By Andreas Kern
While problems have been evident from the outset of the Global Financial Crises, the Eurozone and European Union have revealed their true Achilles’ Heels during the last couple of weeks.
On the one hand, drowning economies such as Greece, Portugal, Spain, Italy and Ireland have come under immense domestic political and economic pressure, due to existing severe macroeconomic imbalances and lack of macroeconomic policy integration in the Eurozone. Even after having implemented far-reaching and drastic austerity measures, economic recovery – and thus an easing of budgetary pressures – are not likely to happen in these economies any time soon. On the other hand, although market expectations towards ‘a new bailout framework’ at the European Financial Stability Facility (EFSF), have geared up during the last weeks, the political side of the European Union has thus far put the breaks on delivering on these expectations. Although under immense pressure to deliver results and a strong commitment to rescue the Eurozone, European policy makers have been struggling to agree on the measures and instruments of how to rescue the Eurozone.
After a long weekend of talks and debates, European political leaders seem far more concerned with domestic political concerns than delivering sustainable solutions. The political behavior of Germany and France is understandable against the background of current domestic economic and political constellations. Aside from German attempts to ease the pain of shouldering this bailout on its own, the main motive behind German economic policy making has been the rescue of the ECB’s independence and the credibility of economic policy making in the Eurozone and the European Union. However, this does not seem to align with the French position, which can be described by two words: “anything goes”.
Germany has successfully banned the ideas of Eurobonds and equipping the EFSF with a bank license, in effect turning it into the ”money-printing workhorse” of European governments. The current “grand solution” and the resulting financial euphoria can be expected to be short-lived. To date, three new policy programs – representing the lowest feasible political denominator for all EU countries – can be found on the table in Brussels.
First, it seems that political tensions along with the ongoing economic recession in Greece have convinced European policy makers to force private debt holders to cut back on their respective debt positions to put the country back on track. In this respect, European leaders have managed a break-through on a 50 per cent “hair-cut” of outstanding Greek public debt.
Second, banks will have not only to shoulder the burden of the Greek haircut but also raise additional capital buffers of up to 9 percent by June 2012 to weather a potential new financial storm. This implies that banks will need to raise additional funds in international financial markets, potentially entering a fierce competition with sovereign borrowers for international savings. The EU-IMF multi-annual program providing banks access to 100 Billion Euros in order to smooth this rescheduling cannot be expected to indefinitely prevent a ‘Lehman Moment’ in Europe. Given the high elasticities in the financial industry and the potential for contagious effects in the European banking system, these recapitalization efforts will be neither enough to secure the stability of the banking system nor calm market sentiments for very long. For this reason, this solution implicitly relies on the assumption that the ECB does not shut its open market window for banks any time soon and thus provides unlimited amounts of liquidity to the banking system. Nevertheless, it can be expected that bank balance sheets might suffer from this forced rescheduling, limiting banks’ ability to expand on the liability side and create capital for credit growth. Assuming that private credit is required for investment spurred economic growth, the financial market status quo cannot be expected to work the miracle of an economic recovery any time soon. However, such a positive economic outlook and enhanced investment activity would be needed not only to calm investor sentiments, but also to ease existing budgetary pressures and thus reduce the risk of sovereign defaults.
Third, concentrating on the sovereign default risk aspect in the Eurozone, European policy makers have agreed on enhancing the effectiveness of the main bailout mechanism, the EFSF. Regarding its structure, the ‘new’ EFSF solution on the table is a debt default insurance mechanism, where its envisaged budget of 440 Billion Euros has been “beefed up” to, at least one trillion Euros. This optimization of the resources can be achieved theoretically through two mechanisms, which rely on leveraging a “not yet existing” asset base.
In first instance, European policy makers are trying to attract funds from national governments and international investors outside the EU (i.e. China, Norway) to ‘pump up’ the EFSF and bailout defaulting governments. Although taking in international investors can be expected to deliver some relief on European budgetary positions and also partially wash out the underlying nature of this new fiscal transfer mechanism, it will certainly not be a free lunch. Besides sending out a devastating signal on the overall economic capacity of the EU and the inability of Eurozone member countries to handle the crisis, the involvement of China and other emerging market economies can be anticipated to lead to a reshuffling of international political standing, weakening Europe’s international bargaining position.
However, at its core, extending guarantees for new government debt is basically akin to repackaging different risk classes of government debt. In other words, these mechanisms can be regarded as bundling toxic assets and spreading them all over international bank and financial balance sheets. Although insurance mechanisms are appealing, the critical question is whether European sovereign default risks can be pooled at all. Given intensive financial, banking and trade links among Eurozone member countries this can hardly be achieved. As accumulated macroeconomic imbalances in the Eurozone have primarily been financed via financial flows from debt guaranteeing economies (i.e. creditor countries such as Germany), also representing the backbone of the EFSF, a sovereign default in a debtor country is expected to require additional bank bailouts in creditor countries. Given the fact that the EFSF is build upon guarantees and non yet existing deposits provided by creditor countries, the whole mechanism might break down in the event of an emergency. Thus, the EFSF might be better regarded as the ‘European Toxic Asset Facility’ rather than a credible bailout mechanism.
Against this background, perhaps the most overlooked, but most decisive actor is the ECB. As German active involvement in the EFSF declines, the ECB will have to shoulder the burden of sovereign defaults and resulting potential banking crises. As the designated President of the ECB, Mario Draghi recently noted the ECB will continue its path of unconventional monetary policies, purchasing government bonds, and bolstering banks with unlimited liquidity in order to dampen market tensions. An ECB backstop makes the EFSF’s nature and design irrelevant for market outcomes and confined principally to disguising the ECB’s true role as lender of last resort in case of an emergency. From my perspective, I conclude that although it has been under immense pressure, the Eurozone will weather this crisis.
Established in 1995, the Georgetown Public Policy Review is the McCourt School of Public Policy’s nonpartisan, graduate student-run publication. Our mission is to provide an outlet for innovative new thinkers and established policymakers to offer perspectives on the politics and policies that shape our nation and our world.