El-Erian: Spain Shows Policymakers Are Running Out of Time
Monday’s disappointing market reception to the bailout package for Spanish banks is a reminder to European policymakers of something that is more than familiar to veteran sovereign crisis managers in emerging countries: The greater the erosion of policymaking credibility, the harder it is to get the private sector to buy into your plans.
As a result, rather than crowd in private capital, seemingly bold policy measures end up facilitating its exit. The answer is not to do less but, rather, to be more comprehensive and coherent in what you do.
On paper, the Spanish package seemed impressive. Specified at up to 100 billion euros, it was notably larger than the range of estimates of the hole in Spanish banks (40 - 90 billion euros, with the IMF coming out on the low side).
It was agreed quickly on a Saturday. And, through its design, it sought to avoid some of the features that have turned the other three bailout countries into quasi-permanent wards of the European state (Greece, Ireland, and Portugal).
After an initial welcome, markets comprehensively dismissed the Spanish bank rescue as insufficient and poorly designed. Most worrisome of all, the yield and risk spreads on Spanish sovereign bonds ended Monday higher than before the announcement of yet another costly bank bailout.
In addition to increasing – rather than lowering the cost of borrowing – this sent a very negative message about policy effectiveness. And, to make things worse, other vulnerable and potentially-vulnerable European sovereign bonds were negatively impacted.
There are valid reasons for the market disappointment. The package did not rupture the increasingly problematic link between weak Spanish banks and deteriorating sovereign creditworthiness. Too many operational details remain unclear; others raised questions about the seniority of existing investors. And the unconfirmed reaction of Spanish banks, which reportedly sold some of their government bond holdings, added to the uncertainties.
These are all legitimate but they do not explain the extent of the selloff in key financial assets. Indeed, the price action suggests that markets overall are losing confidence in the policy response function, and doing so in an accelerated fashion.
As such, rather than encourage the private sector to co-invest along the public sector, the provision of official financing is seen as facilitating its disengagement. In turn, this serves to aggravate the economic implosion and mounting joblessness; it also makes bank bailouts even harder to defend, politically and otherwise.
The vicious cycle is familiar to those who lived through the debt crises of emerging economies in the 1980s, 1990s and early 2000s. The more the private sector losses confidence in the policy response, the harder it is for these responses to stabilize the situation let alone get ahead of it. As private sector de-leveraging accelerates, the already-serious policy challenges become all the more daunting.
This unfortunate reality has two immediate implications for Europe when it comes to the what, how and when of crisis management.
First, governments must pivot quickly to policy responses that are much more comprehensive in recognizing and addressing the enormity of the problems. My column last week for the Financial Times detailed what that would look like in the specific case of Spain. And what was announced on Saturday by European Ministers of Finance was too partial when judged against these suggestions.
Second, policymakers must evolve from their coyness on “Plan B.” When policy credibility is low, the conventional dictum – i.e., continue to insist that there is no “Plan B” so to avoid further disruptions – does not work. Indeed, in the absence of any clarity on Plan B, the private sector will significantly increase its self-insurance and extend technical contagion, making bigger the hole that the public sector faces.
European policymakers should consider carefully the reaction of markets on Monday – and especially so for the leaders of the big four (France, Germany, Italy and Spain) who are scheduled to meet before the big summit at the end of the month. The time for partial policy reactions is past. Difficult decision need to be made now, and not just about individual countries but also about the composition and functioning of the euro zone as a whole.
There is still time for policymakers to regain control. But not much.
Dr. Mohamed El-Erian is CEO and Co-CIO of PIMCO, the global investment manager.