Beyond the European Debt Crisis?
The euro crisis is a direct consequence of the crash of 2008. When Lehman Brothers failed, the entire financial system started to collapse and had to be put on artificial life support. This took the form of substituting the sovereign credit of governments for the bank and other credit that had collapsed. At a memorable meeting of European finance ministers in November 2008, they guaranteed that no other financial institutions that are important to the workings of the financial system would be allowed to fail, and their example was followed by the United States.
Angela Merkel then declared that the guarantee should be exercised by each European state individually, not by the European Union or the eurozone acting as a whole. This sowed the seeds of the euro crisis because it revealed and activated a hidden weakness in the construction of the euro: the lack of a common treasury. The crisis itself erupted more than a year later, in 2010.
There is some similarity between the euro crisis and the subprime crisis that caused the crash of 2008. In each case a supposedly riskless asset—collateralized debt obligations (CDOs), based largely on mortgages, in 2008, and European government bonds now—lost some or all of their value.
Unfortunately the euro crisis is more intractable. In 2008 the U.S. financial authorities that were needed to respond to the crisis were in place; at present in the eurozone one of these authorities, the common treasury, has yet to be brought into existence. This requires a political process involving a number of sovereign states. That is what has made the problem so severe. The political will to create a common European treasury was absent in the first place; and since the time when the euro was created the political cohesion of the European Union has greatly deteriorated. As a result there is no clearly visible solution to the euro crisis. In its absence the authorities have been trying to buy time.
In an ordinary financial crisis this tactic works: with the passage of time the panic subsides and confidence returns. But in this case time has been working against the authorities. Since the political will is missing, the problems continue to grow larger while the politics are also becoming more poisonous.
It takes a crisis to make the politically impossible possible. Under the pressure of a financial crisis the authorities take whatever steps are necessary to hold the system together, but they only do the minimum and that is soon perceived by the financial markets as inadequate. That is how one crisis leads to another. So Europe is condemned to a seemingly unending series of crises. Measures that would have worked if they had they been adopted earlier turn out to be inadequate by the time they become politically possible. This is the key to understanding the euro crisis.
Where are we now in this process? The outlines of the missing ingredient, namely a common treasury, are beginning to emerge. They are to be found in the European Financial Stability Facility (EFSF)—agreed on by twenty-seven member states of the EU in May 2010—and its successor, after 2013, the European Stability Mechanism (ESM). But the EFSF is not adequately capitalized and its functions are not adequately defined. It is supposed to provide a safety net for the eurozone as a whole, but in practice it has been tailored to finance the rescue packages for three small countries: Greece, Portugal, and Ireland; it is not large enough to support bigger countries like Spain or Italy. Nor was it originally meant to deal with the problems of the banking system, although its scope has subsequently been extended to include banks as well as sovereign states. Its biggest shortcoming is that it is purely a fund-raising mechanism; the authority to spend the money is left with the governments of the member countries. This renders the EFSF useless in responding to a crisis; it has to await instructions from the member countries.
The situation has been further aggravated by the recent decision of the German Constitutional Court. While the court found that the EFSF is constitutional, it prohibited any future guarantees benefiting additional states without the prior approval of the budget committee of the Bundestag. This will greatly constrain the discretionary powers of the German government in confronting future crises.
The seeds of the next crisis have already been sown by the way the authorities responded to the last crisis. They accepted the principle that countries receiving assistance should not have to pay punitive interest rates and they set up the EFSF as a fund-raising mechanism for this purpose. Had this principle been accepted in the first place, the Greek crisis would not have grown so severe. As it is, the contagion—in the form of increasing inability to pay sovereign and other debt—has spread to Spain and Italy, but those countries are not allowed to borrow at the lower, concessional rates extended to Greece. This has set them on a course that will eventually land them in the same predicament as Greece. In the case of Greece, the debt burden has clearly become unsustainable. Bondholders have been offered a “voluntary” restructuring by which they would accept lower interest rates and delayed or decreased repayments; but no other arrangements have been made for a possible default or for defection from the eurozone.
These two deficiencies—no concessional rates for Italy or Spain and no preparation for a possible default and defection from the eurozone by Greece—have cast a heavy shadow of doubt both on the government bonds of other deficit countries and on the banking system of the eurozone, which is loaded with those bonds. As a stopgap measure the European Central Bank (ECB) stepped into the breach by buying Spanish and Italian bonds in the market. But that is not a viable solution. The ECB had done the same thing for Greece, but that did not stop the Greek debt from becoming unsustainable. If Italy, with its debt at 108 percent of GDP and growth of less than 1 percent, had to pay risk premiums of 3 percent or more to borrow money, its debt would also become unsustainable.
The ECB’s earlier decision to buy Greek bonds had been highly controversial; Axel Weber, the ECB’s German board member, resigned from the board in protest. The intervention did blur the line between monetary and fiscal policy, but a central bank is supposed to do whatever is necessary to preserve the financial system. That is particularly true in the absence of a fiscal authority. Subsequently, the controversy led the ECB to adamantly oppose a restructuring of Greek debt—by which, among other measures, the time for repayment would be extended—turning the ECB from a savior of the system into an obstructionist force. The ECB has prevailed: the EFSF took over the risk of possible insolvency of the Greek bonds from the ECB.
The resolution of this dispute has in turn made it easier for the ECB to embark on its current program to purchase Italian and Spanish bonds, which, unlike those of Greece, are not about to default. Still, the decision has encountered the same internal opposition from Germany as the earlier intervention in Greek bonds. Jürgen Stark, the chief economist of the ECB, resigned on September 9. In any case the current intervention has to be limited in scope because the capacity of the EFSF to extend help is virtually exhausted by the rescue operations already in progress in Greece, Portugal, and Ireland.
In the meantime the Greek government is having increasing difficulties in meeting the conditions imposed by the assistance program. The troika supervising the program—the EU, the IMF, and the ECB—is not satisfied; Greek banks did not fully subscribe to the latest treasury bill auction; and the Greek government is running out of funds.
In these circumstances an orderly default and temporary withdrawal from the eurozone may be preferable to a drawn-out agony. But no preparations have been made. A disorderly default could precipitate a meltdown similar to the one that followed the bankruptcy of Lehman Brothers, but this time one of the authorities that would be needed to contain it is missing.
No wonder that the financial markets have taken fright. Risk premiums that must be paid to buy government bonds have increased, stocks have plummeted, led by bank stocks, and recently even the euro has broken out of its trading range on the downside. The volatility of markets is reminiscent of the crash of 2008.
Unfortunately the capacity of the financial authorities to take the measures necessary to contain the crisis has been severely restricted by the recent ruling of the German Constitutional Court. It appears that the authorities have reached the end of the road with their policy of “kicking the can down the road.” Even if a catastrophe can be avoided, one thing is certain: the pressure to reduce deficits will push the eurozone into prolonged recession. This will have incalculable political consequences. The euro crisis could endanger the political cohesion of the European Union.
There is no escape from this gloomy scenario as long as the authorities persist in their current course. They could, however, change course. They could recognize that they have reached the end of the road and take a radically different approach. Instead of acquiescing in the absence of a solution and trying to buy time, they could look for a solution first and then find a path leading to it. The path that leads to a solution has to be found in Germany, which, as the EU’s largest and highest-rated creditor country, has been thrust into the position of deciding the future of Europe. That is the approach I propose to explore.
To resolve a crisis in which the impossible becomes possible it is necessary to think about the unthinkable. To start with, it is imperative to prepare for the possibility of default and defection from the eurozone in the case of Greece, Portugal, and perhaps Ireland.
To prevent a financial meltdown, four sets of measures would have to be taken. First, bank deposits have to be protected. If a euro deposited in a Greek bank would be lost to the depositor, a euro deposited in an Italian bank would then be worth less than one in a German or Dutch bank and there would be a run on the banks of other deficit countries. Second, some banks in the defaulting countries have to be kept functioning in order to keep the economy from breaking down. Third, the European banking system would have to be recapitalized and put under European, as distinct from national, supervision. Fourth, the government bonds of the other deficit countries would have to be protected from contagion. The last two requirements would apply even if no country defaults.
All this would cost money. Under existing arrangements no more money is to be found and no new arrangements are allowed by the German Constitutional Court decision without the authorization of the Bundestag. There is no alternative but to give birth to the missing ingredient: a European treasury with the power to tax and therefore to borrow. This would require a new treaty, transforming the EFSF into a full-fledged treasury.
That would presuppose a radical change of heart, particularly in Germany. The German public still thinks that it has a choice about whether to support the euro or to abandon it. That is a mistake. The euro exists and the assets and liabilities of the financial system are so intermingled on the basis of a common currency that a breakdown of the euro would cause a meltdown beyond the capacity of the authorities to contain. The longer it takes for the German public to realize this, the heavier the price they and the rest of the world will have to pay.
The question is whether the German public can be convinced of this argument. Angela Merkel may not be able to persuade her own coalition, but she could rely on the opposition. Having resolved the euro crisis, she would have less to fear from the next elections.
The fact that arrangements are made for the possible default or defection of three small countries does not mean that those countries would be abandoned. On the contrary, the possibility of an orderly default—paid for by the other eurozone countries and the IMF—would offer Greece and Portugal policy choices. Moreover, it would end the vicious cycle now threatening all of the eurozone’s deficit countries whereby austerity weakens their growth prospects, leading investors to demand prohibitively high interest rates and thus forcing their governments to cut spending further.
Leaving the euro would make it easier for them to regain competitiveness; but if they are willing to make the necessary sacrifices they could also stay in. In both cases, the EFSF would protect bank deposits and the IMF would help to recapitalize the banking system. That would help these countries to escape from the trap in which they currently find themselves. It would be against the best interests of the European Union to allow these countries to collapse and drag down the global banking system with them.
It is not for me to spell out the details of the new treaty; that has to be decided by the member countries. But the discussions ought to start right away because even under extreme pressure they will take a long time to conclude. Once the principle of setting up a European Treasury is agreed upon, the European Council could authorize the ECB to step into the breach, indemnifying the ECB in advance against risks to its solvency. That is the only way to forestall a possible financial meltdown and another Great Depression.
Soros is absolutely right, without European Treasury, there is no future for the euro and the risk of another global financial meltdown is high. The Periscope Post also published an interesting comment on this subject, Greek debt crisis: Can the euro survive?:
I remain convinced that Europe will survive this crisis and move beyond it. Why am I so sure? Because my central thesis remains that the financial oligarchs will do everything in their power to stave off a protracted period of debt deflation at all cost. They will pump an insane amount of liquidity into the global financial system, but the game plan remains to reflate risks assets, shore up banks' balance sheets and introduce mild inflation into the global economic system.
France and Germany have moved to calm the mounting Greek debt crisis by insisting that Greece is an integral part of the eurozone. For its part, the Greek government is pushing through the toughest of austerity measures in the face of mass demonstrations. While support for Greece has temporarily calmed the financial markets, real fears persist that Greece will default and the euro will collapse.
To make matters worse for the European economy, credit ratings agency Moody’s yesterday downgraded the creditworthiness of two French banks — Societe Generale and Credit Agricole — and told a third, BNP Paribas, that it is being kept under review.
“A breakdown of the euro would cause a meltdown beyond the capacity of the authorities to contain,” warned George Soros in The New York Review of Books.
- Germany should exit the euro. Jeremy Warner of The Daily Telegraph insisted that Europe’s economic fate largely lies in the hands of Germany: “As the great engine room of the European economy, it has the power to save or break the euro.” Warner said it is time for Germany to cease “engaging in hollow threats to expel offenders” and stop “inappropriately imposing its own monetary disciplines on others, and leave the euro itself. In the spirit of altruism, this might indeed be the best thing it could do for its fellow Europeans.” Germany’s “indecision, … threatens not just the future prosperity of Europe, including its own, but as is clear from the growing alarm of American and Chinese policymakers, that of the world economy as a whole.” Warner warned that “the longer Europe’s debt crisis persists, the more likely it is that some kind of catastrophic denouement will plunge the world back into deep recession and possibly even long-lasting depression.” “Disorderly break-up” involving the forced exit of weaker members “certainly offers no economic panacea,” said Warner, who comncluded: “So what would work? If Germany has become more the problem than the solution, then perhaps the departure of Germany itself is the least disruptive answer.”
- Blame the French political and banking system. Simon Heffer of The Daily Mail pointed the finger of blame at French economic shortcomings: “To say the French economy has been run since World War II using smoke and mirrors would be like saying George Best enjoyed a drink. The truth is that France has lived beyond its means, for nakedly political reasons, for longer than most people alive can remember.” Heffer criticized French bank’s decision to “help others in Europe to live beyond their means as well. As Greece nears default, panic has been sown in the French banking sector for the very good reason that 45 per cent of Greek debt is owed to French banks.” Heffer insisted that “one of France’s biggest problems is that it sees itself as one of the big boys of Europe, in the same league as Germany … But in reality, France may yet prove to be as dependent on its powerful neighbour as any of the Eurozone economic basket cases that have had to hold out their begging bowls to Berlin in the past year or two.” Heffer concluded that “France remains a nation stuck in a fantasy world of reality-avoidance mired in over-regulation, debt, waste and feather-bedded by the state” but headed for a “day of reckoning … The international financial markets are ready to pull the plug on the French style of financial mismanagement.
- Greece is at the precipice of social instability. Jeffrey Sachs at The Financial Times questioned if pushing Greece to implement fresh austerity measures is wise: “[W]e must now understand Greece is at the precipice of social instability. Further cuts will push it over the edge – ending the adjustment programme, and intensifying the financial squeeze and the drumbeat of those trying to push Greece out of the eurozone. It is utterly naive to believe that the downward spiral would stop there. Italy, Spain, Portugal, Ireland, and even France could quite possibly be next, with the risk of bank runs pulling the entire edifice of monetary co-operation into rubble.” Greece needs working capital, backed by the European Central Bank (ECB) and the European Investment Bank, “to prevent a panic-induced implosion,” voted Sachs, who concluded, Greece, its creditors and the ECB “need to show utmost responsibility, macroeconomic judgment and maturity. Greece is doing so, and the rest of Europe must as well. If they do not, the consequences for Europe and the global economy will be dreadful. This is an extremely dangerous moment. Europe must play for the long term.”
- Wenger: Huge financial crisis. The euro-crisis is so alarming that even (the more interlectual) football managers are weighing in with their opinions. Arsenal’s French gaffer Arsene Wenger was quoted in the The Financial Times: “I believe that Europe overall, as a unit, is going towards a massive crisis, which nobody really expects now. I am convinced that Europe will go into a huge financial crisis within the next three weeks or three months and maybe that will put everything into perspective again.” “It would be easy to dismiss a mere football manager’s thoughts on the European economy – but I fear M.Wenger may be onto something,” reacted the paper’s Gideon Rachman.
And what if they don't succeed? Then there will be blood on the streets. The financial oligarchs are scared of the restless masses and they need to prop up the system at all cost. It will be volatile, but I remain convinced that they'll do whatever it takes to avoid another financial meltdown.
Finally, Voice of America reports on Greece's Debt Crisis and the Future of Europe:
Finance ministers from the euro area meet Friday in Poland to discuss the Greek debt crisis. American Treasury Secretary Tim Geithner is joining them. Fabian Zuleeg, chief economist at the European Policy Center in Brussels, says the United States is right to get involved.
FABIAN ZULEEG: "The intervention from the US has also shown at least a risk that the stability of the financial system as a whole -- the global financial system -- might be under threat again. That we might have a financial situation where a possible default of Greece might have knock-on effects around the world as well."
On Wednesday, the leaders of France, Germany and Greece held a conference call to discuss how to contain Europe's deepening financial crisis.
Germany and France are Europe's two largest economies.
Seventeen European Union countries use the euro as their currency. Fabian Zuleeg says the future of the euro zone is anyone's guess right now.
FABIAN ZULEEG: "I don't think a very orderly exit of a single country is a very likely scenario.”
On Thursday, five major central banks agreed to lend additional dollars to European banks in the euro zone. The European Central Bank says the three-month loans will provide as many dollars as the banks need. The operations will end in December.
The European Central Bank is acting with the United States Federal Reserve, the Bank of England, the Bank of Japan and the Swiss National Bank.
The announcement helped lift European bank shares and major European stock lists.
Last week, the Paris-based Organization for Economic Cooperation and Development lowered its growth estimates for the euro area. In Greece the economy has shrunk this year.
German Chancellor Angela Merkel says eurozone nations must do everything they can to avoid an "uncontrolled insolvency" by Greece. On Tuesday Chancellor Merkel warned of far-reaching effects if Greece fails to pay its international rescue loans.
If Greece defaults on its debts, she said, then the effects would quickly spread to other euro zone countries. And, she said, "if the euro fails, Europe fails."
The crisis has increased calls for greater cooperation on European financial policy. On Wednesday, European Commission President Jose Manuel Barroso said the commission will propose creating "eurobonds." The idea is for euro zone governments to jointly guarantee their debts. Germany and France have opposed eurobonds.
Mr. Barroso said the current system that lets individual countries easily block policy is not working.
JOSE MANUEL BARROSO: “I am convinced we need a deeper and more results-driven integration. And let me be clear, this has to be within the community system. A system based purely on intergovernment cooperation has not worked in the past and will not work in the future.”
He spoke to the European Parliament in Strasbourg, France.
Tim Geithner isn't taking part in these discussions because he has time to waste. He's there to defend US banks and tell European leaders to get their act together. Period, end of discussion. Failure is simply not an option. Central bankers are doing their job and now it's up to policymakers to iron out the details of a more permanent solution to this crisis.
Soros is right, it takes a crisis to make the politically impossible possible. European leaders have to save face and they will do whatever it takes move beyond this debt crisis. If they don't, another global financial meltdown will ensue and financial oligarchs will face the wrath of the hungry masses, a scenario which scares them to death.
Important note: Remember to follow me on Twitter (@PensionPulse) as I post articles and trading ideas. I got out of RIM a couple of days ago (Thank God...thx Fred!) and I am still long JDSU for now. In these markets, only traders make money. Still having a great time in Crete, as you can tell from my new pic on my blog and Twitter account. :)