Illustration by Bloomberg View
If this summer has shown us anything, it is this: Europe’s leaders are unwilling, unprepared or unable to take the necessary measures to solve the continent’s financial crisis. More and more, it seems, the well- being of world markets rests with the European Central Bank.
The latest developments in Greece, where a bailout package adopted in July is threatening to fall apart, make clear the danger of the piecemeal solutions that have been deployed so far. Austerity measures are deepening the Greek recession, lessening the government’s chances of paying its debts. European stocks are gyrating, and Italian bond yields have been rising again as investors worry that the trouble could spread to banks and larger governments. Meanwhile, European voters are wearying of failed bailouts, eroding the already limited ability of elected leaders to solve the euro area’s problems.
As Bloomberg News reported, German officials are talking about contingency plans to protect their banks in the event of a Greek default, suggesting that they think -- as U.S. officials did ahead of the Lehman Brothers Holdings Inc. bankruptcy in 2008 -- that a bit of foam on the runway might suffice. They are woefully mistaken.
The market reaction to a disorderly Greek default would put pressure on other countries -- including Spain, Italy and possibly even France, with a combined total of more than 5 trillion euros in sovereign debt -- to do the same. The resulting losses for Europe’s thinly capitalized banks, and for the U.S. institutions that have lent them hundreds of billions of dollars, could trigger a credit freeze bad enough to send the world economy into a deep recession.
Ultimately, as Bloomberg View has advocated, the best solution would be to create a centralized authority -- like the U.S. Treasury -- with the power to collect taxes, issue debt and provide temporary support to countries that run into economic trouble. Such an authority could replace the euro area’s panoply of government obligations with jointly backed euro bonds, creating a market large and liquid enough to rival the one occupied by U.S. Treasury bonds. The bonds’ sound backing would provide markets with assurance that any debt-reduction deals for Greece and other governments would be final, allowing banks to draw a line under their own losses, recapitalize and move on.
Unfortunately, the signals from Europe’s markets have yet to generate the kind of political will needed for what amounts to a deepening of the European Union, and politicians’ dithering has wasted precious time. Greece could default in a matter of weeks, while issuing euro bonds would require EU members to amend the union’s governing treaty and change some of their constitutions -- a process that could take years.
In the short term, then, somebody other than German Chancellor Angela Merkel and French President Nicolas Sarkozy will have to take on the task of avoiding disaster. The only candidate is ECB President Jean-Claude Trichet. Unlike Merkel and Sarkozy, Trichet is not constrained by short-term political concerns, and the ECB has access to an almost unlimited resource: the power to print euros. It has already demonstrated a willingness to use that power by purchasing tens of billions of euros in Spanish and Italian bonds to keep those governments’ borrowing costs from skyrocketing.
In its simplest form, ECB intervention would entail the central bank buying Greek and other euro-area government bonds. To keep countries’ borrowing costs in check until European leaders come up with a more comprehensive solution, such purchases would go far beyond the 440 billion euros available to the European Financial Stability Facility (the euro area’s bailout vehicle). The ECB would be buying bonds from banks at an artificially high price, leaving the central bank to suffer losses if and when some of the debts are written off.
The ECB could also be more activist, spurring governments to restructure their debts and get their fiscal affairs in order. The central bank, for example, could pledge to buy newly issued bonds at full face value only if governments adopt credible rules to balance their budgets over the economic cycle; the bank would guarantee existing euro-area debt at only half its face value. Market prices for existing debt would quickly fall to what investors believed governments could actually afford to pay, putting them in a position to negotiate debt- relief deals with creditors. As with the issuance of euro bonds, this approach would require governments to recapitalize banks that take heavy losses as a result of debt restructurings.
To be sure, ECB intervention would come at great cost, including threatening to undermine the central bank’s inflation- fighting mandate. It would not substitute for a real fix to the euro area’s flaws. Europe is reaching a point, though, where aggressive ECB action could be the lesser of all possible evils.