The European Commission has proposed six measures to enable the eurozone states to encourage – and at worst force – “risky” states to improve their competitiveness. But the European Central Bank (ECB) has criticised these proposals as flawed because there is insufficient “automaticity” in the enforcement and sanctioning process. Nonetheless, when the European Council met in late March it endorsed the eurozone’s “Pact for the Euro”, which it was boldly stated marks a “new quality of economic policy co-ordination in the euro area”.
The period up to the end of June will see these statements tested by the willingness of euro area governments to agree to the operational details of this co-ordination, and to abide by the results. The political backlash in Greece, Ireland and Portugal against the measures designed to improve their competitiveness already raises questions about the political will to stay the course. Critically, the new treaty changes that will create the European Stability Mechanism (ESM) must be agreed by all states.
It’s worth briefly charting events so far in 2011. The initial issue of the European Financial Stability Facility (EFSF) was well received, as investors only want to fund risky states when they have guarantees from other eurozone members, so that there is only a minimum risk of partial defaults (haircuts). And the emergency meeting of eurozone heads of government grudgingly agreed to increase the size of the EFSF/ESM. But after what was in effect the failure of its debt auction in early April, Portugal realised that the future costs were unsustainable. The new European Banking Authority has started the 2011 round of bank stress tests, but stated that banks do not need to make provisions against eurozone government bonds held in their ‘banking book’. However, investors seem to have suspended judgement for the moment as they have been promised full disclosure.
So the question now is whether investors will be able to add back their own assumptions of losses and test the capital strength of the banking system. Will this reveal the fatal flaw in the process? Eurozone governments have committed to preparing contingency plans for the results of the formal tests, but will they be ready and able to deal with the market’s assessment of the real situation about the solvency of banks where the market has now priced in the strong probability of defaults that will impinge on “banking book” debt holdings, and thus the solvency of the banks that hold the debt? There is also the problem of banks that face a failure of a major counter-party in the inter-bank or derivatives market.
"The political backlash in Greece, Ireland and Portugal against the measures designed to improve their competitiveness already raises questions about the political will to stay the course"
All this suggests three scenarios for the future of the eurozone during the next two or three years. Looking at these may be the best mechanism to illustrate the choices that must be made, and each simply lays out the developments that flow logically after each choice:
Scenario 1: Inflationary debt spiral. In this, finance ministers (ECOFIN) eviscerate the Commission’s already weak economic governance proposals, and so make it clear to investors that collectively the eurozone’s governments are unwilling or unable to enforce serious fiscal discipline. This weakness may become all too apparent from the probable stand-off with the European Parliament and the ECB.
Capital then flees from the eurozone and short and long-term interest rates rise significantly in an attempt to prevent the import of rising inflation as the euro weakens. Investors quickly realise that the extra interest costs will add another 2–3 % of GDP on to already-strained budget deficits, and that a debt spiral is now locked in.
Scenario 2: Default. In this, ECOFIN and the European Parliament eventually agree an economic governance package that goes well beyond the Commission’s proposals, and also satisfies the ECB’s demands for automaticity. Yet despite the repeated commitments by all eurozone members since May 2010, one of the risky states holds out against the tough proposals and penal interest rates, and is then voted down and subjected to sanctions, which it ignores.
As a result, investors decline to fund new loans to it, and so it declares default. Because it could be in primary surplus within a couple of years, it would only need new loans to pay interest to the market at that stage. But the dominos start fall in other risky states. Aghast, the eurozone heads of government contemplate the domino effects and consider the BIS data for lending by their banks. The leaders of Austria, France, Germany and Netherlands find that their banks have made 23% (June 2010) of their loans to borrowers in the six “risky” states.
These potential losses vastly exceed their banks’ capital – as demonstrated by the June 2011 stress tests. Widespread nationalisation of many banks in these member states ensues, given the losses on the supposedly risk-free bonds that they were obliged to purchase by regulatory requirements, as well as private sector loans that now default.
Some eurozone members then leave the European Union so as to recreate their own currencies, and do so with large and overtly competitive devaluations. In the remaining eurozone states, public fury at this betrayal by their partners quickly leads to a break-down of the single market and any sense of political unity. The EU ceases to operate as an organised political system.
Scenario 3: A strong, federal ‘eurozone’ emerges. The European Council has its now-normal sub-meeting of eurozone members and concludes that it is indeed in their best interest to avoid a collapse of the euro and that they have no economic, political or historical option except to “do whatever is required”. So it lays down that ECOFIN and the European Parliament must move in parallel with an EFSF expansion that matches the ESM plans. They agree an economic governance package that goes well beyond the Commission proposals, giving certainty to the ‘bond market vigilantes’ that this type of fiscal crisis will not occur again because the eurozone is genuinely in charge. Flanking policy measures on financial regulation ensure that the banking system cannot become so over-exposed again
The ‘competitiveness programmes’ must be made rigorous enough to meet any requirement of tough conditionality for EFSF loans, and are acceptable to the IMF. The size of the EFSF will be increased so that under any plausible scenario it can disburse €1 trillion in cash. Under the existing system of guarantees and cash collateral, that could require a virtual quadrupling of the nominal size. (Governments had realised that the actual banking liabilities that could fall on them under Scenario 2 might be much larger – perhaps even twice the sum they need to be able to disburse.)
Access to the EFSF/ESM is opened to any eurozone state that has had its economic policies approves by the Eurogroup – because that implies it already meets any future “tough conditionality” test. This would require a further change in the treaty revision now being proposed.
The EFSF’s own funding costs will be passed through to the borrowers as an act of solidarity, rather than the current meanness. That will encourage risky states to request EFSF funding at an early stage rather than waiting until disaster is at hand because it will be cheaper and without stigma as the state will already have voluntarily agreed to the terms as part of its programme. As it is, the reduction agreed in April for Greek interest rates suggests common-sense and solidarity are beginning to appear.
"At this stage, the eurozone will have emerged from the financial crisis as a political federation – loose in some respects, but with tightly centralised economic governance at its heart"
The eurozone governments also mount a major education programme to inform their electors of the unpalatable truth of the situation, with the result that electors understand this is the best available outcome. “Risky government” bonds then begin to rally sharply as fears of imminent default dissipate. And the decisions of the Eurozone Council meeting make it clear that the EFSF/ESM have effectively become a joint and several guarantee mechanism for those eurozone members that are resolving their own fiscal and competitiveness problems, together with tough collective oversight to confirm that the ‘strong conditionality’ is being followed through.
The eurozone meanwhile becomes somewhat introverted in order to concentrate on the pressing economic needs of its 330m citizens. Several non-eurozone states accept the invitation to be involved. But there isn’t time to consider the interests of non-members – such as 60m Britons – who still make it plain that they want to have nothing to do with the whole process.
After a year or two, the effects of the drive to enhance the eurozone’s competitiveness begin to come through, and its members’ public finances improve sharply. Any bonds of the risky states still outstanding seem very attractive – to those investors able to buy them. The potential wave of defaults is likely to have precipitated a further round of regulatory reform to ensure that financial institutions such as banks will find it difficult to buy bonds of any but the soundest states. That will be a major constraint on finance ministers ever getting into such debts again.
Risk premia will dwindle steadily as public finances improve and the euro rises, reducing the risk of importing inflation. No EFSF guarantees are actually called as markets are once again willing to fund all eurozone members. But most states continue to find it cheaper to fund themselves via the EFSF as it has also built up a critical mass as one of the world’s most liquid bond markets. The credit quality is now seen as outstanding, given the eurozone’s intrusive institutionalised oversight of competitiveness and fiscal probity. International investors recognise that this policy constraint is more effective in the eurozone than in alternative global bond markets.
At this stage, the eurozone will have emerged from the financial crisis as a political federation – loose in some respects, but with tightly centralised economic governance at its heart. Its future fiscal rectitude could be enforced by adoption of three ideas for automatic sanctions:
- Build on the emerging political union between eurozone members and modify the EFSF (and its successor) to make it the preferred borrowing route for most members.
- That would be a huge carrot, but there must also be a stick that would be virtually automatic, and that can be achieved by inserting into the Definitions Article of the relevant European Commission economic governance proposals the following text: “Special access to financial institutions should mean special treatment for the borrowings of a member state held by any financial institution subject to EU regulations. This treatment is in respect of capital requirements, eligibility as liquid assets and absence of prohibition on concentration of asset holdings. Such special access shall only be available to member states that are permitted to borrow from the European Financial Stability Facility (and its successor), or would be so permitted if they applied.”
- Add an Article to the sanctions sections of the relevant enforcement Regulations that reads: “Any EurozoneMemberState subject to sanctions is ineligible to borrow from the European Financial Stability Facility (and its successor) and therefore loses its special access to financial institutions.”