A deadline for solving a deadly Eurozone sovereign debt crisis

Guillermo de la Dehesa 20 October 2011

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Next Sunday the European Council meeting should, once for all, dispel all of investors’ concerns about the Eurozone crisis. If the Council is not able to achieve this, it will cross the final red line of patience, making it very unlikely to ever regain the confidence of investors. Sunday may be very soon and only a few days before the G20 meeting in Cannes, but it has been two years since the Greek debt crisis explosion – more than enough time to have solved the crisis.

Importantly, investors are not plotting against Eurozone national governments. They are too diverse for any such conspiracy since we are talking about a major share of the world’s government debt. Rather, investors are afraid. They are frightened by the uncertainty created by Eurozone leaders’ decisions. This makes them move in herds – as usual, rationality tends to become more ‘bounded’ under high uncertainty.

Here are the concerns Eurozone (EZ) leaders must address:

  • The first concern is getting a clear and definitive solution to Greece’s insolvency – one that does not provoke a credit event.

Private sector involvement is not the best solution because ‘voluntary haircuts’ are an oxymoron – even more so if they are in the 50% range. They can only be imposed on some European banks, but not on the rest of other private creditors and holders of sovereign debt. For this reason it should be complemented by a “Brady” like plan, by which new EFSF bonds are offered to creditors to be swapped for up to 50% of their old Greek bonds in exchange for longer maturities.

  • Their second concern is how to definitively isolate solvent EZ members from possible Greek contagion.

For this, a full backstop for the rest of the Eurozone members’ debt is needed. This could be implemented through a leveraged EFSF which takes the firm decision to guarantee all future maturing debt from the rest of the Eurozone member states, in exchange for needed structural reforms and debt consolidation when needed.

Investors may test the guarantee for some time, but eventually they will regain confidence that the backstop is solid. At this point, they will again buy EZ sovereign debt,  reducing spreads from their present high levels. If the EFSF is insufficiently leveraged to fully backstop the debt, it should at least be able to guarantee the first loss.

  • Their third, even deeper, concern is about the present structure of Eurozone political governance and about its already well-proven inability to manage crises.

A clear proof of this inability is that Greece (only 2% of Eurozone GDP and 0.5% of world GDP) has been allowed to produce a very serious crisis in the Eurozone. And now it threatens the wider world. Part of this concern is due to the Eurozone’s design failures, which need to be repaired, and part to a lack of political leadership. EZ political leaders first engaged in denial, then in a lack of understanding, and then they bet on short-term national political gains versus long-term Eurozone needs.

The only way to regain investor’s long-term confidence in the Eurozone is by announcing, at the end of the European Council, which articles of the Treaty are going to be changed during 2012, in order to radically improve the Eurozone system of political governance. It needs to be a true change in order to regain confidence. Here are the key changes necessary:

o       First, it is necessary to end the intergovernmental system of governance where Council decisions need unanimous approval within national parliaments to be enforced and move to a system of majority approval from each national parliament.

In the long run, the EU should move to a community or federal system of governance backed by a true European parliament, in order to be democratic. Therefore, European parliamentary elections should eventually be carried in a single European electoral district where each European Party should submit a pan-European electoral list.

o       Second, an independent European Treasury should be created with the aim of making sure member states comply with their budget deficit and debt limits and with their structural reforms needed to gain the competitiveness levels considered appropriate.

This Treasury should also in charge of issuing joint and several Eurobonds which would be swapped for all national debts at maturity, up to a certain level (60% or even more). Therefore, in a period of around six years, most national debts would be converted into Eurozone debt.

  • Their fourth concern is about the Eurozone rate of growth.

Long-run debt sustainability can only be achieved if the nation’s real rate of growth is higher than the real interest rate on its debt. To date, investors have watched every EZ country that was bailed out become even less solvent as it slipped into recession.

The reason for the recession is that they have been forced into very fast and very deep fiscal contractions. This reduces growth in the short and medium term. The various structural reforms increase competitiveness, productivity, and potential growth (and thus debt sustainability) but these work only in the long run. Even worse, EZ members that do not need austerity, like Germany, are also engaging in fiscal contraction with negative effects for overall EZ growth.

At the same time, the private sector is deleveraging and firms and households are reducing investment and consumption. Banks and other credit and financial institutions are being forced to increase their capital partly by reducing their assets and credit lines. But private deleveraging is only possible if government is leveraging at the same time and vice-versa.

As if this fiscal folly weren’t bad enough, the ECB is not reducing its policy rate despite the fact that inflation expectations are low and recession expectations are growing. Because the level of short-term interest rate differentials determines the exchange rate in the short run, the differential between the euro, dollar, and pound interest rates keep the euro strong in the short term. Only repeated failures to solve the Eurozone sovereign debt crisis have brought it down from time to time.

This combination of macro and micro policies is a self-fulfilling bet for low growth in the Eurozone for a prolonged period. Unfortunately, the Eurozone has been the region in the world with the lowest rate of growth in the last two decades, even if the so-called profligate member states added some growth to the mean. If the EZ continues with its present economic policy mix, the EZ will once again win the loser’s trophy on growth this decade. To counter this, low-growth members should have access to structural funds to help them grow; healthy member states should also expand as much as possible.

  • Finally, investors have real concerns about European banks.

The Eurozone reaction has been to propose a bank recapitalisation. This may be necessary for some banks. Nevertheless, it should be addressed only after solving the main cause of the crisis – the sovereign debt crisis. The latest banking stress test was correct, but the sample used (only 90 banks out a several thousand) was a tiny proportion of the total number of banks in the EU. This is also a main cause of concern.

Let’s hope for the best on Sunday. 

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Topics:  EU policies

Tags:  Eurozone crisis, sovereign debt crisis

Chairman of CEPR, Member of the Group of Thirty, and author of "Europe at the Crossroads".

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