Fear and Loathing in the Euro Zone

The annual meetings of the World Bank and International Monetary Fund over the weekend brought together frightened and angry people. The financial crisis that broke upon the world in August 2007 has entered a new and, in crucial respects, more dangerous phase.

European Central Bank
European Central Bank

A positive feedback loop between banks and weak sovereigns is emerging, with a potentially calamitous effect on the euro zone and the global economy: the euro zone is no island. What makes this process particularly frightening is that weaker sovereignsare unable to cope on their own, while the eurozone has nobody in charge. The euro zone may lack the capacity to address the crisis.

The underlying danger is laid out in the latest global financial stability report from the IMF. This is surveillance at its best: clear, compelling, courageous. So what is the message? It is contained in two sentences: “Nearly half of the 6,500 billion euros stock of government debt issued by euro area governments is showing signs of heightened credit risk”; and, “As a result, banks that have substantial amounts of more risky and volatile sovereign debt have faced considerable strains in markets.”

In their seminal book, This Time is Different, Kenneth Rogoff of Harvard and Carmen Reinhart, of the Peterson Institute for International Economics, explained that big financial crises have often led to sovereign debt crises. This is the stage the world has reached, no longer in small peripheral member countries of the euro zone, but in Spain and Italy. The emergence of doubt about the ability of sovereigns to manage their debt undermines the perceived soundness of the banks, both directly, because the latter hold much of the debt of the former, and indirectly, via the dwindling value of the sovereign insurance.

The IMF’s report lays out the processes: “Spillovers from high-spread euro area sovereigns have affected local banking systems but have also spread to institutions in other countries. In addition to these direct exposures, banks have taken on sovereign risk indirectly by lending to banks that hold risky sovereigns. Banks are also affected by sovereign risks on the liabilities side of their balance sheets as implicit government guarantees have been eroded, the value of government bonds used as collateral has fallen, margin calls have risen, and banks’ ratings downgrades have followed cuts to sovereign ratings.” As funding comes under pressure, credit shrinks and the private sector becomes more cautious, weakening economies and undermining both fiscal and financial solvency.

At worst, the world stands on the brink of a big crisis. For this reason, the likes of Tim Geithner, US Treasury secretary, and Christine Lagarde, the IMF’s new managing director, have put eurozone officials under fierce pressure to act: the days of too little, almost too late, are over; failure to act promptly would just be too late, they argue.

So what are the outsiders demanding? The answer is twofold: a recapitalization of weak banking institutions, on a credible scale, and sufficient liquidity to prevent the panic from ending up in the collapse of banks and vulnerable sovereigns. Different estimates of the sums required are circulating. The Americans, mindful of their experience in 2008 and 2009, recommend “shock and awe”. Given the funding needs of banks and sovereigns, this translates into well more than 1,000 billion, and, quite plausibly, several times that number. It is enough to makes a cautious German’s head spin.

How might this be done? My colleague, Peter Spiegel, provided an excellent primer in “Europe thinks the unthinkable” on September 26. First, in the course of October, the euro zone should (with luck) have ratified the modified European financial stability fund, worth 440 billion euros. The EFSF would then be able to inject capital into banks and purchase bonds of distressed governments on the open market. But this fund is far too small. The euro zone needs a much bigger bazooka. Apparently, five different plans are under discussion. These involve leveraging up the EFSF’s money, by issuing guarantees rather than loans, or borrowing from the European Central Bank, or by borrowing in the markets. But if action needs to be immediate, as it does, the only entity able to supply the needed funds is the central bank.

Would this work? My answer to this question has seven parts. First, if agreement were reached on action on the necessary scale, it should halt the panic. Second, it may be impossible to obtain such consent, particularly if funding relied heavily on the ECB, at least in the short run. Mario Draghi, the incoming Italian president of the bank, would find himself in the invidious position of being compelled to save his own country in the teeth of complaints from the German public over the debauching of their central bank.

Third, once banks and sovereigns become heavily dependent on official finance, they may find it quite hard to return to the market. Fourth, such actions cannot solve the deeper difficulty that currently uncompetitive countries will need a sizeable inflow of external funds for a very long time, little of which is likely to come from the now fearful private sector.

Fifth, it is likely that after such a rescue, the imprudent will just go back to their bad old ways, making further rescues necessary. Sixth, internal transfers can be halted only if there is adjustment inside the euro zone, including by the surplus countries, of which there is little sign. Thus the euro zone risks turning into an illegitimate transfer union. Finally, there is a danger that an ambitious programme would degrade the standing of the soundest euro zone sovereigns, though a collapse might do almost as much damage to their ratings.

No good choices remain. The risks involved in the proposed actions are big. But the alternative of financial collapses and sovereign debt crises that ricochet across the globe is vastly worse. The need for such a rescue may be viewed as the price of having entered hastily into an indissoluble monetary marriage, tolerating the emergence of huge imbalances, failing to discipline the banks and then dealing with the emerging crisis so incompetently.

The euro zone has still to decide what it will be when it grows up. But first it needs to reach that stage. The costs of a meltdown would be too grave to contemplate. The members simply have to prevent that. They have no sane alternative.