Likely policy path for European sovereign debt crisis
Given the flurry of activity this past weekend in the euro zone, it seems clear that the Europeans have pushed the panic button. I anticipate that some sort of systemic response is likely in order to deal with Italy (and Spain), two large economies that cannot be supported by the existing European financial assistance programs already in place. Below are some of the details that have come to light and my assessment of what is likely to happen.
It is contagion which has forced a policy response. Think back; when the sovereign debt crisis began two years ago last week, initially it was only Greece which received the market’s penalty for major misconduct, with Portugal and Ireland also in the penalty box for perceived lesser infractions. Since that time, this crisis has metastized and has become a full-blown euro zone crisis affecting every single nation in the euro area including the Netherlands, Finland and Germany.
Many had dismissed this crisis via an economic morality play which saw those affected as fiscal sinners, while those unaffected were fiscally sound. We now know this dichotomy was never true. And with contagion moving to the core, Economists like Paul Krugman have sounded the alarm that this is a ‘euro problem’, not just a sovereign debt problem. As I like to say, it is a rolling crisis. Every country will find its way to the penalty box until we get a systemic solution: full monetisation and union or break up.
I said this would be the ultimate choice a year ago. But the desire to both protect the balance sheets of creditor country financial institutions and to formulate a policy that adheres to German economic orthodoxy without worsening the crisis any further has stalled more vigorous policy responses since then. The approach has been to encourage a quid pro quo of fiscal cuts and economic reform in crisis-affected countries for liquidity support from the European Central Bank.
However, this policy response has had the exact opposite of its intended effect. Indeed, it is this Great Dither which has created the contagion, as it has sapped confidence in bond markets and caused a re-assessment of sovereign risk within the euro zone while sovereign debtors outside of the zone like the United States, Japan and the UK have been left unscathed.
Europe Now Gets It
With the rise in Italian and Belgian yields to unsustainable levels plus the contagion to France, Austria, Finland and the Netherlands as well as the German bond auction failure, what was true all along is now plain even to European policy makers. They have now given up the pretence that they would allow Italy to collapse in a heap and cause an economic Depression. The Great Dither is over.
But what is on offer then? I believe we are likely to see a real systemic solution but it is unclear what structure the Europeans will use to take this systemic approach – and whether this approach is even workable. Here are the plans said to be on the table:
- La Stampa, a well-regarded Italian newspaper, reported that plans were being made for the IMF to offer Italy a 600 billion euro bailout via ECB funding. The Telegraph later said this deal would also involve Spain. While this story is credible, an IMF funding would face significant hurdles. The IMF certainly does not have the funds to commit to a rescue of this size; and any attempt to access more funds would be stymied by a political backlash, particularly in the United States. Nevertheless, Warren Mosler and Phillip Pilkington have drawn up a version of how this plan could work without using additional monies from the IMF. So, while I don’t believe this is the master plan, we should take this effort seriously.
- Bild Zeitung, a German tabloid, reported on another plan which now also has credibility. Under this plan brokered by Germany and France, the EU would force a new euro “stability agreement” by January or February 2012. The essence of the plan is Eurobonds and/or ECB intervention in return for EU fiscal oversight. In order to avoid treaty changes, this agreement would be structured as a contract between nation states like the Schengen Agreement which abolished intra-EU border checks in the 1990s. Bild understands that the Franco-German duo of Angela Merkel and Nicolas Sarkozy want to present this plan at the EU heads of state summit on 8/9 December.
- Die Welt, a German daily newspaper, reported that the Bundesbank, Germany’s central bank, no longer rules out Eurobonds. The prerequisite for Eurobonds is closer financial integration aka fiscal union for euro area countries.
What politicians are saying
I have done a fairly comprehensive review of the European press to see what public statements corroborate either of these plans. What I have read suggests the second plan is more likely to be put forward as a systemic solution. Here’s what politicians are saying:
- In France, evidence of support for fiscal integration: Nicolas Sarkozy is quoted by Le Figaro as saying “if there is a problem for Italy, then it goes to the core of the euro zone.” His office also says "Nicolas Sarkozy and Angela Merkel are working very hard to support Italy.” Separately, Le Figaro reported that the French President, when asked by Agence France Presse about giving the European Commission fiscal oversight, said that the objective is “not at all to give supranational powers to the European Commission” and that Germany also was not looking for supranational powers for the EC. The obvious takeaway here is that Sarkozy and Merkel are already planning to announce a deal that gives the EC fiscal oversight, which they will deny means giving the EC supranational powers.
- In France, evidence of support for ECB activism: Over the weekend, the FT reported that France is pushing for a Christmas gift from the ECB. “The aim now is to create conditions in which the bank, acting within its current monetary policy mandate – and less constrained by overt political pressure – can take additional moves to counter the relentless market pressure on sovereign bonds.” My takeaway: Germany and France have already agreed that they will propose to create the preconditions within the euro zone which would allow the ECB to, as I put it on Saturday, “say that it adhered to its principles despite acting in a quasi-fiscal manner. And politicians can go back to their voters and say they did so as well.”
- In the US, Britain, Spain, Italy, Poland and Asia, evidence of political pressure on Germany: Meanwhile the pressure on European officials to do something has increased. Yesterday, US President Barack Obama met with European Commission head José Manuel Barroso and European Council head Herman van Rumpoy to impress on them that Europe’s situation risked a global economic collapse. UK Prime Minster David Cameron has been particularly vocal in recent weeks as well about the need for Europe to do something (prompting Nicolas Sarkozy in October to tell Cameron to “shut up”). Note that, if you listen or read carefully,you can see that the last, present and future Prime Ministers of Spain are all saying this as well. But now the Poles are at it too. German magazine Spiegel reported that Poland’s foreign Minister Sikorski publicly urged Germany to do something. He is quoted as saying “I have less fear of German power, but I am beginning to fear German inaction.” And finally, Stephen Roach adds to the chorus by indicating that contagion to Asia will be significant. Writing at Project Syndicate, he warns that “even under the now seemingly heroic assumption that the eurozone will survive, the outlook for the European economy is bleak… It is difficult to see how Asia can remain an oasis of prosperity in such a tough global climate.”
What will happen?
Italy! Italy! Italy! Italy is too big to fail. As Nicolas Sarkozy correctly asserts, if Italy fails, the euro fails. I have been telling you for some time now that’s why questioning Italy’s solvency leads inevitably to monetisation. My conclusion from the foregoing is that the Franco-German stability agreement plan will be announced by the EU heads of state summit. The outline will be for a multi-party series of bilateral agreements within the euro zone along Schengen lines. The core pieces of the agreement will be threefold:
- Countries that have deficit problems, i.e. under the auspices of an IMF program, must allow European oversight of their future budgeting process or face being cut off. This group now includes only Greece, Ireland, and Portugal. Italy and Spain will not be included due to the hint from Sarkozy in which he pointed to Greece specifically.
- All countries, however, will agree to allow European oversight of their future budgeting process or face being cut off if they are forced to request community aid under this bilateral agreement. That means that Italy and Spain would effectively be in the same boat as Greece, Portugal and Ireland because they will definitely seek aid if interest rates remain at their present elevated level.
- Since even Juergen Stark has intimated that ECB liquidity could be on offer under the right circumstances i.e. “only when important steps toward political union are made can we have common bonds,” the ECB would get a green light after the bilateral agreements to provide unlimited liquidity until eurobonds are issued.
Here’s the structure I said one year ago “will not be considered a legitimate political option until all other more superficial remedies have failed.”
Euro bonds would be a supranational debt instrument backed by the collective taxing authority of euro zone sovereign governments. As such, it would represent a blended debt structure on the same ‘level’ as the ECB more akin to what we see in other sovereign countries like the UK, the US or Canada.
In practice, you could have sovereigns conduct a ‘sovereign debt swap’ whereby the ECB buys an agreed-upon portion of the existing debt from the sovereigns and then uses these funds to back the supranational debt. In future, the same agreed upon percentage of debt would be issued at the supranational level. Clearly, you have to have all euro zone members commit in equal measure or the benefits would not accrue to the periphery.
-Eurobonds are a potential facet of European sovereign debt monetisation, Nov. 2010
Under this outline, at some point down the line, the ECB would buy an equal percentage of the outstanding debt of each euro member state that acceded to the bilateral agreements in order to qualify as not helping governments finance their debts. An equivalent sum of bonds for which the bilateral agreement countries are joint and severally liable would be issued in the original bonds’ stead. These bonds would then receive an implicit backstop from the ECB. Notice that the ECB has not increased base money. Rather it has affected an asset swap. Moreover, by only buying only part of the outstanding debt and in proportionality, the ECB can claim that it has not acted in a quasi-fiscal manner since the national governments are still exposed to market rates on their other outstanding bond indebtedness, which would compel them to make fiscal cuts.
Clearly, the Mosler/Pilkington understanding of the IMF proposal is along the same lines, with the IMF acting as “lender of last resort” and the ECB being the one writing the check.
I believe this is the kind of action that European leaders are preparing for now. As this policy takes shape, the Europeans will move to institutionalise it in their treaty arrangements including specific language that allows for an euro zone exit path. The Great Dither is now officially over.