Dealing with European sovereigns in trouble

What’s at stake: There has been over the last couple of weeks a series of comments suggesting that there could be some kind of assistance organised for Greece. The first instance of panic on intra EMU spread last year has been solved by massive ECB liquidity operations and an extension of the collateral list. As the ECB slowly withdraws and returns to its core monetary policy mandate, an alternative solution needs to be found and this means the ECB is passing on the burden to fiscal authorities (i.e. Member States and the Commission). The no bail out clause theoretically prevents member states to explicitly take on the Greek debt but nothing prevents a solidarity mechanism to be created. There however needs to be a body enforcing more fiscal consolidation and this will hardly be the EU as its record is relatively poor.

Wolfgang Munchau says that the Greek crisis was started and fuelled by European leaders in what now looks like a very uncooperative and uncoordinated way of demanding fiscal consolidation. The ECB has also played an important role in signalling repeatedly (Weber, Trichet and even doves like Nowotny) that it would not twist its collateral eligibility criteria to suit one particular member state.

Simon Johnson says the Abu Dhabi-Dubai affair shows where Greece is heading. The global funding environment will remain easy for the foreseeable future.  This makes it very easy and appealing for a deep pocketed friend and ally (Abu Dhabi; the eurozone) to provide a financial lifeline as appropriate (a loan; continued access to the “repo window” at the ECB). Of course, there will be some conditions. But, in reality, there are many voices at the ECB table and most of them are inclined to give Greece a deal – put in place a plausible “medium-term framework” and we’ll let your banks roll over their borrowing at the ECB, even if Greek government debt (i.e., their collateral) is downgraded below the supposedly minimum level. So Greece has a carrot and a stick – and refinancing its debt is so cheap in today’s Bernanke-world, they will not miss the opportunity.  The important development is the role of the European Central Bank.  It is becoming a de facto International Monetary Fund (IMF), but just for the eurozone (or is that the European Union?).  It will lend a troubled country money, but only if the government does some of the hard fiscal work.  The IMF may have a role to play in budget advice and assessment for Greece, but it may also be squeezed out of a meaningful policy role.

Paul De Grauwe says that Eurozone governments should make clear where they stand on this issue. Not doing so implies that each time one member country gets into financial problems the future of the system is put into doubt. De Grauwe argues that the other Eurozone governments are very likely to bail out Greece out of pure self-interest because a significant part of Greek bonds are held by financial institutions in Eurozone countries and a failure to bail out Greece would trigger contagious effects in sovereign bond markets of the Eurozone. It is sometimes said that bail-outs in the Eurozone are illegal because the Treaty says so (see Wyplosz 2009 on this). But this is a misreading of the Treaty. The no-bail-out clause only says that the EU shall not be liable for the debt of governments, i.e. the governments of the Union cannot be forced to bail out a member state. But this does not exclude that the governments of the EU freely decide to provide financial assistance to one of the member states. In fact this is explicitly laid down in Article 100, section 2.

Sebastian Dullien and Daniela Schwarzer argued last February that the no-bail-out clause has no relevance in the current crisis and EU member states would bail out a EMU member with solvency or liquidity problems. The question is not only which instruments could be used to raise money (for instance a Eurobond), but also which legal base could apply. Although the financial assistance granted to EU but non EMU members (Hungary, Latvia, Romania…) would be hard to extend legally to EMU members, there are a couple of avenues to support a member. Article 100 TEC, section 2 could, for instance, be used as a legal base:  “Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by […] exceptional occurrences beyond its control”. While inapplicable to EMU members, the balance of payment assistance facility has established the legal and practical foundation for the issuance of the first Eurobonds.

Sebastian Dullien and Daniela Schwarzer argue in a recent post that there is a danger that market reactions drive Greece into sovereign default, if politics does not succeed to construct a clear link between a bail-out promise and very clear conditionality (in terms of reforms expected from Greece). In order to calm market reactions and especially prevent contagion, they argue that the EU should immediately set-out conditionality under which countries would get rescue packages. One condition could be that the national budget would have to be approved by the European Commission and the member states, for instance in the Eurogroup.

The ECB has released a particularly timely article in its ECB legal paper series on “Withdrawal and expulsion from the EU and EMU”. The author argues that a unilateral withdrawal from EMU would force a withdrawal from the EU but that an expulsion through legal means appears next to impossible but he reckons that the use of the euro might still be possible by the departing country, although without the rights and privileges associated with full EMU membership. The use of the euro could be de facto or consensual (cases like Monaco, the Vatican…).

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