I see the debt deal hammered out yesterday for Greece, Ireland and Portugal by European policy makers as a positive step. There are many more steps to take, but this is a step in the right direction.
When I framed the situation in Europe ahead of the debt deal hammered out yesterday for Greece, Ireland and Portugal by European policy makers, I said the crisis was at once about liquidity, solvency, and politics. The liquidity issues are the immediate concern because contagion to Italy meant the Eurozone sovereign debt crisis was at a critical point, having imperilled the euro zone’s third largest economy. That is why Greece has been cut loose. But this deal only buys some time. The solvency and political issues remain to contend with. Despite the positive impact this has had on markets, I believe the solvency and political issues will keep the markets stressed until they are dealt with.
Here’s how I would outline what’s at stake. I look at the short-, medium-, and long-term from a sovereign liquidity and solvency perspective as well as from a bank capital perspective:
- Liquidity: in the short-term, the European Union needs to
- provide enough liquidity to imperilled sovereign debtors – Greece, Ireland and Portugal recently joined by Spain and Italy – to keep yields at manageable levels; and
- differentiate between debtors, isolating Greece as a special case, so as to prevent contagion and to lower yields for the other IMF debtors further and to the non IMF debtors further still; and
- allow bank creditors with capital deficiencies enough breathing space to prevent contagion from the sovereigns into the financial system.
- Solvency: In the medium-term, the EU must:
- provide enough support for pro-growth economic policies that afford solvent but illiquid nations like Portugal and Ireland an ability to reverse the rise in debt that would render them insolvent; and
- deal with Greece’s solvency issue by writing down debt principle and not just extending maturities and lowering coupon rates; and
- discourage moral hazard by forcing financial institutions to make credit writedowns and recapitalize to meet future enhanced capital requirements.
- Politics: Over the long-term, the Euro zone must:
- establish a mechanism for dealing with liquidity issues in large euro area countries like Spain, Italy, France and Germany; and
- establish rules of engagement that allow insolvent sovereign debtors to default without putting the euro project at risk or creating contagion to other sovereign debtors or financial sector creditors; and
- force European financial institutions to increase their capital base so as to withstand large credit events like sovereign defaults.
In my view, the short-term issues have been managed adequately for now. However, the medium-term and long-term issues are almost entirely unaddressed here. Separately, the planned Basel III accord does propose an increase in bank capital but it is early days still on that front. On every other medium- or long-term issue, the EU has done almost nothing.
The EFSF is too small but otherwise this is good for liquidity issues
I am pretty happy with where we have got to on the liquidity side of things. The EU has made a specific reference to its understanding that Greece must be perceived as a special case in its statement on the deal:
As far as our general approach to private sector involvement in the euro area is concerned, we would like to make it clear that Greece requires an exceptional and unique solution.
In addition, the reduction in interest rate to 3.5% for all three Ireland, Greece and Portugal was absolutely necessary to allow chances for growth. It also standardises the terms on each of the deals, outside of the restructuring angle in the Greek deal (which could come later for Ireland or Portugal). While I really don’t see any of the countries clearing the 3% hurdle by 2013 giving the negative impact this deal has on growth, I would imagine Ireland will have the easiest time making its austerity targets, followed by Portugal. I am not optimistic about Greece however. Below is the language used to describe the targets:
All euro area Member States will adhere strictly to the agreed fiscal targets, improve competitiveness and address macro-economic imbalances. Public deficits in all countries except those under a programme will be brought below 3 percent by 2013 at the latest. In this context, we welcome the budgetary package recently presented by the Italian government which will enable it to bring the deficit below 3 percent in 2012 and to achieve balance budget in 2014. We also welcome the ambitious reforms undertaken by Spain in the fiscal, financial and structural area. As a follow up to the results of bank stress tests, Member States will provide backstops to banks as appropriate.
Further, while the EU expects 90% participation from financial institutions, the voluntary nature of private participation in this soft restructuring has boosted the outlook for Europe’s banks.
Below is a copy of the term-sheet for the voluntary exchange presented by the Institute of International Finance (IIF), which represents the banks. It is designed to make all of the exchange vehicles equivalent to a net present value loss to the banks at a 9% annual discount rate. So regardless of whether you take a 15 or a 30-year exchange, you will see the same NPV using a 9% discount rate.
On the other hand, the EFSF has limited firepower. It was designed only to handle Portugal, Ireland and Greece. It cannot handle the liquidity concerns of Spain or Ireland. Going forward, I anticipate that liquidity issues will return because the stick used in exchange for this carrot is austerity. And that lowers growth and makes it harder for the three euro zone nations with bailouts to reach the deficit reduction targets set out in the agreement here.
So at a minimum, the EFSF has to be increased to deal with this issue, not just for Portugal, Ireland and Greece but Spain and Italy as well since contagion will return when austerity targets are missed.
This plan is not a hard restructuring
On the medium term issues, despite the so-called selective default label applied to the agreement for Greece, this is not a hard restructuring that involves principle reduction. In fact, Nicolas Sarkozy, France’s President said the following about Greece’s deal:
"If the rating agencies are using the word you just used (default), it is not part of my vocabulary. Greece will pay its debt," he told reporters.
Greece is insolvent and any plan that doesn’t recognize this concretely is just a stop gap on the road to eventual credit writedowns. I suspect this is yet another swag for political reasons. The banks are undercapitalised and the ECB’s Trichet wanted no part of a default. Sarkozy, Merkel and Trichet hammered out a deal that involves this selective default swag that can be positioned however these leaders want to their respective political and market constituencies.
More worrying over the medium-term is the austerity implicit in the plan. Obviously, the deficits have to be reduced in order to reduce the debt. However, the juxtaposition of deficit reduction and growth cannot be reconciled through this deal. What is likely to happen is that deficit reduction targets will slip and then we will see more deals down the line due to the liquidity crises that the slippage precipitates. If Spain and Italy go into recession because of the loss of output from austerity, they too could be re-coupled and then the EFSF would be inadequate in size. In truth, the ECB is the difference. Only the ECB has unlimited liquidity firepower.
And while this plan is specific to Greece, it can easily be modified to include Ireland and Portugal (or even Spain and Italy down the line). Some are calling this a ‘Brady Plan’ or a ‘Trichet Plan’. If so, we should expect principle reductions like the Trichet Plan outlined by Evans and Allen. That is where this is headed in due course.
This step is positive. It will calm markets – for how long is anybody’s guess. Nevertheless, it is just one step. The budget cuts that this deal requires must be rapid in order to try to calm markets by maintaining the fiction that Greece is not insolvent and that the budgetary crises in Portugal and Ireland are less severe than they are. This approach is another version of extend and pretend and will have the nasty side effect of slowing growth in the euro zone considerably. Muddling through means deepening crisis for the euro zone. My hope is that Europe will be ready to address the medium- and long-term issues when the crisis flares again. But I want to leave you with something I said Wednesday about muddling through, the prospect of a European Monetary Fund and the longer-term viability of the euro zone.
The Germans will never have any appetite for a transfer union. You may hear pro-European noises coming from Germany’s old guard including former Chancellor Kohl, but it is clear that these people are not talking about fiscal union. They are talking about cross-border financial regulation or bailouts via a European Monetary Fund that ensures adherence to the existing stability and growth pact. No Eurobonds, no central treasury, no transfer union. Nein.
Only when all other options have failed and the euro is about to break apart will any of these ideas be entertained by German policy makers. As I have argued on two occasions, that’s the psychology of change and the political economy of large, hierarchical systems like corporations or nation states.
I believe the sovereign debt crisis will deteriorate further for just this reason. And then we will just have to see what the politics of the individual countries in Euroland look like. If austerity brings the economy to a crawl and europopulism is well advanced, the euro will collapse. If not, the Europeans will push forward with greater integration.