Remain Calm: Europe Is Still on Track
European short-term economic growth prospects remain weak because of rampant fiscal consolidation, private sector deleveraging, and the temporary unsettling effects of structural reforms. But European leaders continue to take important and constructive decisions on bailouts and the banking union, suggesting that recovery will eventually get on track. At least three such decisions occurred at the recent informal meeting of the European Economic and Financial Affairs Council (ECOFIN) on April 12–13.
Portugal and Ireland Get Debt Relief
First, I am happy to report that one of my year-end 2012 predictions for 2013 has arrived with a further stealth fiscal transfer to Portugal and Ireland. It came in the form of a lengthening of weighted average loan maturities of up to seven years by the European Financial Stability Mechanism (EFSM) and European Financial Stability Facility (EFSF). This modest forgiveness was conditional on the two countries continuing their program implementation under the terms dictated by the Troika of the European Commission, the European Central Bank (ECB), and the International Monetary Fund (ECB). More important, it highlights the widely held and superficial mischaracterization of euro area policies as austerity and nothing else. The euro area, as should now be obvious, can grant member states burdened by adjustment programs at least some de facto debt relief—when the conditions are right.
The timing of Ireland and Portugal's debt maturity extensions is critical. They were granted because of the political assessment of moral hazard. Many macroeconomists masquerading as euro area commentators never see a fiscal transfer they don't like or that isn't necessary to revive economic growth, without which they are certain that the euro area will break apart and reignite the extremism of the 1930s.
But these commentators forget that more fiscal transfers in the euro area (and elsewhere) mean that the funds come out of someone's tax revenue. Taxpayers, moreover, have a right to know and indeed influence how their money is spent. Absent such influence, a critical democratic deficiency opens up. Cross-border fiscal transfers will thus never derive from macroeconomic computerized generalized equilibrium (CGE) models of what might be optimal for short-term economic growth in the recipient country. Rather, realistically, the transfers will be limited by taxpayer demands on how their money is spent. This is obviously the core justification for the IMF's decades' old conditional lending model for financial crisis assistance that the euro area has adopted since 2010.
Accordingly, the stealth fiscal transfers for Ireland and Portugal have been granted only after moral hazard has been reduced, as the two countries come to the end of their three-year Troika programs, and are seen as having done their reform homework. It has become politically safe—as well as economically sensible to avoid an increase in future funding—to provide such debt relief to program countries this late in their reform programs.
The actions toward Ireland and Spain, moreover, have important implications for Greece and Cyprus. Athens should not expect any additional debt relief for several more years, given how much more Greece's needs are and how many reforms remain unimplemented. Because Cyprus faces far worse growth prospects than projected, Nicosia should implement the Troika program to the letter early on, and await debt relief in later years, as it gets closer to returning to market access.
Europe Moves Toward Its Version of an FDIC
A second important development at the ECOFIN meeting came when Michel Barnier, the European Commissioner responsible for drafting a Single Resolution Mechanism (SRM) as the next step toward a European banking union, indicated the form the mechanism will take. He laid out the future creditor pecking order for who gets hit when banks are dissolved or restructured: first shareholders, then junior bondholders, then senior bondholders, and then if necessary uninsured depositors, followed last by a resolution/deposit insurance fund to reimburse insured depositors.
As discussed several times before on RealTime, this hierarchy of haircuts will end up looking like the ranking of the Federal Deposit Insurance Corporation (FDIC) in the United States. In that sense, Cyprus set a precedent after all, no matter what officials said at the time. Also at the ECOFIN press conference, the ECB's Jörg Asmussen went further and stated that the EU should signal such a ranking to international investors ahead of time, so that European banks are not placed at a disadvantage from having a different ranking than the ones adopted by other market participants, especially the United States. It is now clear that Europe's policy goal is to replicate the FDIC's approach to banking resolution. This is the strongest statement to date from a key European policymaker about how—as stated here in RealTime several months ago—Europe's banking union will ironically make the European banking regulatory system look far more like that in the United States.
The biggest policy disagreement remaining on this matter seems to be the organization of the new European resolution/deposit insurance fund. On one hand, the ECB vice president, Vitor Constancio, indicated his support of a "European level initiative" to deal with cross-border banking resolutions. By contrast, the European Commission remains wedded to its earlier proposal to coordinate national resolution funds, while Germany remains opposed to a single integrated fund.
The ECB has been relatively indifferent about the urgency of agreeing on and implementing a European deposit insurance fund, most likely because of the political opposition in Germany. Constancio's comments represent a new and clearer ECB position on the issue. But it remains uncertain whether the ECB wants a European-level initiative for all the roles of a fund across the members of the banking union, or merely some of them.
As discussed earlier, this author believes that a single joint euro area resolution/deposit insurance fund is required to serve as a new single sovereign-guaranteed anchor in the European banking system. The need is underscored now that more costs are imposed on creditors (except for insured depositors) in bank restructurings. This is the political price that the rest of the euro area should demand of Germany in return for its agreeing to the next-to-no ESM bank recapitalization system envisioned by Barnier's proposals for creditor ranking. Direct bank recapitalizations by the European Stability Mechanism (ESM) seem highly unlikely, except perhaps in times of crisis to help countries maintain full market access.
Is a Treaty Change in the Offing?
Third and finally, a new scare has arisen because of comments by the German finance minister, Wolfgang Schäuble, about the need for a "treaty change" to proceed with the single resolution mechanism. As usual in the euro crisis, the editorial pages of the Financial Times went overboard, describing his utterances as another "German hand grenade lopped into the banking union discussion." The paper's concern was that talk of a potential future referendum indicates German cold feet about the banking union. The reality is different, fortunately.
Barnier's statements indicate, in fact, that Germany is largely getting the banking union it wants—full creditor haircuts (or "bail-ins") and a high bar before the ESM recapitalizes banks. Why would Germany delay the very new institutions it has favored? Were Germany to retract its backing for the banking union, an unlikely occurrence, Berlin could simply say "nein." Why would the Europe's political hegemon have to resort to calling for a treaty change to achieve its desired outcome? However unfathomable it would be to the Financial Times, Germany likely favors a treaty change in order to establish a solid legal foundation for a banking union. Changing the EU Treaty would be somewhat more cumbersome, but such a step need not slow progress toward the banking union.
That is because the EU Treaty is a flexible beast. EU leaders, under similar circumstances, have already revised it in this crisis and can do so again if Germany wants. In December 2010, EU leaders changed Article 136 to create the ESM though a "simplified revision procedure" to enable the ESM to come into force by January 1, 2013 at the latest . The ESM was inaugurated last October 8, within this timeframe, even if all EU countries have not yet ratified the amendment according to their national parliamentary procedures.1
Article 48 in the EU treaty describes the simplified treaty revision procedure, an option when the change: (1) relates to the internal policies and actions of the Union; and (2) does not increase the competences conferred on the Union in the treaties. In a simplified treaty revision, the European Council must act unanimously after consulting the European Parliament and the commission, and the European Central Bank in the case of institutional changes in the monetary area. Thus as long as all EU member governments agree among themselves and with the EU Commission, Parliament, and (sometimes) the ECB on this type of issue, they can amend the EU Treaty quickly.
Schäuble did not make clear what changes he had in mind. But Germany's concerns about the independence of the ECB's monetary policy and its separation from banking regulatory responsibilities are well-known. If Germany's concerns derive from the goal of insulating the ECB politically from a future single resolution mechanism, whether located within the central bank or outside it, a simplified treaty revision procedure seems straightforward. Like the ESM launch in 2012, the introduction of the SRM raises issues related to the internal activities of EU institutions and does not confer new competences to the EU as a whole. These issues make a simplified treaty revision the legal solution.
The Financial Times can relax. A treaty change, even if Germany demands one, will not delay implementation of the EU banking union.