At their meeting last week, European leaders agreed again to “do whatever is necessary to ensure the financial stability of the euro area as a whole”. But they did not say how. Even if Wednesday’s vote in Greece’s parliament averts an immediate crisis, they would be well advised to make use of the long European summer season to turn this unspecified commitment into an action plan. Here are some modest suggestions for their holiday homework:
1. Complete the banking sector clean-up. Financial fragility is heightened by the still-unfinished recapitalisation of the weaker banks. Two years after the US successfully completed its stress tests, Europe is still struggling. The publication of new tests, expected in July, offers a chance to aggressively restore the soundness of banks across Europe. This may cost public money and political capital, but no political expediency can justify missing the opportunity.
2. Explore options to address insolvency. Last week, the German proposal for a compulsory rescheduling of Greek debt was rejected. But to pretend that an insolvent country will repay its debt is no strategy. There are only two economically consistent options. One, call it Plan A, is to socialise the Greek debt. It requires lowering the interest rate on official assistance to a level that makes Greece solvent and deciding who, if needed, will bear the corresponding cost – either the banks, through a special levy or, by default, the ordinary taxpayers. Plan B is to make private creditors pay through an orderly restructuring. To make it a viable option, preparations must be undertaken, not least by the ECB, so that when restructuring takes place its financial fallout can be contained. Each plan is anathema to some of the leaders, but one will eventually have to be chosen. The Europeans should make use of the time they have bought to evaluate their implications and choose a strategy.
3. Make better use of the crisis management facility. The recently created European Financial Stability Facility (EFSF) and its successor the European Stability Mechanism (ESM) are potentially powerful instruments to preserve financial stability. But lack of trust and domestic politics have led to attaching too many strings to their use. As they stand they can neither serve to prevent a crisis through precautionary lending nor to resolve it by serving as a backstop to debt restructuring. This is a waste of scarce resources. The EFSF/ESM should be turned into a more flexible instrument to help preserve financial stability.
4. Devise an adjustment and growth strategy for southern Europe. Fiscal consolidation is of paramount importance but ultimately, what will matter most is whether southern Europe can return to growth. So far the joint European Union and International Monetary Fund programmes have, with some success, focused on the fiscal front. But unlike Ireland, southern Europe has not started reducing the real exchange rate misalignment resulting from a decade of excessive inflation, and growth prospects remain remote. The EU should now move on this front. A first and simple step should be to make better use of the money it spends in Greece and Portugal. Both countries are major beneficiaries of structural transfers, but EU money is both under-spent and badly spent (because guidelines set long ago are at odds with current priorities). The EU should pass special legislation to speed up the disbursement of aid and, as long as assistance programmes are in place, allocate it to supporting their growth component.
5. Address the underlying weaknesses of the euro area. Euro area surveillance reform, about to be completed, will help diminish the risk of future crises. But nothing has been done to remedy the lethal correlation of banking and sovereign crises. Sovereigns should be better protected against the failure of their banks, through the centralisation of supervision and the creation of an insurance scheme akin to the US Federal Deposit Insurance Corporation. By the same token banks should be better protected against the failure of their sovereigns, through diversification of their bond portfolio. Today, any meaningful restructuring of the Greek debt would wipe out the capital of the Greek banks. As long as this concentration of risk persists, sovereign restructuring will remain more dangerous that it needs to be. This is the most potent justification for introducing Eurobonds, because they would offer a natural diversification instrument.
Throughout the crisis the European leaders have consistently demonstrated a strong commitment to the euro. But as Winston Churchill once said of the US, they can be trusted to do the right thing only after having exhausted all other possibilities. This behaviour is too costly to be sustained. The leaders should now move ahead of the curve and take initiatives.
A version of this op-ed was published in the Financial Times on 28th June 2011