Finance and Economics;The euro crisis;A firewall full of holes;
The euro zone's rescue strategy still does not add up;
There is a new swagger among European financial officials these days. As bond spreads narrow, share prices rise and the euro strengthens, many policymakers are convinced the crisis has been solved. At a G20 gathering of finance ministers in Mexico City on February 25th-26th, for instance, the European delegates were touting their success. It is a far cry from the browbeatings they suffered during 2011.
This mood of confidence can largely be credited to the European Central Bank (ECB) and its provision of liquidity to banks. But add in Greece’s second bail-out deal, tough new euro-zone fiscal rules, bold reforms in Italy and Spain and—so the argument goes—it is clear that the Europeans are serious about fixing their problems. Just in case, the imminent introduction of the European Stability Mechanism (ESM), a permanent rescue fund, as well as an increase in the IMF’s resources, also mean that a solid firewall is being erected to cope with another conflagration.
Unfortunately, with one exception, every part of that argument is weaker than it looks. The exception is the ECB’s Long Term Refinancing Operation (LTRO), which provides banks with three-year liquidity at its main interest rate, currently 1%, against a wide array of collateral. On February 29th the ECB announced that it had lent another EURO530 billion ($712 billion), taking the amount of three-year money it has pumped into the banking system over the past two months or so to more than EURO1 trillion (see chart). It is hardly surprising that markets are perkier.
The amount lent at the second auction was slightly higher than expected, and went to far more banks than the initial auction in December. Since so many small banks have now tapped LTRO, hopes are rising that as well as slowing the pace of bank deleveraging and propping up sovereign-bond markets, the liquidity may encourage new lending to the real economy.
It might, but all that money could also have nasty long-term side-effects. Hawks at the ECB are already muttering about the problem of banks becoming addicted to cheap central-bank funds. And by encouraging Italian or Spanish banks to buy their governments’ bonds, LTRO reinforces the close links between the peripheral economies’ sovereign debt and the health of their banks.
LTRO has bought time, however. So, too, has Greece’s latest rescue package. Germany’s Bundestag approved its share of the funds on February 27th. The temporary downgrade of Greek bonds to “selective default”, as a result of moves to restructure private creditors’ debt, has caused few ripples. In the short term a chaotic default has almost certainly been avoided. But few believe the Greek rescue plan will actually work. Eventually Greece will either need more help from its rescuers or will face default and perhaps an exit from the euro.
What matters, therefore, is how well the euro zone uses the time it has bought itself. The signs are worrying. Policymakers’ overwhelming (and misguided) focus on budget austerity is facing increasing resistance. Spain announced on February 27th that its 2011 budget deficit, at 8.5% of GDP, was even bigger than first expected. It wants to renegotiate the 2012 deficit target of 4.4% of GDP.
More worrying still is the lack of progress in building permanent defenses against a loss of confidence in another sovereign’s bonds. Much faith is placed in the ESM, to be launched on July 1st. This EURO500 billion fund is supposedly stronger than the current iteration, the European Financial Stability Facility (EFSF), because it is enshrined in legal treaties and because EURO80 billion of its capital will eventually be paid in, whereas the EFSF relies on guarantees. Although Germany still resists, most euro-zone members hope to run both funds simultaneously, which implies a theoretical cash-chest of EURO750 billion.
The trouble is that this money is not actually to hand. The EFSF, whose AA+ credit rating was put on negative watch by Standard & Poor’s this week, must find its funds in the bond markets, and there is little evidence that it can raise a lot of money fast. And cash-strapped countries, such as France, are reluctant to pay in a lot of capital to the ESM quickly.
The Europeans’ reluctance to put a hefty amount of real money at risk has weakened the second part of the firewall, the IMF’s resources. In Mexico City G20 members made it clear that they would not stump up cash for the fund until there was a “credible” commitment from Europe.
Worse, even if it were fully in place, this is still a rather flimsy sort of defence. Relying on vast infusions of money from the IMF could actually worsen the problems of a country like Italy, since the fund’s presumed preferred-creditor status（IMF） would push private bondholders further down the pecking order. Nor are the amounts being talked about enough to remove the risk of panic. As Willem Buiter of Citigroup points out, the weaker members of the euro zone collectively need to borrow some EURO2 trillion over the next two years.
To get properly on top of its debt problem, Europe needs to be bolder. A growing chorus argues that this must entail some form of joint liability for countries’ debts. A proposal from the German Council of Economic Experts for a European Debt Redemption Fund, which would mutualize all euro-zone members’ debts above 60% of GDP, with strict rules to pay them off over 25 years, is gaining traction in some quarters. Germany itself remains staunchly opposed to anything that smells of Eurobonds, and the current period of calm has only reinforced that resistance. Meanwhile, the clock ticks.