By Peter Boone and Simon Johnson
When Mr. Trichet (head of the European Central Bank, ECB) and Mr. Strauss-Kahn (head of the International Monetary Fund, IMF) rushed to Berlin this week to meet Prime Minister Angela Merkel and the German parliament, the moment was eerily reminiscent of September 2008 – when Hank Paulson stormed up to the US Congress, demanding for $700bn in relief for the largest US banks. Remember the aftermath of that debacle: despite the Treasury argument that this would be enough, much more money was eventually needed, and Mr. Paulson left office a few months later under a cloud.
The problem this time is bigger. It is not only about banks, it is about the essence of the eurozone, and the political survival of all the public figures responsible. If Mr. Trichet and Mr. Strauss-Kahn were honest, they would admit to Ms. Merkel “we messed up – more than a decade ago, when we were governor of the Banque de France and French finance minister, respectively”. These two founders of the European unity dream helped set rules for the eurozone which, by their nature, have caused small flaws to turn into great dangers.
The underlying problem is the rule for printing money: in the eurozone, any government can finance itself by issuing bonds directly (or indirectly) to commercial banks, and then having those banks “repo” them (i.e., borrow using these bonds as collateral) at the ECB in return for fresh euros. The commercial banks make a profit because the ECB charges them very little for those loans, while the governments get the money – and can thus finance larger budget deficits. The problem is that eventually that government has to pay back its debt or, more modestly, at least stabilize its public debt levels.
This same structure directly distorts the incentives of commercial banks: they have a backstop at the ECB, which is the “lender of last resort”; and the ECB and European Union (EU) put a great deal of pressure on each nation to bail out commercial banks in trouble. When a country joins the eurozone, its banks win access to a large amount of cheap financing, along with the expectation they will be bailed out when they make mistakes. This, in turn, enables the banks to greatly expand their balance sheets, ploughing into domestic real estate, overseas expansion, or crazy junk products issued by Goldman Sachs. Just think of Ireland and Spain, where the banks took on massive loans that are now sinking the country.
Given the eurozone provides easy access to cheap money, it is no wonder that many more nations want to join. No wonder also that it blew up. Nations with profligate governments or weak financial systems had a bonanza. They essentially borrowed funds from the less profligate elsewhere in the eurozone, backed by the ECB. The Germans were relatively austere; the periphery enjoyed the boom. But now we have moved past the boom, and someone in Greece, Portugal, Spain, Ireland and perhaps Italy has to repay something – or at least stop borrowing without constraint. So Mr. Trichet and Mr. Strauss-Kahn go, cap in hand, to ask Germany for further assistance.
There are three possible scenarios. First, the ECB may be allowed to really let loose with “liquidity” – and somehow buy up all the bonds of troubled eurozone nations. But this is exactly the process that always and everywhere brings about high inflation. The Germans would fight hard against such a policy, although it would prevent default.
Second, officials still hope that bond yields for weaker governments widen but then stabilize. This is bad news for troubled eurozone countries, but they manage to avoid default. The rest of the world grows by enough to pull up even the European “Club Med + Ireland”. Call this the trickle down scenario or just a miracle.
Most likely, the situation is about to turn much worse and a third scenario unfolds. The nightmare for Europe is not at this point about Greece or Portugal – it is all about Italian and Spanish bond yields. This week those yields are rising quickly from low levels, while German yields are falling – so this spread is widening sharply. The yields for Spain – for example – are rising because hitherto inattentive investors, who always thought these bonds were nearly as safe as cash, suddenly realize there are reasonable scenarios where those bonds could fall sharply in value or even possibly default. Given that Spain has 20% unemployment, an uncompetitive exchange rate, a great deal of public debt, and a reported government deficit of 11.2 percent (compared with headline numbers for Greece at 13.6 percent and Portugal at 9.4 percent), everyone now asks: Does a 5% yield on Spain’s ten year bonds justify the risk? The market is increasingly taking the view that the answer is no, at least for now. So, we can anticipate Spanish (and Italian) yields will keep rising. In turn, this causes other asset prices to fall in those nations, thus worsening their banking systems, and hence leading to credit contraction and capital flight. It is a dismal prognosis.
Then it gets worse. As rates rise, traditional investors in euro zone bonds, which are pension funds and commercial banks, will refuse to take more. There will be no buyers in the market and governments will not be able to roll over debts. We saw the first glimpse of this on Tuesday, when both Spanish and Irish short term debt auctions virtually failed. Once this happens more broadly, the problem will be too big for even Mr. Trichet or Ms. Merkel to solve. The euro zone will be at risk of massive collapse.
If this awful but unfortunately plausible scenario comes about, there is a clear solution – unfortunately, it is also anathema to Mr. Trichet and Ms. Merkel, and thus unlikely to be discussed seriously until it is too late. This is the standard package that comes to all emerging markets in crisis: a very sharp fall in the euro, restructuring of euro zone fiscal/monetary rules to make them compatible with financial stability, and massive external liquidity support – not because Europe has an external payments problem, but because this is the only way to provide credible budget support that softens the blow of the needed austerity programs.
The liquidity support involved would be large: if we assume that roughly three years of sovereign debt repayments should be fully backed – and it takes that kind of commitment to break such negative sentiment – then approximately $1 trillion would be needed to backstop Greece, Portugal, Spain and Italy. It may be that more funds are eventually needed – but in any case, the amounts would be less than the total reserves of China. These amounts would also be reduced as the euro falls; it could be heading back to well under $1 per euro, which is where it stood one decade ago.
External financial support would only make sense if combined with key structural reforms, including an end to the repo window at the ECB. As former UBS banker Al Breach recently argued, the ECB could instead issue bonds to all nations which would then be used subsequently for monetary operations – every central needs a way to add or subtract liquidity from the financial system. These bonds would need to be backed by a small “euro zone” tax, thus making the ECB more like other central banks around the world. It would no longer accept bonds of “regional governments” in the union as collateral, and instead would buy and sell “eurozone” bonds. These new eurozone bonds would also offer a way for governments to roll over some of their existing debts.
If the eurozone does need this package, it cannot be managed under a “business as usual” model. The funds would need to come from the G20, and extremely tough decisions over fiscal and monetary policy need to be handled in a fair and reasonable manner. Someone needs to be in charge on behalf of Europe (would this be the European Commission, or Ms. Merkel and the German government?) and someone needs to represent the G20.
By far the most natural G20 partner to manage this process is – despite all its baggage – the IMF, but there’s a serious problem. Mr. Strauss-Kahn, the current head of the IMF today, very much wants to become the next President of France. There is no way for the G20 to provide funding that he would guide – he has an obvious and unavoidable conflict of interest, and no incentive to make the tough decisions today that are required to sort out the euro zone.
Mr. Strauss-Kahn should resign and a respected financial leader of a relatively independent country should take charge at the IMF. One potential choice would be Mark Carney, the current Governor of the Bank of Canada. Or, if the G20 agrees – finally – that it is time to phase out the leading role of the G7 (which has not done well of late), Montek Ahluwalia of India would be an outstanding candidate.
An edited version of this post appeared this morning on the NYT’s Economix; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.