After the EU-wide calamity and impending doom of the past few days and weeks, you would rightly query what exactly is now going on. Its pretty straightforward – European leaders are starting to get serious. The key element of the October 23rd summit was a sea change in the dialogue. The Franco-German duo of Merkel and Sarkozy have stopped insisting on minor sticking-plaster solutions and have belatedly began to talk about more serious surgery including a keystone proposal to write down (haircut) a substantial portion (40-60%) of Greece’s €350 national debt pile. This would make it hugely more manageable. After listening to the weekend views of the G20 (who are, no doubt, in convulsions over the prospect of a European engineered second ‘double dip’ world recession), there is no doubt the conversation has changed.
EU leaders are not formulating a full scale multifaceted rescue plan to tackle the underlying problems. Previously, the focus was skewed to address urgent liquidity problems, with tackling solvency a long term (#2) aim. Now, the short term focus is starting to change, and with good (economic) reason.
The ‘Liquidity’ Era
For too long, as economist Ken Rogoff outlines in Der Spiegel the discussion in eurozone circles was squarely focused on addressing liquidity problems (getting the day to day financing in order) for those countries most at risk of going bankrupt – Portugal, Ireland and Greece. Remember it was doubt over their ability to pay for the functioning of their own economies which caused their borrowing costs on the bond markets to skyrocket – and caused the creation of the EFSF and the EU-IMF bailouts. But all this has proved ineffective to stop the rot. Greek needed a second bailout less than 7 months after its first and the on-off panic encouraged by the Greek government dragging its feet on meeting its obligations. Releasing the bailout funds in tranches after regular reviews by the troika (European Commission – ECB – IMF) has injected more instability than certainty into the process. With the Greek government promising to get its debt in order by dramatically altering labour laws enshrined in the Greek populace for generations, drastically reducing the size and cost of the public service and budgetary measures such as increased taxes and deep spending cuts – the calamitous environment is ruining investor confidence and prospects for a return to economic growth in Europe and beyond.
The ‘Solvency’ Era
So, the real problem is Greece or more accurately, Greek solvency and the interdependent solvency of the big European banks. Unlike what was believed previously (in the ‘liquidity’ phase), Greece has very weak structural economic strengths to fall back on). A disorderly Greek default would put the solvency of those indebted European banks into question (and with them, the economies in which they operate across Northern Europe). Therefore, there is no stable bottom to this crisis.
The [Solvency] ‘One-Two’ Solution (to the Debt Crises)
- Cutting Greece’s Debt Pile To get Greek debt to a manageable level of at least 110% (from a projected 175-185% in 2012), independent estimates of a haircut of 50-60% would be required. Merkel and Sarkozy hope to assuage concerns of their electorates by using the fig leaf of a ‘voluntary cut’ by private bondholders, rather than a wholesale slashing by those who hold Greek bonds (this would be more controlled and less destructive if managed correctly). On July 21st, private creditors agreed to a 21% write down.
- Recapitalisation of European Banks To the tune of €100bn+ (to underscore their solvency and withstand the ripple effect a default of Greece or others would cause). This was already announced on the 9th of October. As described, private creditors have agreed to a July 21st write down of 21% and have offered to increase this to 40%. There is likely to be a compromise between this agreed 40% level and the 50-60% requirement.
Addressing the Liquidity Problem
Expanding the €440bn EFSF to over €1tn By giving the EFSF beefier (and leveraged) firepower to deal with potential debt crises in Italy and Spain. The French prefer turning the EFSF into a bank (which would borrow money from the ECB and use this as abase to loan out far more). This appears to be a non-starter within the German government. The German parliament will vote on expanding the EFSF on the same day as the EU summit. It is going to be very difficult to enhance the powers of the EFSF (beyond simple ‘bailouts’) without changing the Lisbon Treaty. Either way, the Germans now foresee direct intervention.
Creation of a eurozone Treasury and/or turning the EFSF into a European Monetary Fund to coordinate eurozone fiscal policies and avoid causing this whole crisis to happen again in the future. The Germans will have to oversee a much enhanced stringent interpretation of the rules for operating the euro under the Maastricht Treaty (the Maastricht Criteria). But all this boils down to a simple quiet reality – how much are the Germans prepared to pay to keep the eurozone (and the EU) functioning? Are they wiling to finance the rebuilding of its economic health and reputation on world markets? Are the German people willing to accept the cost? And if not, then what?
It becomes almost inevitable that in exchange for German financing and strong coordinated leadership, Europe will have to accept a far greater German design – and this time, it’ll be one that doesn’t let free riders (such as Greece) enjoy the facilities without playing to the rules of membership.
The next EU summit will try to hammer out a comprehensive detailed plan is on the 23rd October (Wednesday)