Unsinkable like the Titanic

Nearly a century after the 10 April 1912 departure of the Titanic from Southampton to New York, only to sink a few days later, the informal ECOFIN and Eurogroup meetings will take place on 8/9 April 2011 in the beautiful Royal Palace of Gödöllő, Hungary. In April 1912 there were repeated iceberg warnings and Captain Smith of Titanic slightly altered his course southwards. But the sudden collision with an iceberg on a dark night sank the liner in a few hours, even though the vessel had been thought of as unsinkable.

The Gödöllő meeting of finance ministers is not expected to be followed by a sinking, specifically by the sinking of the euro area. But there are important warnings that should be taken very seriously. I list three of them.

First, two rating agencies, Standard and Poor’s, and Fitch, concluded that the recent agreement on the European Stability Mechanism (ESM), which will be Europe’s own ‘European Monetary Fund’ from mid-2013, will actually make the current crisis worse. According to political declarations on the design of the ESM, no sovereign default will occur before mid-2013; sovereign defaults might occur thereafter, but only concerning bonds issues after mid-2013.

But this dichotomy is inconsistent. Whenever a country has a solvency problem, it will not be able to borrow from the markets as the newly issued bonds will have a junior status compared to existing bonds. With the lack of market borrowing, countries with doubts over their fiscal sustainability should either borrow from the ESM (or during the next two years, from its predecessors, the EFSF and EFSM – so many complicated acronyms), or default/restructure.

Greece and Ireland already have official financing programmes which will transfer about one third of their debt to official creditors. It is unlikely that the German, Dutch or Finnish electorates, for example, would be happy to agree to a new financing programme for these countries on the expiry of their current programmes in 2013. Unanimity will be needed for an ESM programme, and the lack of it will most likely block this. And while economic situations may change by 2013, a new programme would most likely be undesirable on economic grounds as well.

Therefore, in the absence of a new programme, default must come, but as there will be no newly issued debt, default will apply to existing debt despite current declarations. Even though among the three threatened countries, Greece, Ireland and Portugal, only Greece has a fundamentally unsustainable situation in my assessment, the uncertainties about their fiscal sustainability and eventual ESM lending may push the other two countries to the brink as well.

Second, Der Spiegel reported the IMF as demanding Greek debt restructuring, though this was strongly denied by the IMF’s spokeswoman. Certainly, it is not possible to know for sure what goes on backstage at the IMF. But this can be an indication that the stance is changing at the IMF and indeed there are good reasons for a restructuring of Greek public debt. The major arguments against a restructuring are that it could have an unexpected impact on Greece (clearly: it’ll be a messy process), it could spill over to other countries, and thereby it could impact the euro-area banking industry, which is thought to be fragile. But if something is unsustainable, then the choice is more one of timing. An earlier default could bring clarity, while a later default may occur at a time when the euro-area banking industry might be stronger.

A third worrying factor is related to expected euro-area interest rate developments. The rise in euro-area inflation expectations will make it inevitable for the ECB to start a series of interest rate hikes in April 2011. The ECB will be right to do this, even though the critics are legion. In the euro area's flawed governance framework, the ECB remained almost the only institution that more or less maintained its credibility. Giving up its anti-inflationary mandate, as many suggest, would undermine this last pillar of the euro, and in any case, solving the euro-area debt crisis should not be the job of the central bank. The ECB has already stretched the limits of its mandate by purchasing Greek, Irish and Portuguese bonds and by giving euro-area banks, in particular Irish and Greek banks, a lifeline. But it should not compromise its monetary policy credibility. Clearly, a rise in short term interest rates will feed through to long-term interest rates and will make it more difficult for all euro-area governments, including the most troubled ones, to regain control over public finances.

To avoid the fate of Titanic, the Eurogroup and ECOFIN should pay proper attention to these warnings. The conclusion is that they should concentrate on solving the current crisis. They should not mix sovereign solvency and liquidity crises as it may drive purely liquidity-constrained countries into insolvency. But it is clearly not sufficient in itself to push Greece into debt restructuring. Prior to that, the systemic interdependence between banking and sovereign crises should be addressed, for which proper stress tests and bank recapitalisation are needed across the whole euro area. A better way of managing distressed cross-border banks is also required. Unfortunately, such decisions are not likely to be reached in Gödöllő, partly because such moves are costly in terms of votes and money, and partly because the iceberg might be avoided for now. But note that Captain Smith was also confident of this in April 1912.