Germany Exacts a Stiff Price in the New Financial Crisis Mechanism
The EU Council last week accepted Germany's demand for a change in the EU Treaty to allow for the establishment of a "permanent European crisis mechanism." As suggested by the EU Council Conclusions, such a mechanism looks certain to include both "private sector participation" (e.g., haircuts on privately held debt of any member seeking access to EU funds) and an explicit role for the International Monetary Fund (IMF) similar to the one it played in the Greek program of the Spring of 2010.1
But in true European fashion, some of these agreed upon "treaty changes" are more likely to be ratified than others. The hard constraint on adopting such revisions remains the desire by EU leaders to avoid national referenda to approve them. Fortunately, there are escape hatches. The Lisbon Treaty's Article 48 envisions two types of EU Treaty changes: the "ordinary revision procedure," which calls for an intergovernmental conference and national referenda in several member states according to their national constitutions, and the "simplified revision procedure," which has less onerous requirements. Under the simplified scheme, if the EU Council consults with the European Parliament, European Commission, and the European Central Bank (ECB), and agrees unanimously on the change, it may revise the EU Treaty, so long as the adjustment does "not increase the competences conferred on the Union in the Treaties."
A "simplified revision" must still be ratified according to the constitutional requirements of each member state and hence could be subject to referenda. But because most members' "constitutional referenda triggers" relate to the "transfer of national sovereignty to Brussels" (i.e., the kind of thing that cannot be done under a "simplified procedure"), member states can rely on national parliamentary ratification. The fact that the "permanent crisis mechanism" must be in place by 2013 (when the European Financial Stability Facility, or EFSF, expires) discourages EU governments from calling for a referendum for "domestic political reasons."2
But the avoidance of a referendum could impose some complications.
First, because a simplified revision cannot transfer more power to the European Union as a whole, the permanent mechanism will likely affect only the eurozone members. Being excluded from its application, the United Kingdom will find it relatively easy to sign up.
Second, a simplified revision cannot entail the option of suspending members' voting rights in the EU Council for violating the restrictions on excessive deficits under the Stability Growth Pact (SGP). A simplified treaty revision thus drives a stake through this part of the Franco-German Deauville proposals.
Third, a simplified revision cannot (as also explicitly stated in the EU Council Conclusions) revise the Treaty's Article 125, which bars fiscal bailouts for members. The legal ambiguity of the Greek bailout will therefore persist, requiring any future assistance for crisis-stricken members to be repaid as loans rather than granted as transfer payments or aid. EU rescue funds will thus in the future come with a political "preferred creditor status" functionally similar to the status demanded by the IMF.
Fourth, with Article 125 remaining on the books, it will be difficult for any future crisis resolution mechanism to loosen the tough conditionality of future loans even when that might be warranted. Future German governments will invoke Article 125 to play the powerful "bogeyman card," asserting that the German Constitutional Court ties their hands and forces them to impose the toughest possible conditions on future loans.
Fifth, neither the European Parliament nor the European Commission will like the idea of revising the treaty on the basis of approval by national governments and parliaments. The remaining euro-federalists, now mostly marginalized as members of the European Parliament, can be expected to try to cause as many problems as possible for this process. Undoubtedly, they will attempt to link this issue (on which they are only to be consulted) with issues where the European Parliament has real power, for example the EU budget. This will make for a noisy affair, unlikely to block approval of the simplified treaty revision. There is no public appetite in Europe for more integration and new institutions, and in any case the European Parliament lacks genuine democratic legitimacy when compared to national governments.
Then there is the time frame. At German insistence, the "European Council will revert to this matter at its December meeting with a view to taking the final decision both on the outline of a crisis mechanism and on a limited treaty amendment." It is rare for the European Union to take important decisions in just a few months. The parameters of the permanent crisis mechanism will be largely known as early as December, even if they have not yet been ratified. The mechanism could well play a significant role in the inevitable negotiations next year over the required extension of the Greek program.3
Because haircuts for private creditors will inevitably be part of the permanent crisis mechanism, the ambitious timetable for its adoption suggests more than ever that creditors will take a hit in any extension of the Greek lifeline by the European Union and/or IMF to Greece.
The likelihood of such haircuts was underscored recently when both President Nicolas Sarkozy of France and Chancellor Angela Merkel of Germany dismissed concerns voiced by ECB President Jean-Claude Trichet about the impact of proposed haircuts on the short-term borrowing costs for peripheral eurozone members (mainly those on the southern tier of Europe).
It is clear from its own proposals that the ECB would have preferred a tough SGP with automatic sanctions as part of the new EU fiscal policy framework. Some sour grapes from the ECB could be expected, now that this has not materialized. In addition, the fact that a rise in peripheral European borrowing costs might also force the ECB to purchase more government bonds has aggravated splits within the bank's governing board and soured the mood in Frankfurt.
The crucial issue, however, is that the leaders of the EU core in France and Germany seem unconcerned about the impact of such haircuts for peripheral eurozone members. As suggested by Chancellor Merkel, the ECB's concerns about the stability of the eurozone financial system are trumped by the need for elected EU leaders to consider the views of their publics, particularly taxpayers unwilling to bear the only cost of bailouts. The drive to make the private banking system pay is so strong that concerns about the system's solvency are no longer a major issue.
But for all that, the risk profile of peripheral sovereign debt might well be heightened, ushering in higher yields as the "new normal" for sovereign peripherals and their banks. What the financial markets gave weaker eurozone countries in the form of "German interest rates" from 1999 to 2008, they are now taking away. Yields on Irish, Portuguese, and Greek bonds have already risen dramatically since the EU Council last week.
These higher costs of refinancing debt look certain to impose greater austerity on the budgets of peripheral governments, including spending cuts and structural reforms aimed at improving their growth potential and debt service capacity. Haircuts for private creditors will therefore be good for structural reforms in the European periphery.
Haircuts for private creditors and the associated required austerity measures will also increasingly force peripheral eurozone members to renege on promises to their own residents, a kind of "preemptive default" on citizens rather than bond holders.
The proposal from Germany and France for a permanent crisis resolution mechanism with haircuts will therefore protect taxpayers, but only taxpayers in the core of Europe. In fact, the permanent crisis resolution mechanism will end up transferring the costs of bailouts from German and French taxpayers to the shoulders of residents in the European periphery, whose governments must now break the promises made to them. Taxpayers in Germany (and France, whose bonds after the recent pension reform can be expected to track Germany's benchmark) will hardly suffer at all.
Machiavellian as this may sound—and make no mistake, European solidarity this is not!—it is nonetheless appropriate that the costs of running unsustainable economic policies in the eurozone periphery are borne by its citizens, some of whom gained premature entry into the eurozone. The bill is now coming due for the decade of rock-bottom real interest rates and increased government spending that they enjoyed without having to go through any required economic reforms.
Increased street-level anti-EU sentiment in the periphery should be expected, but it should remain politically manageable, partly because the costs of leaving the eurozone remain prohibitively high and partly because most residents in the periphery know that tough economic reforms will be required no matter what.
And while it may seem strange that peripheral eurozone members of the EU Council could ever agree to Germany's demands for haircuts in a permanent crisis resolution mechanism—the proposal has already increased borrowing costs for Ireland and Portugal—it is important to remember the strength of Germany's hand. Though it would be messy, Germany (with the implicit backing of France) can say "nein" to an extension of the EFSF (or even the Greek program) without a large risk of contagion to the core European banking system or to the critical eurozone members in Spain and Italy. Even with the €60 billion EFSM nominally still in place, Ireland, Portugal, and Greece could face their bond holders in 2013 without the political backing of the rest of the eurozone and without the realistic prospect of any sizable European financial support.
Such a prospect is far more uninviting than any increase in borrowing costs from the implementation of a permanent crisis resolution mechanism. In the EU Council, if not the United States, turkeys sometimes do vote for Thanksgiving.
1. This would, in addition to debt haircuts, mean "IMF conditionality" on any loans extended and some degree of minority IMF financial participation in the program.
2. This is what happened in 2005 when Jacques Chirac's voluntary decision to put the new "EU Constitution" to a French referendum spectacularly backfired.
3. Without an extension of the Greek program negotiated during 2011, Greece will have to return to the long-term private debt markets by 2012 Q1. This looks unlikely to be feasible at sustainable interest rates without additional official sector assistance.