Ireland's Endorsement of Austerity and Other Reasons for Euro Optimism
In a hopeful development for Europe's struggle to stabilize its economy, Irish voters last week endorsed the proposed Fiscal Compact Treaty by a resounding 60.3 to 39.7 majority. For all the nonsensical predictions of a grass root rebellion against austerity across the continent, the striking thing in Ireland was not just the acceptance of fiscal discipline but also the low the turnout—only 50.6 percent, or much lower than usual for such balloting. Far from seething with rage and determined to send a message of rejection, large numbers of Irish stayed at home, while the majority backed the European route out of this crisis.
Not that anger doesn't exist. But fear almost always trumps anger among rich and ageing electorates. Despite suffering deep recessions and falling living standards, the Irish understood that they still have a lot to lose from a collapse of the euro and their government's finances. This author continues to believe that the same pattern will hold for Greece when it votes on June 17, 2012 and that a Greek parliamentary majority will favor most of the current International Monetary Fund (IMF) program. Greece's flirtation with radical populism in May underscored its unique status in Europe, where such populism has failed to transform popular resentment into political power.
But in a proportional representation system, populist parties with 20 to 25 percent of the vote are largely irrelevant if a general center-left and center-right consensus backs the overall direction of the country and its relationship with the European Union. Except for Greece, this is the case across Europe. As the traditional parties converge at the center, parties that try to merge right-wing anti-immigration rhetoric with left-wing anti-austerity policies stay at the fringes.
How Brinkmanship Works in Europe
The outcome in Ireland may undercut the political beliefs of many stimulus-hungry market analysts and euro crisis pundits. Many of these academic macroeconomists and financial market analysts—based in London and New York and particularly at the New York Times—confidently pontificate about euro area politics and what they think European (and especially the German) electorates will do, and also how the European Central Bank (ECB) will respond. The practice of economists making political predictions does not necessarily play to their comparative advantage.
As for the euro pessimism of the market prevailing nowadays, the irony is that just as the markets' mispricing of risk in the first decade of the euro contributed to the bubbles and imbalances today, so now are the markets failing to understand European crisis politics and the political nature of the euro crisis. What they fail to understand is that market volatility and pressure—stemming from the fear of a collapse of the euro—are strengthening the political will of euro area to fix the euro's design defects, however gradually they move.
As C. Fred Bergsten and I have described [pdf], the fundamental problem of the euro area is a political crisis over the need to surrender national sovereignty to new EU/euro area institutions. Euro area leaders must do this to complete the half-built house of Europe's Economic and Monetary Union (EMU). But as any student of international relations knows, national sovereignty is a closely guarded treasure, not to be given up unless threatened with military force. True, EU members have pooled their sovereignty over these past decades more than international relations theory would have predicted. But when it comes to the "deep sovereignty" of control over national banking systems, fiscal policy, taxes, and spending, no euro area government would ever give up these prerogatives voluntarily. If you doubt such a thing, ask Prime Minister Mariano Rajoy about his Spanish banks right now!
The importance of this cannot be underestimated, especially for all those "Pareto optimizing" economists. There is no "collaborative solution" to the euro area crisis! Its leaders will not get together at a summit and simply do all the right or least costly things. They will only respond to acute political, economic, and financial market pressure (i.e., just a little short of the intensity of a military invasion threat).
Going further, one could even say that the volatility of financial markets is great news for the euro's long-term sustainability, as euro area leaders head to their next summit at the end of June. Paradoxically, only when markets think they will fail can they seize the political opportunity for success.
As I have described at RealTime before, the required steps to complete the EMU are guaranteed to be drawn out and gradually negotiated amid intense brinkmanship and financial volatility. It is harder to construct a new quasi-sovereign center for Europe voluntarily from the bottom-up than to impose it from a preexisting center that has been through war, as the United States had been in the 18th century. Consider also the violent circumstances in which other continental-size political entities like the United States or China were historically "unified." Was that a preferable option? The Cherokees and Tibetans certainly never got a referendum.
Misunderstanding the requirements of brinkmanship has also led to wrong normative evaluations of key actors. Germany's Chancellor, Angela Merkel, and the ECB are often accused of dithering and inconsistency. These perceptions fail to understand their game of brinkmanship. As Ralph Waldo Emerson once remarked; "A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines." At no time has this been truer.
As the examples of the "day after" of the Lehman Brothers collapse and the initial rejection of a US fund for banks demonstrated in 2008, bailouts occur in due course. In the euro area, brinkmanship helped secure the best deal for the most powerful players, particularly Germany and the ECB. Their shifts of position were not flip flops but features of strategic bargaining. This is not to say that Berlin and Frankfurt have a grand master plan for Europe. No such thing exists. It means, however, that as the strongest economy in Europe, Germany can afford to wait for the best deal, because the cost of an escalating crisis hurts others (and their bond yields) before Germany.
Because Germany and the ECB favor sustaining the euro, they can afford to say no before they say yes. Time works in their favor. Yes, it is a high risk and high pressure game, but there is no alternative. We are not living in a world of relying on the genius of a set of founding fathers but on the product of crisis—just as originally envisioned by Jean Monnet.
Moreover, the risk of accidents is smaller than many observers believe. The Irish vote shows that the threat of populism gaining power outside of Greece is slight. The political center in Europe will hold, despite all those commentators evoking the memories of the 1930s.
How Brinkmanship Helps the ECB
As for the role of the ECB, it has been reluctant to provide financial assistance to euro area governments in this crisis, except at periods of acute financial market tension. That is what it did after elected leaders agreed to strengthen euro area institutions in May 2010 and last summer and December.
But while the ECB has taken on risks with its acceptance of lower quality collateral in its repo transactions with euro area banks, it has purchased a small amount of assets (about €281 billion in Securities Market Program, or SMP, purchases and covered bonds, or about 3 percent of euro area GDP), resisting bigger purchases for political reasons. The size of the risks of repo transactions to the ECB balance sheet is a subject of controversy. On one hand, the ECB has offered huge amounts of three-year loans in return for collateral of questionable quality. On the other, the ECB has imposed sizable haircuts on this collateral (53 percent according to ECB President Mario Draghi). By their nature, repo transactions result in losses for the ECB only if the counterparty euro area bank collapses. That is an important timing issue in the ECB's strategic bargaining with euro area governments. Before a counterparty bank collapses, however, its national/euro area government(s) would likely feel the threat and launch a rescue. The fact that bank bailouts tend to happen protects the ECB's repo balance sheet exposure. The ECB can keep euro area (zombie) banks afloat with liquidity, until sufficient pressure forces politicians to inject capital and further integrate the sector. These facts help explain why the ECB has been calling recently for a euro area banking union, which would of course further enhance the implicit protection of its repo exposures.
It is therefore a mistake to think that the ECB lacks the capacity or will to act forcefully. Yes, its political response function is different from that of the Federal Reserve or other normal central banks. Comparisons between the euro area and the gold standard, the embrace of which produced bank failures in the 1920s and 1930s, are misguided. Just because so many economists studied the gold standard in graduate school and like to invoke its history does not make it applicable today.
Enhanced Outlook for a Banking Union
What should we expect in the euro area in June?
Certainly lots of financial market volatility and warnings from EU leaders about the survival of the euro are in the offing. Hopefully the high bond yields and real economy slowdown and declining confidence will focus the minds and force the hands of euro area leaders at their summit. But as discussed earlier on RealTime, there is reason to be optimistic that the summit will deliver progress on the euro area's most pressing problem—establishing deeper banking sector integration, including euro area deposit insurance and banking resolution and regulation. There are at least two reasons for this optimism.
First, the continued inept and amateurish handling of Spain's banking crisis by Prime Minister Rajoy's government has underscored the need for a more integrated euro area banking sector regulatory framework, especially for the top ECB leadership. Spain's dithering illustrates the dangers of relying on national governments to do what is necessary and do it fast. Owning up to the true state of Bankia's losses and calling in the independent auditors for the entire banking sector are positive developments. But these steps have been a case of too little, too late. Because Spain is a systemically important member of the euro area, the risk of bank deposit runs in that country will jolt leaders into action in a way similar developments in Greece would probably not. The fact that the ECB is now pushing publicly for action is good news, and a reminder that the central bank has generally gotten the institutional improvements (like the Fiscal Compact) it has wanted in this crisis.
Second, one takes encouragement from the progress of the European Union's new EU-wide bank recovery and resolution rules. They are to be proposed by Internal Market Commissioner Michel Barnier shortly. These rules are expected to include expanded opportunities for EU governments to impose losses on the private holders of bank bondholders in case any European bank needs rescuing in the future. Regrettably, this ability was not granted the Irish in 2010. Now, however, the rules will potentially limit the bill for European taxpayers in future bank bailouts and also increase the cost of funding for junior bank debt in the euro area for many banks.
A major political obstacle to a pan-euro area banking resolution fund, which would relieve national authorities of the responsibility to fund bank rescues, has always been the implied "fiscal transfers" between euro area governments. That is to say, the government in the country of a bank rescued by the pan-euro area fund would receive an automatic de facto fiscal transfer in the same way that, for example, Nevada did when regional banks went bust during the housing crash and were rescued by the Federal Deposit Insurance Corporation (FDIC). Germany has previously resisted such an implied transfer. But the enhanced potential for imposing losses on bank bondholders would lower the potential magnitude of bank rescues. In the process, the total cost to taxpayers and the associated fiscal transfers between euro area member states in the process would be reduced. This prospect should make a banking union more politically palatable.
Finally, as I have described before here on RealTime, broader opportunities to impose losses on private bank bondholders under new European banking regulations will allow Ireland to get a better deal on refinancing its outstanding National Asset Management Agency (NAMA) bank bailout promissory notes. After all, these notes were issued by Ireland because its request for losses imposed on private bondholders of Irish banks in late 2010 was denied by European authorities and the ECB. The reason was their concern for systemic and national banking sector stability. Now that Irish authorities have done their homework by endorsing the Irish referendum, and Europe has introduced what the Irish sought in 2010, Europe must give Ireland a better deal. It is in Europe's own interest to walk an extra mile to help its top performer restore full market access as soon as possible.
This week Chancellor Merkel went a bit further on the bank supervision issue when she discussed to "what extent we need to put systemically relevant banks under a specific European supervisory authority so that national interests do not play such a large role." She seemed to be referring to a specific pan-euro area banking regulator for only the largest and most important euro area banks. If that is the case, the euro area banking regulatory system would take on characteristics of the US system, in which banks of different size (national or state charter) have different regulators.