Our disgraceful leaders did it again. They managed to deeply unsettle financial markets by once again sparking off doubts on the orderly rollover of distressed sovereigns (Reguly 2011). This has pushed interest spreads over German Bunds to unprecedented heights – over 2300 basis points for Greek sovereigns – and raised fears that contagion might spread not only to Spain and Italy, but reaching the Eurozone core, starting with Belgium (Micossi 2010). The public discussion stands out for its especially damaging effects.
It was clear from the start that Greece’s adjustment programme was unfeasible and that the Greek government would not be able to regain access to private markets for its funding. In less than a year Greece has managed to cut its public deficit to 10.5% of GDP, i.e. by some 5 percentage points, but has missed the 8.1% programme target, owing in part to a steeper than expected fall in economic activity. They are now deciding additional measures needed to meet the 7.5% target for the current year. Public asset sales of up to €50 billion are also being contemplated. Meanwhile, the consensus estimate is that Greece will need some €66 billion in additional financing to rollover its maturing debt.
This fairly predictable scenario has been read in Germany as proof that Greeks can’t be trusted; additional financing is dubbed in public discussion as “more bailout money” and will need to be approved by an increasingly restive Bundestag. Similar sentiments are fed by populist political parties in the other Eurozone creditor countries. So far there has not been a single penny of fiscal transfer from creditor to debtor countries in the Eurozone, and no such transfer is being contemplated. Public discourse tells a different story. And, in order to appease disgruntled electors in creditor countries, financial assistance programmes must include punitive conditions that can’t be met.
Meanwhile in Greece social resistance to wage and expenditure cuts is escalating, together with anti-German and anti-European feelings. In sum, we are back to the bitter recriminations that one year ago preceded approval of the Greek emergency assistance. Then it only stopped when everyone realised that the alternative to rescuing Greece was much worse (Wyplosz 2010). It is a safe bet to predict the same outcome this time, of course with permanently higher financial and political costs for all the parties involved.
Open confrontation on the bailout
The novel feature is open confrontation between Eurozone creditor governments and the ECB on the possibility of some kind of – even ”soft” – restructuring of Greek sovereign debt. The latest step was the open threat by ECB Executive Board member Jürgen Stark to stop accepting Greek paper as collateral in ECB refinancing operations if a restructuring occurred.
Only few days after Lorenzo Bini Smaghi, another ECB Executive Board member, referred to as ”devastating for overall financial stability” even the mildest restructuring option – a voluntary debt rescheduling involving no write-down of principal. An influential market analyst commented on this latter statement as follows: “All this strikes us as very odd, since all [such voluntary restructuring] could do is help (his italics) Greece. We are going to take Bini Smaghi at his word however, and hold off on making a re-entry into these markets [for Greek sovereigns], as his comments suggest a very large problem without an apparent solution.”
Direct ownership of distressed debt by the ECB is not the biggest concern. Outstanding securities in the ECB balance sheet under the securities market programme amount to €75 billion, out of which some €40 billion are Greek government debt. The larger problem is the burgeoning exposure of the Eurosystem to debt of Greece, Ireland, Portugal and Spain through its bank refinancing operations. That is, the use by private banks of the debt as collateral for their loans from the ECB.
At end of March 2011 the total claims of the Bundesbank vis-à-vis the Eurosystem were around €330 billion (up from €177 billion at the end of 2009). This roughly corresponds to the net liabilities of Greece, Ireland, Portugal and Spain. As of the same date, lending by central banks to their domestic banks – who are in turn the main holders of government debt – was 54% of GDP in Ireland, 38% in Greece, and 23% in Portugal. Thus, the first victim of debt restructuring would be the ECB and the Eurosystem.
The dangerous link between sovereign debt and banks
A haircut in any form on distressed sovereign debt would heavily hit banks’ balance sheets, with immediate reverberations on the Eurosystem possibly demanding fiscal support from national Treasuries and putting in jeopardy the system’s independence. Our monetary authorities have pretended that the Greek and Irish debt crises were temporary liquidity crises, while the problem was one of solvency. As a consequence, they have placed an inordinate burden on the ECB. Now, in order to protect itself and the Eurosystem, the ECB is raising walls that financial markets will test with increasing virulence until they fall. And they will. These walls are on flimsy foundations.
At the same time, a potential escape route has been intentional shut off by operational limitations that have been placed on the European Stability Mechanism, and its current predecessor, the European Financial Stabilisation Facility. Namely the inability to buy secondary government debt (this would have allowed a soft, voluntary restructuring by buying the debt at the heavily marked down market price from private holders). This ensures that the ECB cannot unload its balance sheet of substandard paper without destabilising the Eurozone financial system.
Thus, the difficulties that have emerged with the Greek financial assistance programme are an accident and not the central issue. The same is bound to happen again with Ireland and Portugal, each time with higher risks that the fabric of cooperation within the Eurozone will tear irreparably.
Surely it is plain to see by now that there are serious flaws in the design of our crisis-management system. It keeps periodically pushing us back to the brink of financial meltdown of the Eurozone. In order to fix them crisis-management arrangements and the design of the European Stability Mechanism must be changed notably in three respects.
- Firstly, there is a need to circumscribe direct political involvement of the Eurozone member states in individual crisis-management decisions and monitoring of implementation, so as to isolate these decisions from domestic political discussions.
This requires in turn that operational decisions on individual programme design be entrusted to the executive board of the new mechanism, under rules and procedures similar to those of the IMF – of course, following clear guidelines established by the ministers of finance of the Eurozone, but not under direct instruction from them.
- Secondly, it requires rescinding the direct link that has been established between the decision to offer financial assistance to a Eurozone member state and the national budgets.
To this end, the new mechanism should be able to borrow freely as needed to restore financial viability of distressed debtors. This is the only way to overcome the “foreign currency” syndrome that is at the root of mounting financial instability within the Eurozone (De Grauwe 2011). The institutional model already exists within the EU, e.g. the European Investment Bank. The new mechanism should be adequately capitalised and allowed to issue EU bonds, with no explicit quantitative ceiling, but a clear mandate to act as needed to preserve Eurozone financial stability.
The bonds would be issued under the joint and separate guarantee of the member states. Solid design of financial assistance programmes, with adequate conditionality, would make sure that the guarantees would not be called upon except in extreme circumstances; in ordinary circumstances the European Stability Mechanism would never lose money, let alone become the vehicle for fiscal transfers to the beneficiary country. The financial assistance programme would also include, as required, provisions on debt sustainability, private sector participation, bail in clauses and the like.
- Thirdly, the European Stability Mechanism must be entrusted with the operational flexibility required to ensure the success of its financial assistance programmes.
This would include purchasing distressed debt in the secondary market (operating through an ECB account); swapping distressed debt with its own (Triple A) securities, as in the Gros-Mayer proposal (Gros and Mayer 2011); providing its own securities as collateral in debt refinancing operations after restructuring, as in the US Brady plan at the end of the 1980s.
Of course, no such operation would take place before a financial assistance programme is in place. And the ECB should be freed of all non-monetary support tasks in addressing debt crises of Eurozone members, and indeed be allowed to unwind its present exposures to distressed sovereign debtor countries by ceding them to the European Stability Mechanism (who would issue EU bonds to finance them).
These arrangements should immediately apply to existing financial assistance programmes under a new mandate by the European Council to the European Financial Stability Facility, the Commission, and the IMF.
De Grauwe, P (2011), “The Governance of a Fragile Eurozone”, CEPS Working Document 346.
Gros, D and T Mayer (2011), “Debt Reduction without Default?”, CEPS Policy Brief No 233, February.
Micossi, Stefano (2010), “The Eurozone in bad need of a psychiatrist”, VoxEU.org, 10 December.
Reguly, Eric (2011), “EU debt crisis spreads to richer nations”, Global and Mail, 25 May.
Wyplosz, Charles (2010), “And now? A dark scenario”, VoxEU.org, 3 May.