The Two Things Now Required by EU Leaders

July 20, 2011 10:30 AM

With Italian and Spanish 10-year bond rates still at record highs, despite the new Italian austerity budget approved over the weekend, it is evident that the markets are telling EU policy makers to fix the debacle over "private sector involvement" (PSI) in the second Greek bailout.

At the heart of the current fiasco is the demand by euro area leaders that financial institutions and other creditors share the burden with taxpayers for financing Greece for the next couple years. This demand would effectively reverse the EU leaders’ promise in 2010 to consider PSI only after 2013 and in no program under current consideration. More important, the demand for sacrifice from creditors would set a precedent for private investor haircuts as part of rescue packages for countries facing liquidity problems, 1 not official sector insolvency.

This distinction is critical. A precedent of imposing sacrifice on private creditors for illiquid countries will inevitably threaten the risk-free status of all peripheral euro area countries, leading to a generalized reevaluation of risk levels in Europe.

The failure to resolve the Greek crisis, coupled with the political demand for a Greek PSI, has unleashed a contagion that has become a kind of slow-motion version of the first vote against the Troubled Asset Relief Program (TARP) in the US House of Representatives in October 2008. In that instance, the initial rejection by lawmakers caused the single largest daily stock market decline of the 2008–09 financial crisis.

Fortunately, just as the US Congress later approved the TARP, euro area policymakers can be expected to respond to the recent violent market signals. As in America, EU politics can correct themselves. Europe does not have the capacity to bail out both Spain and Italy, so policy makers face the necessity of changing their mind—or else.2

This would echo the events in October–November 2010, when the Franco-German Deauville Declaration [pdf] opened the doors "for an adequate participation of private creditors" in euro area rescue packages and financial markets tanked. Subsequently, EU leaders climbed down by clarifying that

Whatever the debate within the euro area about the future permanent crisis resolution mechanism and the potential private sector involvement in that mechanism we are clear that this does not apply to any outstanding debt and any programme under current instruments. Any new mechanism would only come into effect after mid-2013 with no impact whatsoever on the current arrangements3.

(In May 2011, EU leaders performed a separate U-turn by demanding PSI as part of fully funding the original May 2010 program. Little wonder that markets are more and more jittery.)

Arguably, the euro area’s latest bout of contagion is a crisis created by policy blunders and posturing, analogous to the US debt ceiling debate. Like lawmakers on Capitol Hill, EU leaders will have to untie the knots they have constrained themselves with when they meet in a summit gathering on July 21.

Two principal things are now required by EU leaders:

First, they should irreversibly commit themselves to not making PSI a condition for any euro area financial assistance to a member state suffering from a liquidity problem, as opposed to a solvency crisis. As is spelled out in the European Stability Mechanism (ESM) Treaty Article 12 [pdf], PSI should only be sought on a case-by-case basis and after a country has been found insolvent in a debt sustainability analysis. The article states further that the ESM " shall take due account of the risk of contagion and potential spill-over effects on other Member States [author’s emphasis] of the European Union and third countries."

In short, EU leaders must comply with their own institutional framework and ensure that any PSI is not precedent-setting and thus non-contagious. Official sector financial support in the euro area must not be preconditioned on PSI.

One option will be to simply drop PSI as part of a new Greek program funding altogether, although that will be a high political hurdle in several euro area countries.

It should be recalled, however, that the demand for PSI is political in nature, stemming from Chancellor Angela Merkel’s desire to tell German taxpayers that bankers will be sharing their pain.

EU leaders do have alternative options that would serve as "political equivalent" of PSI, however. They could impose a new "bank tax," a Tobin Transaction Tax, bank bonus taxes, or other money-raising methods to "extract value" from the euro area financial sector. While such new taxes would be wholly independent of any new funding for Greece, a joint announcement of a new tax and more financing for Greece would achieve the political goal of linking the two in the eyes of the public.

Such a step, moreover, would constitute a general change in the regulatory environment for euro area banks, while avoiding a "selective default" declaration by credit rating agencies, providing an incentive to private Greek creditors to accept deeply discounted bond buybacks/swaps in the future.

In addition, EU leaders must be able to point to progress in restoring Greek debt sustainability and addressing wider financial sector stress in the euro area. Such a step would require empowering the European Financial Stability Facility to purchase bonds in secondary markets, or to provide funding (or guarantees) to member states enabling them to buy back (or swap) their own outstanding debt at distressed market prices. It would further be helpful if, as suggested by my colleague Nicolas Véron, the EFSF gets the ability to guarantee national deposit insurance schemes to prevent retail depositor bank runs.4

EFSF loans should also be extended at rates close to the cost of funding and current International Monetary Fund (IMF) rates and for maturities far beyond the current status. These changes should moreover be made available to all three euro area IMF program members to help promote debt sustainability in Greece, Ireland and Portugal.

While measures for Greece should focus on returning it to debt sustainability, a full scale restructuring of Greek sovereign debt would not be appropriate at present. Greece is not yet sufficiently along in its domestic reform program to warrant such an action. Instead Greece needs to produce a lasting primary surplus, permanently reduce the size of the public sector, and complete the liberalization of Greek product and labor markets.

Time is of the essence now for euro area leaders. While Greek debt sustainability need not be achieved at this week’s summit, the reasons for contagion to Spain and Italy must be addressed. EU leaders must equip themselves to put Greece on a permanently sustainable debt trajectory when the time is right.

The record of recent dithering makes it uncertain whether Spanish and Italian bonds will immediately be re-evaluated once again by markets, even if EU leaders do the right thing. Perhaps markets now need more convincing. The elevated Spanish and Italian spreads of today will only come back down gradually over time as their national governments restore their downward debt trajectory and improve their growth prospects.

Like the US Congress’ sleepwalking into losing the nation’s AAA, Europe’s leadership risks not the end of the euro area but years of higher interest payments.

Too little, too late will certainly be costly, though not disastrous.


1. The latest IMF Review of Greece considered the country’s debt challenging but did not declare it insolvent.

2. It is worth noting though that even in the second TARP vote, a majority of Republican members of the House of Representatives voted "no" 108-91 [xml].


4. No that such a guarantee would not insulate national banking systems from runs initiated by wholesale and institutional customers with very high deposits in individual banks, as was for instance seen in Ireland in 2010.