Die Finanzmärkte durchschauen den Bluff

14.01.2011

GERMANY'S CHOICE

By: Barry Eichengreen

Europe’s crisis will not wait.  Investors are signaling that the current strategy of taking Greece and Ireland out of the markets by extending them multi-year IMF-EU loans is not working.  Spreads on Greek and Irish government bonds are not falling, as they would in response to well-thought-out rescue packages.  To the contrary, they are rising, reflecting the political backlash in both countries and pressure on the Greek and Irish governments to renegotiate the terms of the foreign assistance.  And where Greece and Ireland lead, others will follow.  Spreads are up across peripheral Europe.  Once more the crisis is on the move.

The nature of the problem hardly needs repeating.  The crisis countries are heavily indebted.  Their IMF-EU programs now propose to pile yet additional obligations on top of these existing debt mountains.  If all goes according to plan, public debt will top out in the neighborhood of 150 per cent of GDP. 

But even modestly disappointing growth could throw this scenario terminally off course.  And there are good reasons to fear disappointment.   Servicing all this debt will require high taxes, discouraging investment.  With less investment will come less growth, at which point forecasts of debt ratios stabilizing and then declining go out the window.  The IMF has already acknowledged that the rosy forecasts on which its Irish program is based might quite possibly fail to materialize.

EU leaders, led by Ms. Merkel, have been nothing if not consistent in addressing this danger.  They have consistently refused to acknowledge it.  If the crisis countries fail to meet their budgetary targets, EU leaders insist, then they should impose deeper spending cuts – this despite the fact that deeper cuts will mean even slower growth.  If there are going to be further bailouts when the existing rescue fund, the European Financial Stability Facility or EFSF, expires, then this should be conditional on private investors taking losses – this despite the fact that heavily indebted countries will then find it impossible to roll over their debts. 

This stance of unmitigated denial may be consistent, but it is not coherent.  It can only lead to disorderly defaults, bank distress, and contagion to yet additional countries.  If German policy makers think their economy can remain an island of prosperity in such stormy financial seas, then they have forgotten how to navigate.

The feasible alternatives are two.  European leaders can allow countries like Greece and Ireland to write down their already heavy debts.  They can use some of the resources of the EFSF to collateralize or provide guarantees on the new “discount bonds” the Greek and Irish governments offer investors in exchange for existing obligations.  Their debts will again become sustainable, and their governments will be able to play by the new, more demanding rules put in place in 2013. 

But this will also mean losses for banks in Germany and elsewhere.  Shareholders will be unhappy if those banks have to go out and raise more capital.  Taxpayers will be unhappy if the banks find themselves unable to do so and governments are forced to inject public funds.  No wonder that this course does not appeal to Ms. Merkel and Mr. Sarkozy.

Alternatively, the EU can re-think the terms of its rescue packages.  To give Greece and Ireland fighting chance, it can reduce the 6 per cent interest rate they are being charged on their IMF-EU loans.  It can triple the size of the EFSF to enable it to provide cheap and ample funding for Spain when the time comes.  Issuing “e-bonds” backed by the full faith and credit of EU member states as a group and allowing the crisis countries to exchange their existing debt for these new securities up to some limit, say 60 per cent of GDP, would be another way of achieving the same goal.

The EU will also have to relax the rules governing the extension of assistance when the EFSF is replaced by a permanent entity, the European Stability Mechanism, in 2013.  It can authorize the ESM to lend not just to countries that pass a “rigorous debt sustainability analysis,” as the German government has proposed, but more freely.  It can authorize the ESM to lend at concessional rates.  It can back away from the idea that ESM loans will have seniority, a situation that makes it more likely that other claims will have to be restructured. 

This would represent a transfer of resources from Germany and the other members of the EU core to the crisis countries.  It would be the first step toward a fiscal union in which there were ongoing payments from rich to poor European countries.  Again, this is not something that will appeal to decision makers in Germany and the other members of core Europe.  The cost, approximately 3 per cent of the combined GDP of Germany and France, would be equivalent to the cost of recapitalizing those two countries’ banks.

But that both feasible alternatives are unappealing does not relieve European leaders of having to choose.  Pretending that doing nothing is also a feasible alternative leads only to chaos. 

   

Barry Eichengreen is George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley.  His book, Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System, has just been published by Oxford University Press.