Can the Euro Area Use Its New Stability to Continue Reforms?
Everywhere you look, the survival of the euro seems to be an idea whose time has come. In France, a limited measure of progress occurred when the country's social partners agreed to some labor market reforms. Chancellor Angela Merkel's party lost a German regional election, with no dire consequences for its commitment to save the currency union. The euro area has debated bank recapitalization and the selection of a new chairman. Meanwhile, the euro area financial markets continue their normalization with peripheral primary market yields continuing to fall. The mighty doomsayers in Davos are being forced to revise last year's confident projections of imminent euro exits. The new consensus is an intellectually meaningless long-term projection of a euro collapse. Even the Economist asks on its cover this week if "the euro zone is out of danger."
Are the prognosticators right this time?
Financial markets are certainly internalizing the realization that the euro is here to stay and that a sovereign default is not in the offing. Portfolio managers no longer need to keep their investments calibrated for an outbreak of thermonuclear war. The great euro area wealth destruction from the lemming-like real investor run into safe haven assets like German government bonds has abated, despite German negative nominal (!) interest rates. As the saying goes, the focus has shifted from the "return of capital" to the "return on capital." Irish or Italian five-year bonds yielding around 3 percent or five-year Spanish bonds at almost 4 percent attract more investors than a German five-year still yielding just around 0.7 percent.
The problem is that if, as expected, this market sentiment dominates other euro area developments for a while, complacency in Europe and elsewhere could settle in.
In France, Concerns Remain
What does the agreement between France's social partners herald for the country's economic prospects? For someone like myself, who has castigated President François Hollande for not taking tough decisions on structural reforms, especially in labor markets, the question is urgent. Three areas should be addressed: 1) increased firm-level flexibility to negotiate wage and working conditions independent of sectoral national collective bargaining agreements; 2) a massive reduction in the role of labor courts litigating labor market outcomes in France; 3) a reduction in the tax wedge on labor in France (for example, the difference between take-home pay and the employer's total cost, including social contributions and benefits).
In late 2012, following the Gallois report on French competitiveness, the government announced a commitment to lower social welfare payments by up to €20 billion over three years, with the cost shifted to increased consumption taxes. Certainly, Hollande was moving in the right direction. But because France in 2011 had the fourth highest total tax-wedge in the entire OECD1 at 49.4 percent, the announced move will hardly dramatically increase the relative cost competitiveness of French businesses.
More encouraging, perhaps, is an agreement to introduce more firm-level flexibility to reduce working time and pay during downturns, enabling firms to adjust their labor input to the amount of production that they can expect to sell. While welcome, however, this agreement is a far cry from the far more generalized firm-level opt outs from national collective bargaining agreements long available to businesses in Germany and elsewhere in Northern Europe and, since the crisis, increasingly in Spain and Italy.
One question is whether French businesses will act on this agreement now or have to wait for a recession. Most likely that it will be the latter, preventing French firms from responding rapidly to the demands of a globalized world economy. Simply put, French firms need more freedom to negotiate their own wages and working conditions now. It is not clear that this deal meets that need.
As for labor courts in France, the window of opportunity for French workers to challenge their dismissal in a labor court was reduced from (an insane) five years to (a still intolerable) two years. In addition, the possible compensation that the court can award laid-off workers was reduced. Needless to say, this is an underwhelming change of the rules. (In Italy, the particular rules change regarding labor courts was equally unimpressive.) One can historically appreciate the existence of special labor courts in France. But the club they wield makes businesses hesitant to hire new workers in the first place. Other changes are necessary in the regulation of part-time work in France, aimed at encouraging firms to hire more people on permanent contracts, reducing the discrepancy between insider and outsider workers in France.
Despite heading in the right direction, these changes cannot make a real difference in the working environment for businesses in France. Many firms will want to avoid hiring more than 49 employees so they can remain below the size threshold for many of these rules. With his failure to promote real labor market reform, Hollande is squandering his opportunity to emulate former Social Democratic German Chancellor Gerhard Schroeder in 2010 and increase employment in France. If this is all he is going to do he has probably lost the chance to improve labor markets to help him win reelection in 2017.
Plainly the euro area crisis has not (yet) spurred France to reconsider basic economic policies, as Spain and Italy have done. French Socialists seem unable to make the shift embraced by the German Social Democrats (SPD) and other Northern European counterparts, not to mention the center left in the Southern periphery.
Two of France's five labor union confederations have rejected even these modest reforms, although the fact that three have not does create the opportunity that less confrontational labor market relations are possible. This possibility likely holds the key if Hollande's labor market reforms are going to have any real economic effect. Without more harmonious labor relations, companies and unions at local levels outside the headlines are less likely to change the status quo. France's economic future remains precarious, raising the possibility of new volatility in the euro area.
In Germany, Merkel Suffers a Loss
In Lower Saxony last weekend, Merkel's Christian Democratic/Free Democrats (CDU/FDP) coalition lost the regional election. One should not over-interpret these local election results, but Merkel did invest considerable time in campaigning for the local CDU candidate. The result was less of a disappointment for the FDP, which got 10 percent of the vote, a surprisingly good return prompted by vote-shifting by some CDU voters. (Such vote shifting would not likely be repeated in the German federal election, so one should not assume that the FPD has recovered electorally) The election cements the main characters in the September national balloting: Philip Rösler will continue to lead the FDP and Peer Steinbrück, despite his rocky start, will be the Social Democratic candidate for Chancellor.
The headline from the returns could arguably be: "Pro-Eurobond Party Sweeps to Victory in German Regional Elections." It was the strong showing of the Green Party that led to the opposition victory, illustrating that for the euro area crisis as a whole, there is little to fear from an electoral triumph of the SPD/Green coalition. Indeed, a new German SPD/Green party coalition might make it easier for the euro area to agree on new crisis measures. The opposition's added votes in the German parliament's upper house also strengthens its influence on German euro area policies.
Another welcome development was that the political extremes—Die Linke on the left and euro-skeptic Frei Wählern and nationalist NDP on the right—garnered no more than 3.1, 1.1, and 0.8 percent of the vote respectively. The populist Pirate Party similarly fizzled, taking just 2.1 percent. There is thus no sign of political extremism or euro skepticism in the voting patterns of Germans. German leaders—as well as headline-focused financial analysts—can safely ignore the occasional opinion poll showing heightened German opposition to the euro and bailouts. Evidently, German voters do not let such notions affect who they elect to run the country.
For all these developments, Merkel remains Germany's most popular politician. Her personal popularity is likely to be a bigger factor in the national elections, making it likely that she will remain chancellor, though possibly with a new coalition partner. But Lower Saxony's vote did show the possibility for a non-threatening political upset in Germany later in the year.
For the Euro Group, a New President and a Possible Redefinition of the Scope of the Banking Union
The euro group met on January 21 to introduce its new president, Dutch center-left finance minister Jeroen Dijsselbloem. He listed his three priorities for a two-and-a-half-year presidency:
- Completing the euro area banking union (defined as the completion of the single resolution mechanism (SRM), and harmonization of national deposit guarantee schemes. (There will not therefore be any attempt to fully integrate euro area deposit guarantee schemes in the short term.)
- Continuation of the euro area fiscal consolidation strategy.
- The restoration of a sustainable growth path.
These steps highlighted the policymaking continuity in the euro area, irrespective of whether the leader is from the center-left (as he is) or center-right (like outgoing President Jean-Claude Juncker).
There was little news of new policies from the euro area leaders. Technical work on the details of the European Stability Mechanism's (ESM) capability to recapitalize euro area banks will only be completed during the first quarter of 2013. But the euro area committed itself to making this capability an "important element in breaking the vicious circle between government and bank balance sheets."
That commitment—as only one "important element"—could redefine the ESM's scope, which could determine whether the ESM lends money to a struggling sovereign, or takes an ownership stake in a failing bank. The latter is far riskier than the former. The equity in a bailed out bank may still in extremis be worth zero at the end of the crisis, whereas the recovery rate on loans to governments will be higher. Because the ESM has only €80 billion in capital and relies on leverage to reach its €500 billion lending capacity to governments, its ability to recapitalize banks and retain its AAA-rating will be well below €500 billion. Bank rescues and resolutions in the euro area may therefore become as uncontroversial as in the United States only after these issues are sorted out with establishment of a resolution fund financed by the banking sector. This may take time. The US government took from 1933 to 1948 to recover the $289 million ($3.7 billion in 2005 chained dollars) it initially injected into the newly created Federal Deposit Insurance Corporation (FDIC) to cover both resolution and deposit insurance in a smaller and more tightly regulated banking system.
More importantly, the euro area is signaling its intention to dial back the scale of the mutualization of banking sector contingent liabilities, even after completion of a banking union years from now. Moral hazard concerns continue in a currency union of still sovereign nations, even though they are less sovereign than they used to be. These concerns will limit the full mutualization widely envisioned after the announcement of the banking union at the June 2012 EU Council. Absent further political integration, which is unrealistic in the short run, the euro area will not achieve this outcome as long as the potential joint recapitalization of a bank has to come from the ESM, rather than an industry-sponsored private insurance based fund. A private fund can be calibrated in size. But given the enormous size of the banking system, reaching that goal will take decades.
Accordingly, rather than completely removing the cost of a bailout from sovereign balance sheets, the euro area seems destined to install a more limited system. Direct recapitalization from the ESM will be determined by how much the cost exceeds the capacity of a country to finance such a backup itself. This means that there will not be full insurance against the costs of national banking crises. Rather there will only be insurance against the cost of a banking crisis destroying the market access of the stricken country. In light of the euro area's definition of long-term debt sustainability in Greece, the ESM would in extremis recapitalize the parts of a country's cost of a banking sector bailout that exceeded 120 percent of GDP. Any euro area member would be left with "skin in the game," even as the European Central Bank (ECB) assumes responsibility for banking supervision.
In reality, it is not possible to gauge when the cost of a bailout to a euro area member will close off market access to financing. Rules defining when a country must shoulder most of the cost of a bank bailout cannot be drafted in detail. One needs to factor in the benefits to the ESM of a country avoiding a market shutout and averting its having to finance a country for years. As a result, the ESM will likely see the benefits of shouldering much of the cost of a banking sector bailout before a crisis threatens the market access of a debt-wracked country.
The euro group secretariat made this intent clear in an issues note to finance ministers this week.2 The first suggested eligibility criteria for direct ESM recapitalization of a euro area bank was listed as;
The Member State should be unable to provide financial assistance to the institution in full—including, as a rule, via the regular (indirect) bank recapitalization instrument—without very adverse effects on its own fiscal sustainability. The use of this instrument can also be considered if it is established that other alternatives could have the effect of endangering the continuous market access of the requesting ESM member and consequently require financing of the sovereign needs by the ESM.
Such a case-by-case system of direct ESM bank recapitalizations, where the principal aim is to keep a country's access to market financing at sustainable rates, implies several things.
First, it implies that the "first loss" and also the "first considerable loss" in any future euro area banking crisis will be borne by the national government, rather than the ESM, which will function only as a backstop.3 Second, the scope of losses by shareholders and bondholders in future banking sector crises will be large, because debt restructuring will likely be pursued aggressively by national and euro area authorities. The associated costs to investors holding senior unsecured euro area bank bonds should, in turn, lead to longer-term changes in the capital structure of many banks. This may further lead to capital/bond market financing gaining market share at the expense of bank intermediated credit in the euro area. Introducing such a framework may ironically make the euro area financial markets look more like the bond-dominated US markets.
Finally, a case-by-case direct ESM bank recapitalization has implications for other euro area bailout recipients. In Spain, the cost of the banking sector recapitalization will be retroactively transferred to the ESM only if the Spanish economy deteriorates and loss of market access becomes a possibility despite an application for an Outright Monetary Transaction (OMT) lifeline. For Ireland, which lost market access because of its banking crisis, the new system suggests that the euro area will find a way to grant Ireland more financial assistance retroactively. Such aid would then help nudge it back to full market access during 2013. And in the case of Cyprus, as recently discussed on RealTime, the changes suggest aggressive bank bondholder haircuts among the scarcely bond-financed Cypriot banks or, as a last resort, direct ESM recapitalization of individual Cypriot banking institutions.
1. Data for a single individual without children at the income level of the average worker.
3. This sequencing will already indicated by ECB Executive Board member Jens Asmussen in a speech in late 2012,. The euro area issues note cited above also makes this clear, as it lists it among the eligibility criteria for ESM aid that private sources of capital, including debt write-downs, must have been exhausted.