What’s at stake: The European finance ministers were meeting yesterday in Brussels. Some ministers are pushing to increase the bailout fund and others are arguing for "E-bonds" – joint European government bonds. But Germany rejected both suggestions. For weeks, European leaders have tried, and failed, to restore calm. Existential questions about the euro have resurfaced. A radical solution is now needed to put the genie back into the bottle.
A contagious disease
Daniel Gros argues in VoxEU that the ESM seniority creates a vicious cycle. More than just the punitive interest rates, the seemingly innocuous provision of the European Stability Mechanism (ESM) to make future official financing senior to private creditors leads to the paradoxical situation where large financing packages push up long-term government bond interest rates and hence increase the risk of default. The ever larger resources available for bailouts could be taken as a signal that an ever greater share of eventual losses will be shifted to long-term government bonds. FT Alphaville has more on this issue.
Jacob Funk Kirkegaard argues that the issue is not so much whether the EU policymakers can contain contagion or even have the will to do so in extremis. Rather the issue is which policy tools to rely on and who should take action – the ECB or eurozone governments.
Kevin O'Rourke argues that the contagion argument has lost all validity at this stage, since contagion has already happened anyway. At the start of last week, it was, for example, possible to make the argument that ‘burning the bondholders’ was irresponsible, since it would inevitably lead to contagion and the spread of the crisis to Iberia. Now that that contagion happened, leaders should just consider all possible options.
Beefing up the EFSF
In his project syndicate column, Daniel Gros argues that when the EFSF was created, it was assumed that the only problem was to ensure financing for the government deficits of the four prospective problem countries (Portugal, Ireland, Greece, and Spain). From this perspective, the headline figure of €750 billion allocated to the EFSF looked adequate. But the EFSF’s founders did not take into account banks’ enormous short-term liabilities, which in a crisis effectively become government debt, as Ireland has been the most recent to demonstrate. The EFSF might be just enough to guarantee the public debt of the four problem countries, but certainly not their banking sectors’ liabilities as well.
Segregating Financial and Sovereign Debt
Barry Eichengreen argues that a bright red line should have been drawn between the third of Irish government debt that guarantees the obligations of the banks, on the one hand, and the rest of the government’s debt, on the other. The third representing the debts of the Irish banking system could have been restructured. If European policymakers were afraid of the impact this restructuring could have had on European banks, the appropriate response would have to properly capitalise the French, German, and British banking systems so that they can withstand the inevitable Irish restructuring. Irish public debt would then have topped out at maybe 100% of GDP. And the Irish programme would have had a hope of working.
Edwin Truman notes that given how integrated the European economy is in real terms, trade terms and economic terms, as well as financially, these things will have huge knockout effects. You need to manage the process of write-down. You need to have an overall plan for how you’re going to apply the write-downs and how you’re going to support the economies and the financial systems – of Greece, Ireland, Portugal, Germany, and France and Italy and Belgium and The Netherlands – subject to the backlash effect of the write-downs.
Opening restructuring talks
Daniel Gros argues that Eurozone nations should simultaneously open restructuring talks while continuing to service their debts normally. A sudden collective default would, of course, constitute a "mega Lehman" and would have catastrophic consequences. However, it is entirely possible for the countries in question to make investors an exchange offer while continuing to service their payment obligations. There should thus be no technical default, but simply an offer to bondholders to engage in discussions about debt restructuring accompanied by a concrete exchange offer. All countries should thus move at the same time, but every country has different problems and would make a different offer to creditors. Germany, France and other core Eurozone nations would have to stand ready to recapitalise the banks most exposed to the restructured debt. The ECB would then stabilise the banking system and the EFSF would stabilise sovereign debt.
Jean Claude Juncker and Giulio Tremonti have proposed the issuance of E-bonds by a European Debt Agency (EDA) in a way that shows very similar features to the Brady program of the 1980s; exchanging domestic debt trading at distressed levels for a new security, achieving a deep haircut and boosting both confidence and liquidity. The switch between national and European bonds is the built-in default mechanism. The EDA could offer countries in trouble the possibility to switch national bonds for E-bonds at a discount, whose size depends on the degree of market stress. That would overcome the problem that secondary markets in many EU sovereign bonds are not sufficiently liquid during crises. Eurointelligence argues that this is probably the single most important proposal ever made since the outbreak of the European sovereign debt crisis.
Stephanie Flanders argues that it is not clear how the proposal would "halt the disruption of sovereign bond markets". Or at least, not until we know the precise terms under which such a market would operate – or the obligations that it would impose on governments. This would provide welcome liquidity to institutional investors who are stuck holding peripheral bonds they can't get rid of. But the conversion would also crystallise their losses. It's not obvious that they would be any keener to buy more Spanish or Greek debt in the future than they are today. And as Germany pointed out, it is not clear how you could possibly create a bond market for which all European Union member countries were responsible, without changing the treaties on which the single currency is based.
SMPing big time
Although the ECB didn’t give any indication during its press conference last week that it could take more radical action or revise substantially its Securities Markets Programme (SMP), ECB support for struggling sovereigns is at its highest since July. Data just released show that €1,965m bonds bought by the European Central Bank settled last week.
Gavyn Davies argues that if the ECB is really serious about ending this crisis, it could announce a large extension of the Securities Markets Programme. If this were used mainly to buy Portuguese and Spanish government debt in advance of these countries facing intolerable pressure from the bond markets, it might just work. Mr Trichet would love to squeeze the “speculators”, just as he did when defending the franc in 1993. From the ECB’s point of view, the problem with the SMP is that it involves tacit support for government funding programmes, which they view as near to a breach of their legal authority. There would also be issues in deciding how to divide this communal eurozone support operation among the several member states in need of assistance.
Jean Claude Trichet explained in an interview following the ECB press conference that it is also possible for an individual central bank in the euro zone to decide to purchase assets in its country outside the Securities Markets Programme. All central banks have their own funds, and they are investing their own funds. We have the general agreement, to be sure, that this is fully compatible with the monetary policy of the euro area. This is an agreed principle since the setting up of the euro.
Guido Tabellini argues that the implicit assurance that we can count on the central bank under extreme conditions is what makes the system stable. The experience of crises in emerging economies shows us that in a situation of systemic crisis, market confidence can be regained only if there is an assurance that the central bank is prepared to support the government bonds of a country under attack. This means we must suspend the separation of fiscal and monetary policy, one of the pillars on which the European Monetary Union was built. If European authorities are not willing to take this step, the contagion will spread. For a diametrically opposed view, see Wyplosz.
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