow self-interest of exposed capital-market investors. But now that the insolvency of larger countries like Spain or even Italy seems possible, the ECB doctrine of "no European sovereign default" becomes simply untenable.
European guarantees for Spanish or Italian public debt are just unacceptable to the French, German, or Dutch taxpayer because of the magnitude of the risk involved.
- The Finns have already said their farewell to the Greece rescue plan and they cannot be blamed their good common sense.
- When the full financial burden of EFSF guarantees falls upon the German taxpayer over the next three years, it will become evident that Chancellor Merkel has led her Christian democratic party down a road to political suicide.
Eurobonds not the solution
Some believe a Eurobond could rescue the situation, but this is akin to magical thinking. A Eurobond is just shifting the problem to those countries which still enjoy capital market access (see Alesina and Giavazzi 2011).
- Eurobonds would bring neither debt relief nor any new fiscal resources to the table.
- The claim that the Eurobonds could be traded for more fiscal austerity and/or constitutional limits on further debt are delusional.
Such commitment will mostly exist on paper, given low levels of government effectiveness and rule of law in some periphery countries (Gros 2011). Peer monitoring at the European level has already failed, as seen in the violation of the Maastricht criteria, the Lisbon Agenda, and so on.
Eurobonds: A bundle of nails for the euro coffin
The central problem of the Eurozone turned out to be not the asymmetric shocks predicted by many euro-sceptic economists in the 1990s, but its corrosive effect on fiscal discipline.
- When the newly-elected French president Mitterrand embarked on a fiscally-irresponsible spending spree in 1981, the German mark-French franc currency peg immediately came under pressure and forced a policy change within 6 months.
- The common currency has essentially prolonged the time of reckoning.
A common Eurobond would sweep away the last remnants of fiscal discipline, a sort of death verdict for the common currency through soft budget constraints.
However, the common currency is defendable at least for the core countries. Yet, whatever scarce fiscal resources there are need to be focused on bank recapitalisation instead of on bailing out all investors. Indeed, orderly sovereign default need not have catastrophic economic consequences if the banking sector is sufficiently capitalised to absorb losses from sovereign default.
We therefore need a mandatory large-scale recapitalisation of European banks to a level of equity capital that allows them to absorb further sovereign defaults and debt write-downs, as recently proposed by new IMF chief Christine Lagarde (see Harding 2011 in the Financial Times). Such a defence of the euro is in the common interest and feasible (because only a fraction of Europe's sovereign debt is owned by banks).
Public recapitalisation gives taxpayers a stake in the upside
In return for new equity capital, the taxpayer should get equity shares, which means that he/she stands a good chance of breaking even in the long run when these shares are sold back to the capital market. In Sweden and Switzerland, such sales netted handsome government profits. Expected bank losses from sovereign default will be priced into the new bank shares so that the taxpayer gets a fair deal and existing equity owners take the loss. The disciplining role of the capital market is fully restored – bank valuations will suffer only to the extent to which they took on sovereign default risk.
Such an alternative plan would concentrate the financial losses with those most responsible for the credit misallocation, namely specific bank capital owners and owners of sovereign credit. By contrast, the wholesale bailouts of Greece, Ireland, and Portugal would all socialise private losses. Moreover, this socialisation of private losses implies a gigantic redistribution of wealth to the 5% richest in the world who own roughly 70% of all financial assets and, by extension, own a similar percentage of the private losses (Hau 2011). Ironically, the current rescue plans for Greece unburden the capital market investors most capable of taking large losses – indeed, the so-called private sector involvement is largely a farce (Cabral 2011).
A debt crisis and a competitiveness crisis: Different causes and solutions
It should also be highlighted that a debt crisis and a competitive crisis are distinct problems. The Irish and the Italian states might become insolvent, but that does not imply that either economy is in need for a nominal devaluation and therefore needs to leave the Eurozone. Default by more European countries (other than Greece) does not imply the demise of the euro as sometimes claimed. In fact, orderly sovereign default - while shielding the banking sector through mandatory recapitalisation - may offer a fast track exit from the current debt crisis and be the best chance for the euro's survival and a fast recovery. It certainly forces instant fiscal adjustment to a balanced budget without any attacks on fiscal sovereignty which can only poison European politics.
A major obstacle to such a solution is the banking and capital market lobby - they like Eurobonds as the best way to socialise private losses. Chancellor Merkel should therefore expect a lot of scapegoating in the months ahead. But her true shortcoming so far is the failure to prepare a workable line of defence for the euro - one that would allow for sovereign default but would simultaneously avoid a European banking crisis. That means focusing on a mandatory bank recapitalisation.
Alesina, Alberto and Francesco Giavazzi (2011), “Why a slowdown in Germany could be good for Europe”. VoxEU.org, 1 September.
Cabral, Ricardo (2011), "Greece’s 2nd bailout: Debt restructuring with no debt reduction?", VoxEu.org, 29 July.
Gros, Daniel (2011), "Eurobonds: Wrong solution for legal, political, and economic reasons", VoxEu.org, 24 August.
Harding, Robin (2011), "Lagarde calls for urgent action on banks", Financial Times, August 27.
Hau, Harald (2011), “Europe’s €200 billion reverse wealth tax explained”, VoxEU.org, 27 July.
Wyplosz, Charles (2010), “And now? A dark scenario”, VoxEU.org, 3 May.
Wyplosz, Charles (2011), “They still don’t get it”, VoxEU.org, 22 August.