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Europe’s debt crisis--Fudge, the final frontier

opean leaders are at a fork in the road.
They’ll probably go straight on.

Sep 10th 2011 | from the print edition  

SEPTEMBER is a cruel month in international monetary history, when regimes that once seemed inviolate have shattered. In 1931 it was the month when Britain went off the gold standard. In September 1992 the same country was booted out of the European Exchange Rate Mechanism. This month will not see the end of the euro, but could go a long way to deciding its fate.

 The brief period of calm brought about by the European Central Bank (ECB) wading into the bond markets from early August to buy Italian and Spanish government debt is over. That intervention at first lowered Italian ten-year bond yields down from over 6% to around 5%. But yields have been creeping up since late August, and jumped above 5.5% on September 5th (see chart 1).

Equity markets, which had taken a battering over the summer, have been clobbered again this week. Germany’s Dax 30 index fell by over 5% on September 5th alone. Since the start of July it has declined by 27%. Italy’s benchmark index is down by 29%, France’s by 23%. Such falls have outplunged America, where the S&P 500 has lost 11% over the same period.

European banks have suffered still steeper drops. German banks are down by 36% since early July, Italian ones by 38% and French banks by 43%. Plenty of spectres stalk the sector, among them the naming on September 2nd of some big European lenders in lawsuits filed by the US Federal Housing Finance Agency for mis-selling mortgage-backed debt. But the biggest by far is the potential loss that European banks face on their holdings of sovereign debt. Credit-default swaps on European banks are above even the levels they reached in late 2008.

In running from some markets, investors have overwhelmed others. The inexorable rise of the Swiss franc, in demand as a haven in troubled times, is threatening the health of Swiss exporters. The Swiss National Bank this week announced that it would cap its value against the single currency (see article). That will mean even greater demand for German Bunds, whose ten-year yields fell to a record low of 1.85%.

The market volatility reflects three sources of uncertainty. The first surrounds the ability of Europe’s political classes to carry out their promises. Euro-zone bigwigs agreed in July to put together a new rescue package for Greece and to ramp up the scale and remit of the European Financial Stability Facility (EFSF), the euro area’s bail-out fund. One hurdle was negotiated on September 7th when the German constitutional court endorsed the legality of bailing out European countries. But the plan still needs to be ratified by all 17 euro-zone parliaments.

The willingness of pressurised countries to get their houses in order is also in doubt. The flip-flopping of Silvio Berlusconi’s government in pushing through the austerity measures it pledged for Italy during the summer has perturbed investors. Officials from the IMF and Europe reviewing Greece’s bail-out programme suspended talks and pulled out of Athens on September 2nd because of reform slippage.

The second source of uncertainty centres on Europe’s capacity to grow even as euro-zone countries rush to pass national laws that bind them to the mast of budgetary restraint: Spain, for example, is enshrining a budget-deficit cap in its constitution. The euro area grew by a paltry 0.2% in the second quarter, suffering both from the global slowdown and weakness in domestic sources of demand, with consumer spending falling by 0.2%, the first decline for two years.

Sentimental journey

The economic-sentiment index published by the European Commission, which tends to track GDP growth, fell in August by 4.7 points to 98.3, taking it below its long-run average over the past two decades. This composite measure of confidence took a particular tumble in Germany, hitting hopes that the euro area’s biggest economy could help pull southern Europe out of the mire. The premature tightening in monetary policy this year has done nothing to help, although the ECB was expected to keep its main interest rate unchanged at 1.5% on September 8th (after The Economist had gone to press).

The third and biggest source of uncertainty is the inadequacy of the euro zone’s bail-out arsenal. A beefier EFSF—with an effective lending capacity of €440 billion ($620 billion), some of it already committed—can cope with small economies like Ireland and Portugal and provide help for Spain. But the moment markets started to fret about Italy in July, the strategy looked broken-backed. The third-biggest economy in the euro area, with total debt of €1.9 trillion, is simply too big for the EFSF to rescue. Charles Wyplosz, an economist at the Graduate Institute in Geneva, says that this was the critical moment when the scale of a potential rescue overwhelmed the resources available to mount one.

Since the EFSF is too puny to do the job it has been given, the solution might appear obvious: to bulk it up still further. But the EFSF’s borrowing is backed by guarantees from euro-area states, each of which vouches for an amount roughly in line with its share of the euro-area economy. The bigger these commitments get the more they add to worries about countries’ overstretched public finances. Ratings downgrades would reduce the EFSF’s resources or force it to operate as a less highly rated, and more expensive, borrower.

Relying upon the ECB to hold the fort is tricky, too. The central bank made its latest bond purchases with ill-disguised reluctance and, importantly, they were opposed by Jens Weidmann, the president of the German Bundesbank. Whatever its legal independence and ability to finance the purchases by creating money, the ECB depends implicitly upon support from the German public. An extended programme of bond purchases could forfeit that—indeed, trust in the institution is already waning (see chart 2).

A more fundamental step towards a fiscal union may be needed. One way forward is to introduce Eurobonds, which would pledge “joint and several” liability. In theory that could mean that a small state is on the line for such debt; in practice it would mean Germany. Advocates of Eurobonds point out that the public finances of the euro area, taken as a whole, compare favourably with other big economies such as America and Britain, whose governments are currently able to borrow at record low yields. If the euro area were able to borrow as a whole, it too should benefit from low borrowing costs, helped by the liquidity advantage of creating what could become a vast government-bond market.

But critics of Eurobonds say that creating them within the current framework would actually weaken budgetary discipline, reducing the incentives for weaker states to get their finances in order. The legal obstacles are daunting: unlike the EFSF, they would require changes to European treaties. The political barriers are higher still: their introduction would push up Germany’s borrowing costs quite steeply. The German and French governments have ruled them out, at least for now.

If a big leap towards fiscal union is unlikely, what of the opposite outcome, a break-up of the single currency? Until recently the idea of the euro area fragmenting seemed far-fetched. It says something about the pass to which Europe has come that this is now a possibility being seriously discussed.

There are two ways in which a break-up could occur. First, weaker countries like Greece could decide that life outside the single currency might be more tolerable than life inside it. If output continues to slide not just this year but next and unemployment continues to rise, political pressures may mount within Greece to leave the club.

The second break-up scenario would be for Germany and some small creditworthy economies like the Netherlands to set up a new currency. The dilemma for Germany, says David Marsh, an historian of the euro, is that there is now an agonising trade-off between being European and achieving the country’s cherished goal of economic and monetary stability. Even so, he does not expect Germany to break away. Its political class remains resolutely pro-European. The ruling CDU party is proud of its heritage as a European party; the opposition parties favour solutions like Eurobonds. More to the point, policymakers who have repeatedly bailed out Greece (2.5% of euro-zone GDP) for fear of the consequences of default will surely be petrified of the impact of a wider break-up.

Barry Eichengreen, a monetary historian at the University of California, Berkeley, says that the economic costs of disintegration would be catastrophic for Europe and beyond. In the case of Greece, he fears the result would be a 1930s-style Depression brought about in particular by the collapse of the financial system. If Germany were to leave, its export-based manufacturing economy would take a body blow as the new currency soared. Other costs are incalculable because much would depend on responses that cannot readily be modelled: a Greek exit, say, could spark bank runs in other peripheral countries.

Fragment analysis

Not everyone accepts these dire warnings. Daniel Gros of CEPS, a think-tank in Belgium, thinks that the impact on other vulnerable countries of a Greek exit could be contained as long as European leaders made clear that they would be protected. Charles Calomiris of Columbia Business School argues that Greece could ultimately benefit by leaving because it would bring about both the harsh default needed to restore debt sustainability and the big devaluation needed to restore the country’s competitiveness. As for Germany, it has a knack of coping with a high exchange rate.

Fear of the consequences of break-up is the strongest reason why fiscal union seems a more probable outcome than a fragmentation of the euro. But Europe’s institutional and political capacity to take bold decisions in a crisis is feeble. That is why the immediate focus of debate is on how to gear up the EFSF so that even with its limited resources it could do more.

The facility should be turned into a bank, say Mr Gros and Thomas Mayer of Deutsche Bank. It could then do a lot more by borrowing from the ECB to finance its activities. An alternative suggestion, from Mr Wyplosz, is that the ECB issues guarantees for sovereign bondholders. These warranties would be partial, but they would put a floor on potential losses. Another option is for the EFSF to offer investors protection against a first loss on bonds, and for the ECB to provide those investors with cheap, non-recourse loans. Euro-zone leaders decry the financial engineering that sparked the banking crisis. They are coming to appreciate its merits.