News and events
David Llewellyn on the Euro crisis: Can the circle be squared?
2 August 2012
The markets remain, at best, hesitant about Spanish and Italian sovereign debt and at times in recent weeks yields have risen to unsustainable levels of around 7 percent. Everyone of importance in euro decision-making circles has been making public statements of support. The most significant was the commitment of ECB President Mario Draghi who, at a conference in London, said “within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”. This had the effect of calming the markets. But we have yet to see the beef! The qualification “within our mandate” can, of course, be broadly or narrowly defined. The President seems to mean that intervention can be made if market conditions hamper the normal conduct of monetary policy.
THE STAKES ARE HIGH
The stakes are exceptionally high now because the markets are conscious that past measures have not worked, market expectations of action are high, and if credible action is not taken to stabilise Spanish and Italian bond yields they will again rise to unsustainable levels which would likely force requests for formal “bail outs”. This would raise a question about the available resources to support two large economies, and whether the principal “donor” countries (Germany, Netherlands, and Finland) would be prepared to commit to substantial support operations. Furthermore, in several countries (particularly “donor” countries) public opinion is moving steadily against the euro. For all these reasons, and the sustainability of the euro in its current form, decisive action is needed and all eyes will be on the meeting of the ECB Governing Council today (Thursday, 2nd August).
I have always argued that the problem is at two levels: an immediate crisis management problem which needs to be addressed with urgency, and correction of structural fault-lines in the euro project. Without addressing the latter for the medium term, emergency support operations in the short term will, as in the past, have only a small and short-lived impact on markets. Without fundamental structural reform (such as the creation of a credible banking union, a rescheduling of some sovereign and bank debt, a further realistic re-capitalisation of some banks, substantially increased fiscal integration, some form of debt mutualisation, and necessary structural reforms to enhance competitiveness) the euro will be subject to periodic crises with ever greater frequency. The commitments made at the recent Summit will not be enough to deal with the structural problems.
The immediate priority is to stabilise financial markets, stabilise and lower sovereign bond yields of Spain and Italy on a sustainable basis, and break the symbiotic link between banks and governments that arises through sovereign bond markets. Only the ECB currently has the resources to do this. Three elements of crisis-management strategy are needed: (1) substantial intervention by the ECB in the relevant bond markets even though Germany is at best hesitant about this, (2) a massive increase in the support facilities of the ESM (which does not come into effect until September) and the EFSF, and (3) an easing of the many austerity programmes around Europe in order to avoid what will otherwise become a perverse Austerity Trap. With respect to the size of support facilities, a point of perspective is that, as it currently stands, the ESM will have resources of around €500 billion whereas the size of government bond markets in Italy and Spain is around €2,000 billion and €800 billion respectively.
If that is the broad strategy, what are the techniques? There are seven broad options available: a re-activation of sovereign bond purchases by the ECB via its currently dormant Securities Management Programme; the granting of a banking licence to the ESM so that it could borrow from the ECB in order to support banks and governments; a further round of LTRO; an easing of collateral requirements; and credit-easing measures such as those being introduced in the UK. In addition, the ECB has two potential interest rate weapons: a further cut in its basic interest rate; and posting a negative interest rate on bank deposits held at the ECB with a view to creating incentives for banks to increase lending. Some scepticism is warranted about the impact of the latter: if, for whatever reason, banks are reluctant to lend they will simply find alternative “safe-havens” to park their excess liquidity.
PROBLEMS FOR EVERY SOLUTION
None of these options are without their technical or political problems. For instance, ECB bond purchases could have the perverse effect of reducing private demand if the ECB retains priority status which would raise the risk attached to private holdings of debt. At the political level, the usual issue arises about who absorbs the risk and what the liability to taxpayers in “donor” countries would be. Political developments in some countries are also moving against decisive action. Anti-euro sentiment is increasing in some countries with a recent poll in Germany indicating just under 50 per cent of the population supporting the single currency. Furthermore, a recent report from an influential German research institute has suggested that, while the costs of a Greek exist from the euro would be substantial for the German economy and tax-payers, the costs of further support would be even greater. Even senior politicians in Germany have begun to make ominous statements.
SQUARING THE CIRCLE
So much for the technical options that are available. The key issue is whether all or any of them will have the support of governments at the political level (notably Germany, of course) and also the Bundesbank. The Bundesbank in particular is against further bond purchases and granting a banking licence to the ESM as it sees this as an indirect way of the ECB being engaged in monetary financing of budget deficits which is against EU law. Furthermore, the argument is that both measures create a moral hazard by reducing the pressure on governments to exercise fiscal discipline. On the other hand, Chancellor Merkel seems to be softening a little even in the face of political pressure to maintain a hard line.
So how is the circle to be squared: the need for urgent crisis management measures in the face of resistance from some important “donor” countries? This is where the second element of the Euro crisis comes in: the structural fault-lines. It seems that the only way to square the circle is for the short-term crisis management measures to be conducted within a more credible and enforceable commitment to correcting the structural fault-lines in the Euro model.
If nothing of substance emerges today, the crisis will intensify and the costs will be high.