Markets’ initial reaction to the latest EU emergency summit has been positive. Risk assets are trading up, risk-sensitive currencies are up, European bank stocks are up, and the broader stock market is as well. This relief rally is unexpectedly large. The bigger picture is quite a bit more downbeat. This summit does not address the core issues of the European sovereign debt crisis and is just the latest in stopgap measures on the way to a real fix to what ails Euroland.
Let’s step back a moment and look at how we got here.
Defining the problem
The urgency of the sovereign debt crisis is all about liquidity. Sovereign governments in the euro currency area have been shut out of debt markets by skyrocketing interest rates. The principal reason these liquidity issues have become critical stems from the new era we entered after Dubai World in late 2009 in which investors reassessed the risk associated with sovereign debt. Dubai World came as a real shock to markets in much the way the subprime mortgage problems at BNP Paribas did in August 2007. Potential sovereign default was an issue for which investors were ill-prepared. And so there was a rush to the exits as investors re-appraised risk.
Initially, there were many debtors that were under the gun, Eastern Europe in particular. However, after a period of sorting out, Greece was deemed the most critical sovereign risk and investors began to focus on the euro zone. Greece had a longstanding budget deficit that had exploded after the credit crisis in 2008, making its debt to GDP ratio balloon to well over 140 percent. Increasingly, it became clear that the country was not prepared to reduce these deficits. Therefore, investors lost faith in Greek debt and it sold off. With no entity standing in as a lender of last resort, Greece entered a death spiral.
At that point, it was clear that all of the euro zone members lacked a lender of last resort. And what started as a crisis in Greece metastasized into a euro crisis. Any country that was deemed risky was immediately reassessed. And the great yield convergence play that ushered in the euro zone went into reverse. First it was Portugal, then Ireland, then Spain in that order. Later, yields in Italy, Belgium, France, and Austria increased in that order of perceived vulnerability.
These problems not only affected the creditworthiness of the sovereign nations of the euro area but also the creditworthiness of their creditors, large euro area financial institutions. Dexia, the Franco-Belgian bank was rescued by Belgium, France and Luxembourg as a result of the liquidity constraints brought on by doubts about its solvency due to its exposure to these debts. So what was a sovereign debt liquidity crisis because of high sovereign debts and deficits not backed by a lender of last resort became a banking crisis as well.
The problem, therefore, is existential. It is an inherent flaw in the euro system in that it lacks a lender of last resort which creates a liquidity crisis. Japan, which has had macro federal government budget fundamentals far worse than Greece for far longer has nearly the lowest bond yields in the world. And this is not merely because of Japan’s net saver position. Countries with large current account deficits like the United States and the United Kingdom also have not experienced the liquidity crisis that the euro zone has. While the ultimate problem is government debt and deficits, the proximate problem is the sustainability of those debts and deficits without a lender of last resort.
This liquidity problem is one which each Euro area country faces. The solution to the immediate liquidity problem is to either have the central bank act as a lender of last resort or to credibly reduce deficits in order to demonstrate a sustainable fiscal trajectory in an environment that lacks this lender of last resort. The euro zone has adopted the latter approach because it is viewed by the dominant euro zone policy makers, particularly in Germany, as the more conservative approach that lends itself to price stability.
How this solution addresses the problem
The solution hammered out yesterday lacks details because it was cobbled together quickly to meet a timetable despite the policy differences at the national level within the euro zone. Nevertheless, the solution sets out a number of agenda items to be implemented. Given the differing agendas, some of are inherently contradictory.
The principle ones are as follows:
- An intention to seek economic growth as a primary vehicle for implementing the sustainability of longer-term national fiscal trajectories in a non-lender of last resort context. “The European Union must improve its growth and employment outlook, as outlined in the growth agenda agreed by the European Council on 23 October 2011. We reiterate our full commitment to implement the country specific recommendations made under the first European Semester and on focusing public spending on growth areas.”
- An intention to move toward fiscal consolidation and make structural reform if necessary in order to move to sustainable longer-term fiscal trajectories in a non-lender of last resort context. “All Member States of the euro area are fully determined to continue their policy of fiscal consolidation and structural reforms.”
- A recognition of efforts made in Spain and an intention to do more, especially regarding labour market reforms. “Further action is needed to increase growth so as to reduce the unacceptable high level of unemployment. Actions should include enhancing labour market changes to increase flexibility at firm level and employability of the labour force and other reforms to improve competitiveness, specially extending the reforms in the service sector”
- An exhortation for Italy to do more followed by a recognition of their plans for reform. “We welcome Italy’s plans for growth enhancing structural reforms and the fiscal consolidation strategy… We… call on Italy to present as a matter of urgency an ambitious timetable for these reforms… We note Italy’s commitment to reform labour legislation…We take note of the plan to increase the retirement age to 67 years by 2026 and recommend the definition by the end of the year of the process to achieve this objective.
- A recognition of efforts in the countries with IMF programs made in Ireland and Portugal and encouragement for more, especially if targets are not met. “we are pleased with the progress made by Ireland in the full implementation of its adjustment programme which is delivering positive results. Portugal is also making good progress… We invite both countries to keep up their efforts, to stick to the agreed targets and stand ready to take any additional measure required to reach those targets.
- An invitation to make a hard restructuring in Greece with invitations to private-sector creditors to write down notional principal amounts owed. “The Private Sector Involvement (PSI) has a vital role in establishing the sustainability of the Greek debt. Therefore we welcome the current discussion between Greece and its private investors to find a solution for a deeper PSI. Together with an ambitious reform programme for the Greek economy, the PSI should secure the decline of the Greek debt to GDP ratio with an objective of reaching 120% by 2020. To this end we invite Greece, private investors and all parties concerned to develop a voluntary bond exchange with a nominal discount of 50% on notional Greek debt held by private investors.”
- An intention to recapitalise banks in the euro area, with private sources preferred, sovereign sources welcomed and the now TARP-like bailout funds as a last resort. Capital outflow via dividends and bonuses will be restricted as a result. “Capital target: There is broad agreement on requiring a significantly higher capital ratio of 9 % of the highest quality capital and after accounting for market valuation of sovereign debt exposures, both as of 30 September 2011, to create a temporary buffer, which is justified by the exceptional circumstances… Banks should first use private sources of capital, including through restructuring and conversion of debt to equity instruments. Banks should be subject to constraints regarding the distribution of dividends and bonus payments until the target has been attained. If necessary, national governments should provide support , and if this support is not available, recapitalisation should be funded via a loan from the EFSF in the case of Eurozone countries.”
- An intention to leverage the existing funds of the EFSF bailout facility in order to maximize the funds available for emergency use. “We agree on two basic options to leverage the resources of the EFSF: providing credit enhancement to new debt issued by Member States, thus reducing the funding cost. Purchasing this risk insurance would be offered to private investors as an option when buying bonds in the primary market; maximising the funding arrangements of the EFSF with a combination of resources from private and public financial institutions and investors, which can be arranged through Special Purpose Vehicles. This will enlarge the amount of resources available to extend loans, for bank recapitalization and for buying bonds in the primary and secondary markets. The EFSF will have the flexibility to use these two options simultaneously, deploying them depending on the specific objective pursued and on market circumstances. The leverage effect of each option will vary, depending on their specific features and market conditions, but could be up to four or five.
These measures are inadequate.
In Greece, I find it odd that private sector creditors are invited to write down notional debt while the European Central Bank and the Troika are not. Clearly, the voluntary and private sector nature of this structure is necessary to at once avoid triggering credit default swaps, to assuage voter anxiety about taxpayer losses outside of Greece, and to protect the ECB from an explicit loss of capital which would render it technically insolvent.
All of these are legitimate aims. But the optics of this are poor and I am not at all convinced participation in the voluntary arrangement will be adequate to cut the debt burden enough to prevent a further ‘haircut’ down the line. Likely this is just the beginning in Greece. And given the now permanent presence of the Troika in Greece and the austerity they will attempt to enforce, the socialist government will be overthrown making a unilateral and much larger credit default swap triggering default a very likely outcome.
Intentions to maintain fiscal consolidation will reduce medium term economic growth, and are therefore at odds with intentions to meet fiscal sustainability by increasing growth. Moreover, the plan to increase fiscal consolidation if poor economic growth makes fiscal targets unreachable is a path which creates a debt deflationary outcome. In Ireland and Spain, this is critical as much of the fiscal trajectory is tied to the collapse of domestic housing markets.
Moreover, the EFSF is not yet a credible backstop for Italy or Spain because it is still too small. This makes fiscal consolidation in those countries that much more urgent in order to prevent the EFSF resources from being depleted.
Europe is already in recession. Greater fiscal consolidation will deepen this downturn, causing Portugal, Ireland, Italy, Greece and Spain to miss fiscal targets and induce calls for greater cuts. Meanwhile the fiscal trajectories in the rest of Euroland will also deteriorate with the economy, making the likelihood of taxpayer-funded emergency packages less. I could be wrong but I see this as the last major bailout package Europe will be able to get through. When the fiscal trajectories in the periphery deteriorate, bond markets will react negatively. If Italy and Spain are involved in the contagion, the EFSF may not be large enough to meet these requirements and this will trigger another crisis, the outcome of which is unknown. Will the ECB step in. I think they will have to or we will see a deep Depression. Still, this is all a ways off. For now, let’s appreciate that Europe has gotten this done and that markets have reacted positively.