The war in Libya and the terrible disasters in Japan have diverted the public attention from the conclusions of the most recent European Council (24 and 25 March 2011). Most commentators have noted the limited scope of the decisions (such as Euro Intelligence (2011) and Münchau 2011 in the Financial Times). One might almost say it is as Shakespeare, "Much Ado About Nothing". Unfortunately, the decisions concerning the new European Stability Mechanism, the ESM, are about much more than nothing, and could prove detrimental to the stability of the Eurozone. Here's why.
Stability pact and the macro imbalances
Most comments focused on the measures aimed at strengthening the “corrective arm” of the Growth and Stability Pact (countries should reduce their public debt in proportion to the distance from the target of 60% of GDP), its “preventive arm” (countries should adopt national budgetary rules consistent with the objectives of the pact); and the proposals aimed at reducing macroeconomic imbalances, such as monitoring competitiveness and productivity growth (see Manasse 2010 and my recent public hearing at the European Parliament here). Yet these issues are hardly mentioned in the summit conclusions. And for a good reason – the European legislative process on these matters is still ongoing, requiring the approval, possibly after important changes, of the European Parliament. The summit, however, decided about the ESM.
The European Stability Mechanism
Since June 2013 the new fund will succeed to the European Financial Stability Facility and to the European Financial Stabilisation Mechanism with the task of providing financial assistance to Eurozone members. This will be done through loans (conditional on adjustment measures) and, in exceptional cases, through the direct purchase of government bonds in the primary market. The ESM architecture has at least four major problems.
- The first problem is that the endowment is too little too late.
The endowment amounts to €700 billion, which gives a loan capacity of €500 billion. Member countries will actually disburse only €80 billion, in five annual instalments starting in 2013. The rest will take the form of guarantees and "callable capital" (see also Buiter 2011).
"Too little, too late", one may say, considering that during the 2011 (and not in 2013!) the debt coming to maturity of Greece, Ireland, Italy, Portugal, and Spain, will top €502 billion, and that financial requirements of Spain central and local governments up to 2013 are estimated around €470 billion. The agreement provides for the possibility of accelerating payments should a crisis unfold before 2013. Yet delays may be uncertain and long, leaving the Eurozone’s sovereigns exposed to speculative attacks.
- The second weakness lies in the funding system.
Because the new fund is financed by guarantees that will be called in case of need, rather than by an endowment of its own, the activation of the guarantees is likely to produce multiplier effects and contagion (see again Münchau 2011).
Take Italy. For every €100 billion that may be necessary to "save" other countries of the euro, the Italian budget will be burdened by almost €18 billion (equal to the percentage in the budget of the European Central Bank), about one percentage point of Italian GDP, and this would occur at the worst possible time, when the markets would likely require high and rising interest rates.
- The ESM’s third and very serious defect concerns the voting mechanism.
Unlike the IMF, whose decisions require a simple majority (of the shares), the ESM decisions of approving a loan, determining the interest rates and the terms of conditionality, require the unanimity of Eurozone finance ministers. Each country is effectively given a veto power on the Board. It is not difficult to imagine scenarios like the following: country G, which is in good financial health, trades his consent to lend to country I, in exchange for the latter consenting to adopt the very policy measure that mostly benefits country G (e.g. the increase in the corporate tax rate).
- Finally, the statute requires that the European Commission should carry out an assessment of sustainability of public debt of the country, presenting difficulties in accessing financial markets.
If the European Commission were to conclude that a country is technically insolvent, then the ESM will provide a loan only to the extent that private sector will be involved. First note that, on economic grounds, if a country has difficulties in tapping the financial markets, it must be exactly because investors perceive it as insolvent, so it not difficult to imagine that the Commission will also come to this conclusion for most aspirant borrowers. While it is understandable to try and prevent moral hazard and not reward excessive risk taking, this norm may prove very damaging. Imagine what would happen if Europe were to declare today that all the countries (still) tapping European money after 2013 will default with absolute certainty in 2013 (albeit partially). This is exactly what this norm states. As of today, the markets will require higher yields on the new issues of actual and perspective ESM clients, precipitating the insolvency crisis. Just as is now happening in Portugal.
In short the design of the ESM presents serious flaws. The fund is unlikely to withstand the shock of a severe financial crisis (involving Portugal and Spain), it may accelerate and even spread the crisis to high debt countries, while leaving the Eurozone in the grip of paralysing vetoes.
Eurointelligence (2011), “The 24/25 March EU Summit”, 23 March.
Manasse, Paolo (2010), “Stability and Growth Pact: Counterproductive proposals”, VoxEU.org, 7 October.
Münchau, Wolfgang (2011), “A grand design that cannot end the crisis”, Financial Times, 27 March.
Buiter, Willem (2011), “Global Economics View: The Debt of Nations”, Citigroup Global Markets, 7 January.