16th September 2011
The Malta Independent on Sunday
The euro system is under severe stress. This weekend the EU finance ministers will meet in Poland and they will have a special guest in the person of US Treasury Secretary Tim Geithner. The topic will be whether to continue bailing out Greece or to cut it loose. The cost of bailing out Greece is pretty clear and given its size, quite affordable
The cost of cutting Greece loose is much less certain and Mr Geithner will no doubt sound a stern warning about taking such risks, having been burnt by the Lehman collapse just three years ago; an event that unleashed a financial crisis of global proportions.
Many economists warn that a dirty default of Greece on its sovereign debts will unleash a financial turmoil which will make Lehman look like a walk in the park.
A lot is at stake this weekend. The existence of the euro, the sustainability of the EU in its current format and the endowment of 60 post-war years of free trade, political cooperation and economic well-being in peace and prosperity is what is at stake. If politicians stick to their introspection and forego their wider pan-EU responsibilities, we are doomed. Markets will not wait and will take cover wherever they can seek it if they perceive that EU leaders and national politicians cannot agree how to put out the fire inside the Euro house. Investors will stampede to run out of the small door and consequences would be unpleasant, possibly disastrous.
I have been writing about this for two-and-a-half years now. On 13 February 2009, I wrote in my erstwhile Friday Column an op-ed titled ‘Will the euro survive?’. Many thought I had lost it, asking questions that should not be asked. On 10 June 2010, I wrote a piece titled ‘Plan C for the euro’.
I asked: “So what future is in store for the euro? Plan A, built on hope rather than realistic expectations, sees austerity in errant countries bringing order for the euro to continue as it did during its first decade of existence. Plan B is just to muddle through somehow from crisis to crisis as the austerity measures cause instability and greater disharmony within the euro club. The ECB had better think of a Plan C!”
We have tried Plan A. It has not worked. Democracy has a limit on how many rounds of austerity it can accept without blowing up before it delivers the intended benefits. The risk starts taking shape that under crushing sequential rounds of austerity, democracy elects demagogues bent on sowing anarchy.
Plan B is also not working. Only last 21 July the terms of the second Greece bailout were approved and here we are again. Not only the market judged that what was agreed then was insufficient but the EU has severe problems even to implement what was agreed. Netherlands wants the creation of an EU budget Tsar as a condition to approve the deal. Finland wants collateral security which if given would force default on Greece through infringement of negative pledge clauses in its sovereign bonds. The German constitutional court insists that each disbursement has to be approved by parliament. The Slovakia government coalition will table a deal for parliamentary approval only after all others have approved it in the clear hope that someone else will abort it before as it is doubtful whether the Slovak government coalition can stay together to vote the deal through. Greece itself is falling behind in its privatisation schedule and tax collection plan on which the deal is conditional.
Faced with this indecision, the markets are solidifying their opinion that in the EU there are many leaders but really no one is in charge. The markets are demanding catharsis and they are demanding it now. Chancellor Merkel can fool herself thinking that she will not be bullied by the markets but she would be well advised to consult James Carville, President Clinton’s advisor, who famously articulated how he was stunned by the power the bond market had over governments: “I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.”
So what Plan C can the EU leaders put together over the next weekend to give the market the catharsis it is demanding?
Before answering this crucial question it is worth considering what the default position would be if no Plan C is reached. A dirty Greek default on its sovereign debt will set in motion a chain reaction which could force many EU banks into bankruptcy leading to their nationalisation. Investors hurt by Greece’s default will shun sovereign exposure to other EU governments perceived in distress, including Italy, Spain and maybe France. These countries would find it difficult or prohibitively expensive to borrow to recapitalise their banks so that financial confusion will be the norm, leading to gummed up financial markets and to breakdown of the euro as the problems would be too big for the ECB to handle. When a tsunami hits, even solid buildings cannot stand in its way.
The break-up of the euro will force countries back to their domestic currencies, or to much smaller currency groupings (e.g. Germany, Austria, Finland and Netherlands). Such currencies will shoot up in value rendering exports uncompetitive just as most of the markets of countries in distress disappear through devaluation of their domestic currencies, trade barriers or outright reduction in demand caused by the financial collapse. Unemployment and consequent social unrest will bring back memories of the great depression of the 30s.
Can the EU survive in such a scenario? I doubt it. The risk of 60 years of post-war cooperation being flushed down the drain should not be under-estimated. Wars will re-enter the European dictionary. From trade wars, to economic wars, to cold wars and God forbid military wars. Countries in distress will inevitably form alliances with existing or upcoming super-powers. China and/or Russia will forge strategic alliance with some countries in distress putting Europe back to a cold war scenario.
This stark reality must be borne in mind by European leaders as they make their choices this weekend. Chancellor Merkel in particular would do well to read a research published this week by UBS top economists where they estimate that the cost of bailing out Greece, Ireland and Portugal together would amount to a little over €1,000 per person in a single hit, whereas the break-up of the euro will cost a single hit of between €9,500 to €11,500 per person and an annual hit of between €3,000 to €4,000 per person.
So what Plan C can EU leaders put together? Given the problem in getting any fiscal measure approved by 27 or 17 national parliaments, in order to remain within the realms of practicality, the solution will have to be spearheaded by the ECB as a monetary measure. The ECB is the only pan-EU organisation that can act autonomously with a speed to match the market.
The ECB has these choices:
• Continue acting as the bond buyer of the last resort for countries in distress. This is okay as a temporary measure but it offers no long-term solution as persistence will render the ECB, supposedly an anchor of solidity, as a mega bad bank where sovereigns borrow cheaply to avoid market discipline. This apart, even this temporary measure has already created deep divisions inside the ECB with resignation of two prominent German exponents from the governing council. It is not healthy to have an ECB divorced so drastically from the old Bundesbank tradition.
• Fund a substantial bank rescue operation on the basis of the US TARP programme, to recapitalise the EU banks which take a hit on their capital by marking sovereign bonds to market.
• Concurrently with such bank rescue, organise a voluntary debt exchange mechanism to offer deep haircuts to sovereigns in distress on their debt exposure to give an incentive of light at the end of the tunnel for persisting with the austerity of adjustment policies to restore their competitiveness.
• Loosen monetary policy, if necessary through quantitative easing measures, to keep markets liquid as well as to reduce the overvaluation of the euro on the foreign exchange markets in order to render EU products more competitive with the rest of the world, especially the US and China.
• Renegotiate the euro rules to create the EU Budget tsar that will give substance to enhanced discipline of the Stability and Growth Pact.
• Start a political process for an EU treaty change leading to an EU Treasury, co-ordinated fiscal policy and eventually the launch of eurobonds to replace separate sovereign borrowings.
This might not be a perfect recipe but any real lasting solution cannot wander too far from it.