Europe is Closer to Resolving the Eurozone Crisis...with an Outline of a Plan

“I’ve said it before and I’ll say it again, this is a marathon not a sprint”. Thus spoke Jose Manuel Barroso, European Commission president, after unveiling the latest rescue package designed to solve the euro crisis once and for all. Yet the fact that the details of the rescue package were agreed upon after the general summit during an all-nighter of fraught negotiations paints a picture of prevarication, uncertainty and lack of political leadership which evokes harrowing memories of the US’s responsible politicians engaging in political brinkmanship over the debt ceiling this summer. 

Last night’s plan is comprehensive in many respects, perhaps more so than previous plans have been, such as the one agreed last July. The fact that shares in European markets rose when news of the deal emerged is reassuring and helped assuage fears that eurozone leaders had fudged the task yet again.  It touches upon the three main points that I deemed essential for resolving the crisis in my last article, namely imposing a significant haircut on private holders of Greek debt, adding to the European Financial Stability Facility’s (EFSF) firepower and recapitalising European banks which are severely exposed to Greek debt. Banks holding Greek debt have accepted a 50% loss which should cut Greece’s debt from a projected 180% to 120%; this is close to Italy’s level and thus should prove more manageable. The EFSF will see its firepower boosted to about €1tn from its present paltry €440bn, with the current remaining €250bn leveraged around 4-5 times. There are two main options for achieving this. One entails the EFSF acting as an insurer on eurozone members’ debt so as to lower borrowing costs for countries in trouble, such as Italy and Spain. The alternative is to set up a special investment vehicle which could receive contributions from big public and private investors (notably China). However, the details have not yet been finalised so it is unclear where exactly this money will be coming from for now. Finally, banks have been asked to raise €106bn in new capital by June 2012 so as to protect them from any ensuing losses from government defaults and to protect larger economies such as Italy and Spain from market jitters. Again, how the banks are expected to raise this amount of capital is left unclear.

The package can therefore be said to have achieved one of its principal aims, namely to buy the eurozone precious time so that Greece may concentrate on fixing its finances and countries like Italy and Spain can implement structural reforms to avoid being sucked into the quicksand. To claim that the dilemmas lurking over the Eurozone have been solved though is flippant at best. Alen Mattich, writing for the Wall Street Journal, claims that Europe’s latest generation of politicians have been trying to build a pig out of sausage as they wrestle with half-measures rather than having a fundamental rethink of the project itself. He believes that unless the European Central Bank (ECB) takes on a prominent role in the solution, politicians will simply stumble from eurofudge to eurofudge. The ECB is the only institution with the wherewithal to shore up Europe’s banks and countries such as Italy and Spain which need to refinance their debt as they work towards rectifying their crooked finances. It can do this directly or indirectly by giving the EFSF access to its mighty “printing presses”, but the intransigence of its previous president, Jean-Claude Trichet, seems likely to persist as the new incumbent, Mario Draghi warns that it is up to European countries to solve the debt crisis. Yet even Mattich states that the ECB’s role is merely a stopgap for much deeper problems which have stalked the eurozone since its inception.

Gavin Hewitt, writing for the BBC, does not cast doubt on the ambition of the European leaders to extract themselves from the mess that is the eurozone, but is wary of the technical details of the plan which are yet to be unveiled. The Greek haircut is all very well but even a 50% write down looks rather paltry if one takes into account that its economy is shrinking fast and years of austerity loom, hardly a prognosis for growth. Furthermore, a public debt to GDP ratio of 120% is still regarded as twice what is deemed to be economically healthy, let alone when the economy is seemingly contracting inexorably. With regards to the EFSF, many experts regard €1tn as too little to protect bigger economies like Italy and Spain should they run into trouble. The technical details have been left vague yet they are crucial in determining whether the EFSF really will be strengthened this much. Furthermore, it may pass the test by lowering their borrowing costs, but does not even come close to tackling the underlying problem of growth. Uncertainty also looms over how Europe’s banks will raise the amount of capital that has been required of them, with many suggesting that national governments will have to step in entailing what is effectively another bailout.

The fundamental problem, however, remains growth, and this latest package does precious little to tackle it. It is intended to provide breathing space for Europe’s leaders as they attempt to find another plan to kick start growth, but it remains unclear to me how they are supposed to do this if they cannot even finalise the technical details of the interim plan. Jose Manuel Barroso ought to stop his political grandstanding by announcing bullishly that “Europe is closer to resolving its financial and economic crisis and to getting back on a path of growth”. Europe will not resolve its financial and economic crisis until it gets back on a path of growth; however it will not get back on a path of growth until it resolves the financial and economic crisis. The 50^th anniversary of Joseph Heller’s Catch-22 is ironically pertinent when it comes to the euro crisis.

The Euro: What to Do?

Yet another summit, yet another vague plan. France’s finance minister Francois Baroin said the EU summit due to be held later this month will agree “decisive” measures to tackle the crisis that is engulfing the euro zone. “Decisive” however, does not seem like the right word to use after European politicians delayed the disbursement of the next €8bn tranche of the rescue package for Greece until November, thereby disseminating even more uncertainty in the markets. Furthermore, all the public talk about a possible further restructuring of Greek debt has done precious little to soothe investors’ frazzled nerves.

The decision to postpone the next disbursement of money is the least of problems however, and was probably taken in an attempt to push Athens into further reforms as there are no big bond payments due in the next weeks. The medium and long-term decisions are the ones that European leaders are proving unbelievably loath to take, such as agreeing on a partial write-down of Greece’s debts, recapitalising European banks and bolstering the European Financial Stability Facility (EFSF). Yet everyone seems in agreement that the more European leaders prevaricate, the more entrenched and harder to resolve the crisis becomes.

Most experts agree that some kind of haircut on Greek bonds is necessary, as long as it is combined with bank recapitalisation and a significant increase in the size of the EFSF. In July, European leaders had suggested a voluntary debt restructuring on the part of private banks coupled with fresh inflows of official money, but both The Economist and Martin Wolf from the Financial Times argue that the deal fell short of helping Greece whilst providing excessive relief to the banks. Raoul Ruparel of Open Europe, a think tank, claims that around 50% of Greek debt ought to be restructured and that European banks ought to be able to weather the ensuing storm thanks to a recapitalisation program through the EFSF. However, the European Central Bank (ECB) has long been adamantly opposed to any form of write-down which also raises implications for how exactly the EFSF would be able to build a firewall around endangered economies Italy and Spain without ECB funding. Gavyn Davies, writing on the Financial Times, explains that in order for Greece to reach an ambitious debt target of 80% of GDP by 2016, the rescue package would have to amount to €200bn. A 50% haircut on Greek debt that is held in private hands and which currently amounts to €240bn would thus raise €120bn, which still leaves a hole of €80bn. Furthermore, it is highly unlikely that the 50% haircut could be implemented voluntarily, thus raising the spectre of a technical default which is anathema to the ECB.

A corollary of the debt write-down is the problem of banking liquidity (or lack of it). Martin Wolf explains that the debt overhang impairs both solvency and liquidity in the banking sector, and proposes financing through capital injections and central bank support as the solution. However, as Gavyn Davies rightly points out, the amount of recapitalisation needed depends on the size of the write-downs on Greek debt and on the market’s expectations of possible future write-downs on other sovereign debt because of a loss of confidence. This is why it is absolutely vital to protect Italy and Spain from being engulfed in the crisis by putting Europe’s banking sector on sound footing. George Magnus, a senior economic adviser at UBS Investment Bank, believes that the ECB ought to be prepared to stand by and buy any amount of Spanish and Italian bonds to prevent banking contagion.

Unfortunately, the need to build a firewall around Italy and Spain entails a bolstering of the EFSF, which at its current €440bn capacity, is insufficient to ring-fence the crisis. Policy-makers have been bending over backwards to get around the ECB’s unwillingness to buy struggling economies’ bonds and to lend to the EFSF, touting various ideas which involve borrowing from public institutions that already have a banking license and that therefore have access to ECB funding. Another option would be for the EFSF to guarantee the first 20% loss on any new bonds issued by ailing countries; it would be able to implement this without requiring money from the ECB but the prospect of a bank recapitalisation will sharply deplete its reserves rendering this harder. Gavyn Davies argues that the EFSF however could use its remaining capital, estimated at €200bn after various rescue packages and possible recapitalisation programmes, to insure about €1000bn bond purchases in Spain and Italy which would cover their bond issuances for the next three years. This would soothe markets’ nerves and more importantly, buy European leaders a window frame in which they could tackle the euro zone’s underlying problems, namely lack of competitiveness and growth in the periphery countries.

Fostering growth in Greece and its neighbours is a daunting task, to say the least. Yet without growth the debt burden will linger on, as Vicky Pryce, senior managing director of economics at FTI Consulting, has said. The fiscal austerity to which Europeans have been adhering so zealously is only one side of the coin and does not solve the structural problems that affect the Mediterranean countries. One need only to look at the ominous slashing of growth forecasts in the United Kingdom, which has embarked on an audacious deficit reduction programme, to see how austerity can tighten the tap of an economy reducing it to a mere trickle. Christopher Smallwood, writing for Lombard Street Research, claims that the Club Med will restore competitiveness by falling wages and mass layoffs, both of which are likely to have extremely painful repercussions. External financing may mitigate the shock but will also have the corollary effect of slowing down the adjustment process. Furthermore, Martin Wolf points out that if external deficits are to fall in Greece and its neighbours, then surpluses must fall in other countries, notably Germany. Yet discussion on this aspect has been conspicuously absent. The quagmire in which the euro zone finds itself then, is only the beginning of a very long and tortuous process to address the fundamental imbalances within it which were disastrously overlooked in its inception.