Why a Spanish Approach to the ESM Will Help

September 21, 2012 10:15 AM

Several people have asked me in recent days about my assertion that a Spanish government and indeed the euro area as a whole would benefit from seeking a lending lifeline from European authorities, including the European Stability Mechanism/European Financial Stability Facility (ESM/EFSF) and the European Central Bank's new Outright Monetary Transactions (OMT) facility.

Arguments opposed to my view emphasize that if the OMT program gains credibility as a potential backstop, its actual use should not be required (the bazooka stays in the pocket). Because one purpose of the OMT program is to reassure investors that recipients will not exit the euro area, and repay debts in a devalued currency (incurring a "redenomination risk"), fiscal and structural conditionality on member states can be seen as a superfluous and indeed potentially dangerous distraction. The European Central Bank (ECB), according to this theory, should focus on its job as a backstop for the euro area and not impose additional austerity demands on Spain, which would likely damage growth and debt sustainability. The other problem with turning to the ESM/EFSF and ECB debt purchases is that such a move might stir fears in the markets that they will insist on senior status as creditors, to the detriment of existing debt holders.

Because I generally view the euro area crisis as improving under the gradual initiative of policymakers, I wouldn't necessarily applaud the need for Spain to seek additional outside financial support. It would be wonderful if the prior actions of Spanish governments and the rest of the euro area had already made such a request unnecessary. Despite my general optimism about the euro area, however, I don't think we are there yet.

Moreover, the option of a European borrowing lifeline for Spain is a key component of the euro area's broader answer to the question about how to stabilize countries that are "too big to bail out"—Spain, Italy, and—if President François Hollande fails to get serious about structural reforms—perhaps even France in 2014–15. The answer must also include moving toward a euro area banking union and other longer-term banking reforms launched at the June European Union Council. Concerns about the OMT's credibility invariably raise questions about the entirety of the euro area's recent new efforts to put in place the long awaited firewall.

To be viewed as credible, the ESM/EFSF and OMT option must pass at least three criteria. First, it needs to be financially adequate to make a difference for countries the size of Spain and Italy. Obviously the involvement of the ECB's unlimited balance sheet through the OMT addresses this issue. Any financial contribution from the ESM/EFSF is actually required overwhelmingly for political rather than financial or market impact reasons, as discussed in my last posting.

Second, the ESM/EFSF and OMT facilities must command political support in the core countries—Germany first and foremost. Given the involvement of the ECB's balance sheet, this requirement politically necessitates the ESM/EFSF conditionality to both protect against moral hazard (the Berlusconi rebuff and ouster seen in the fall of 2011) and the independence of the ECB. (An independent and democratically unaccountable central bank cannot sustainably be the entity to dictate explicit policy conditionality to elected leaders.) Chancellor Angela Merkel and Finance Minister Wolfgang Schäuble of Germany support the ECB's plans in the face of politically opportunistic Bundesbank opposition. Their willingness to slight the Bundesbank makes it clear that the ECB's conditional OMT program is politically sustainable in Germany.

However, the third criterion for the credibility of the ESM/EFSF and OMT option is that their demands must also be politically acceptable in Spain and Italy, or any other applicants in the future. There is little doubt that Madrid or Rome would apply for support if they were on the brink and faced with acute funding pressures and a collapsing domestic economy. But for this option to be fully beneficial, an application would need to be filed long before Spain or Italy reached such a critical stage. In other words, these national governments must be willing to overcome the domestic political stigma attached to such an application before a loaded market gun is pointed at their temples. Of course, the definition of "on the brink" is in the eye of the beholder. But with a bank bailout of up to €100 billion already in the pipeline, and three and a half years of parliamentary majority still to go before the next elections, Spain is not quite there right now. Hence an imminent application by Prime Minister Mariano Rajoy for ESM/EFSF and OMT support would signal that Spain can overcome the application stigma and that Spain and the euro area would not need to go to the brink before stabilizing the current situation.

Hence a pre-emptive move for assistance would not only signal political sustainability in the periphery, it would effectively herald a future in which euro area crisis management is less reliant on brinkmanship and acute market pressure to achieve the necessary outcomes. Global investors should appreciate both as signs of progress.

With all three credibility criteria for the ESM/EFSF and OMT option fulfilled, investors will likely look more favorably on credibility of the entirety of the euro area's most recent measures. A host of market participants previously on the sidelines might then provide more credit for Spain and the euro area as a whole.