Europe’s Surprisingly Bold Step Toward Solving Its Sovereign Debt Crisis

March 15, 2011 11:15 AM

The outcome of the euro area meeting last week was far more substantive than expected, even if one takes into account that the expectations had been at rock bottom. Not only did European Union (EU) leaders demonstrate how they intend to prevent peripheral defaults, they also gave us an idea of their longer-term solutions for Europe's economic problems and future integration1.

Despite the talk by European federalists of their higher driving purpose toward an "ever closer union,"  the EU and its institutions have always been a very pragmatic entity, built principally in times of crisis with the aim to avoid specific undesired outcomes, whether war among its members or excessive exchange rate volatility. Since you rarely get political benefits merely avoiding really bad outcomes, the EU project has persistently lacked popular appeal among Europeans.

Last week the EU returned to this time-tested style of "avoiding catastrophe and muddling though." The solutions embraced by EU leaders avoided the undesired outcome of the current crisis, namely the destruction of the risk-free status of euro-zone sovereign debt, by barring haircuts to private creditors of Greek and possibly other debt, averting the spread of bond-market contagion. As predicted on this blog since late 20102, EU leaders did so by giving themselves the ability to grant fiscal transfers in another name to members facing acute financial stress.

The EU declared that while "taking into account the debt sustainability of the recipient countries," lending rates imposed by the European Financial Stabilization Fund or its successor, the European Stabilization Mechanism, can be lowered to a level just above these facilities' funding costs. Such a step puts them in line with International Monetary Fund (IMF) pricing principles and interest rates. Compared to the current "financing fee" of 300 basis points, this discount amounts to potentially large de facto fiscal transfers to countries like Greece, Ireland and soon Portugal.

Crucially, however, the summit made it clear that this potential self-interested largesse from Germany and the other AAA-rated countries doesn't come free. There will be "IMF-plus" additional political conditionalities for recipient countries that wish to qualify. In return for Greece pledging to privatize state assets for €50 billion, for example, euro area leaders agreed to give Athens a longer maturity of 7.5 years. They also reduced the interest rate by 100 basis points. Not a bad evening's work for Prime Minster George Papandreou, who recently sacked his chief tax-collector for failing to raise enough revenue and last week got lower interest rates from Angela Merkel in return for something (such as privatizations) that he would have had to do anyway to raise revenues. Initial estimates suggest that the Greek government may have reduced the costs of its loans by up to €6 billion. In other words, the necessary restructuring of official sector Greek debt has begun.

By contrast, Ireland got nothing in terms lower interest rates, as the country's new Prime Minister, Enda Kenny, was deemed to have "not engaged constructively on the issue of tax-base harmonization." This was a euphemism for Ireland's refusal to consider broadening its corporate tax base, as demanded by France and others. The broader message is clear. Recipient countries will have to do what the AAA-rated countries want to qualify for lower lending rates. This has nothing to do with "economic necessity" or defending the euro. (Changing Ireland's corporate tax base is hardly economically vital to survival of the euro area!) It has everything to do with extracting political concessions from recipient countries. Moral hazard will surely be checked by such demands, irrespective of the lower cost of financing available.

As for "debt sustainability," it will be up to euro area leaders to determine. But Greece is almost certainly not solvent even with longer maturities on its debt and interest rates lower by 100 basis points. Thus we can expect this scenario of pragmatism by euro area leaders to play out again in the future, as circumstances require, to avoid default. Similarly, at some point, Ireland can also be expected to get lower interest rates, when an understanding is reached on taxation. Ultimately, the euro area playbook is Machiavellian in its practicality – you do what we politically want, in addition to the technical stuff demanded by the IMF, and we will ensure that you don't default.

Euro area leaders have also agreed to expand the effective lending capacity of the ESM to €500 billion and give it conditional access to buy debt in the primary markets directly from a crisis-stricken euro-zone government. It would take such steps upon the recipient country agreeing to enter into an IMF program. Ultimately, whether the EFSF/ESM lends directly to a government or buys its bonds directly at subsidized prices is not of particular short-term relevance. However, this ability becomes a potentially very important "safety valve" if for instance Greece in 2012 or later still doesn't have access to private funding. At that point, Greece has an avenue to get additional funding from the EFSF/ESM – again as last week in return for explicit political concessions – which will prevent it from having to default on private bondholders.

What matters more in the short-term, is that the EFSF/ESM did not get the permission to – like the European Central Bank's Securities Markets Program – buy bonds in the secondary markets. This is surely a defeat for the ECB and its president, who would have preferred to not engage in such quasi-fiscal purchases in the name of maintaining financial market stability.  EU politicians said no, however, clearly intending to limit the potential scope of their own purchases of euro area government financed bonds. In all likelihood EU leaders are confident that – ECB independence or not -- Frankfurt can be trusted to maintain the stability of financial markets if necessary, by buying bonds in the short term.

By denying the ECB's president's request for governments to take over their new role as "financial firefighter" in secondary European asset markets, political leaders endorsed the new more activist and pragmatic role of the ECB in fighting financial crises. Put another way, it suits the German government well to have the ECB act in future crises as it has done in this, namely to buy bonds to stabilize secondary markets in the short run. The "new ECB" was been so successful that EU leaders denied Jean Claude Trichet's his request to transfer back to governments some of the new crisis-fighting powers that the ECB gave itself in May 2010. EU leaders have clearly said that there can be no returning to the old "Bundesbank approach" for the ECB. Perhaps Axel Weber, the Bundesbank president, knew what was coming and therefore decided to drop out of the race to succeed Trichet at the ECB.

Whatever the ECB says, euro area politicians are right to deny Frankfurt this request. With its ability to create money and expand its balance sheet muscle, the central bank is the right entity to carry them out to promote stability in a crisis. There is no reason that governments should tie up scarce public resources ahead of time (pre-funding would be necessary step to have credibility in a crisis) for fire-fighting on short notice. Short-term financial market stability IS a core responsibility of the central bank and should be so also in the euro area!

Like the Federal Reserve in the U.S., the ECB will ultimately book a hefty profit on its distressed SMP purchases when its bonds, along with the bonds owned by private investors, are retired by peripheral governments at par. These "profits" can then be redistributed to euro area governments according to the ownership formula of the ECB.

Also at their weekend meeting, euro area leaders agreed to a so-called "Pact for the Euro." The choice of the title word "pact" is of course unfortunate, evoking memories of the failed Stability and Growth Pact (SGP). EU leaders clearly missed Marketing 101.

But the word "pact" is also false labeling. If this wasn't politics, it would probably be illegal. In reality, when thinking of a pact as a legal document summarizing the agreement between parties, this has nothing to do with a "pact." Instead of setting up rules, the euro area leaders committed to initiatives by member states towards certain common objectives. These include fostering competitiveness and employment, contributing to the sustainability of public finances, and reinforcing financial stability. Initiatives would be national responsibilities, but would be politically monitored by the other heads of state and governments in the euro area. This is "peer pressure on political steroids." (Perhaps the euro area will adopt the Clinton Global Initiative model, where you are invited back only if you have fulfilled your previous pledge.)

The impact of this "pact" can only be judged when we see the nature of national commitments and the degree to which national governments are willing to commit political capital to implement them. Early German acceptance of lower interest rates on loans suggests that Chancellor Angela Merkel of Germany got politically credible commitments from other members for "national initiatives" in relevant areas. The first commitments will be made by the EU summit in late March and no later than the next summit in June 2011.

Hope springs eternal, but cautious optimism might be warranted here. Ad hoc economic coordination does suggest a potential expansion of coordination of economic objectives outside the traditional framework of EU-level regulation. Unavoidable labor market and pension system reforms could therefore be speeded up. Merkel now has more political cover behind which to criticize Italian labor laws or French retirement ages. Whether she will use it is of course another matter. Mutual political non-aggression pacts seem inevitable, though fewer policy areas will be off limits. That is a good thing.

The EU Summit Communiqué text also re-emphasizes several potentially far reaching policy initiatives. For example, euro area member states "commit to translating EU fiscal rules as set out in the SPG into national legislation" (e.g. constitution of framework law), and Euro area members "commit to putting in place national legislation for banking resolution." If faithfully implemented, both would be significant. Although of course no one in Brussels would EVER acknowledge this, both ideas are institutional imports from the United States. In the United States since the mid-nineteenth century, most states have had constitutional debt clauses in their constitutions. Led by Germany, the euro area is now clearly moving in the same direction. Similarly, the Federal Deposit Insurance Corporation (FDIC) in the United States has for decades routinely closed down hundreds of regional banks in an orderly manner through various economic cycles. The fact that national euro-zone regulators now will get that same legal authority and can therefore avoid the stark choice of bailout or collapse will hopefully in the longer-term lead to more regulatory willingness to deal forcefully with the problems in the European banking sector.

The fact that these types of policy initiatives now happen at the euro area level will sharply raise the political opportunity costs of "non-participation" for the current euro opt-outs. This is true for all Eastern European countries, but most noticeably Sweden and Denmark, whose kroner currency is already pegged to the euro. These countries have no problems with economically qualifying for euro-membership. Don't be surprised therefore if these new euro area initiatives shift the domestic political "referendum calculus" in Denmark (and Sweden), one of which could become the 18th member of the euro sooner than many think3.

Another pre-announced far-reaching policy initiative included in the Summit Communiqué – and probably the one whose inclusion surprised this author the most – is that euro area leaders agreed to reintroduce "debt levels" into the still evolving SGP. This reverses the original sin of the SGP, when Italy and Belgium became founding members of the euro while disregarding the original 60 percent debt criteria in the EU Treaty. Euro area leaders have now agreed to set up an annual "numerical benchmark" of 1/20th for debt reduction, to be assessed taking into account "all relevant factors." What this means is that there will be an annual numerical target for debt stock reduction of 1/20th of the existing national debt stock in excess of 60 percent of GDP in euro area countries. The devil will be in the details of implementation, of course, and the definition of "relevant factors" could render the exercise meaningless. Yet, including national debt stock in the fiscal sustainability assessments is a positive step.

Unsurprisingly, Italy has traditionally been most opposed to this reintroduction of a numerical debt stock target in EU fiscal surveillance. Its inclusion in the Communiqué suggests that Prime Minister Silvio Berlusconi may have realized that adhering to it will be a headache for future Italian leaders, not for himself. What if anything did Italy get in return for this concession? Nothing in the text looks like an obvious Italian policy victory, although the shift to national commitments in the "pact" instead of the original Franco-German list also benefits Rome. Instead, Berlusconi seems to have simply banked political capital with Angela Merkel for the future.

Could, for example, the chances of Mario Draghi, governor of the bank of Italy, becoming ECB president have gone up? His political stars now seem better aligned. Angela Merkel seems likely to have concluded that getting Italian acceptance of a numerical debt stock target (with due consideration to Italy's ability to finance a lot of its high debts domestically) was more important than having to buy of the smaller EU members with a small country national at the helm of the ECB.

Other good news from the Summit included "non-news." No new initiatives to support Portugal were announced, for example. It only got the same verbal assurances of full support for its "new initiatives" that Greece got just ahead of its bailout in May 2010. While Lisbon's recently announced reforms, including labor market adjustments, were baby steps forward, getting "verbal support only" from other EU leaders would be the kiss of death for Portugal in the financial markets. Only more support from the ECB, which would be politically and economically indefensible (after the ECB defeat on secondary bond purchases perhaps also more unlikely), can now prevent it from approaching the IMF/EFSF. The only question is when Prime Minister Jose Socrates bites the bullet, resigns and puts the required reformation of the Portuguese economy in more capable hands. This is likely to occur shortly after the EU Summit in late March.

Finally, despite the progress on some fronts, euro area leaders again underperformed on banking sector reform and recapitalization. The pledge to introduce national resolution authorities notwithstanding, there was precious little in the communiqué to indicate that Europe's imminent next round of banking stress tests will impress anyone. The stage now seems set for a repeat of the 1980s American banking experience after the Latin American debt crisis, which saw U.S. regulators allowing U.S. banks to lie about their losses (e.g. no marking to market) until they could afford to voluntarily enter into the Brady bond process several years later. This is a large mistake. It means that last week's summit did not reach a comprehensive solution to Europe's systemic financial sector weaknesses and that elevated economic volatility will continue. While EU leaders took big steps, there is much more to do.

Notes

1. See Eurozone Summit Conclusions here http://consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/119809.pdf .

2. /?p=1893

3. In the context of the next Danish elections, which must be held in 2011, this idea has already been floated by Prime Minister Lars Loekke Rasmussen. He is way behind in the polls, so may try this as a desperate pre-election strategy to split the center-left opposition. This would be an extremely risky strategy, as voters might reject the euro, as a way to punish an unpopular incumbent ahead of the election. However, regardless of what happens, this will be an issue that the next Danish government will have to deal with (i.e. likely have a new referendum) early in the next parliament.