One of the benefits of being an academic economist is that market participants and government officials will often tell you what they think in relatively frank terms.
Here is what I learned in dozens of meetings last week in Frankfurt, Madrid and London:
-- There is wide agreement that the status quo is unsustainable, and no one is optimistic about the future. The elevated cost of borrowing for banks and some governments must be addressed within weeks or at most a couple of months.
-- The euro area needs more integration and cooperation or it will dissolve. European central bankers say a breakup would cost a lot more than maintaining the union, yet they admit that there are severe -- and possibly insurmountable -- political impediments to getting Germany to guarantee other countries’ debt.
-- The prescription for what needs to be done has evolved in recent months. Many outside experts long believed that the largest European banks were seriously undercapitalized. The core of the problem was the high levels of sovereign debt that had not been marked to market that are held by banks in many countries. For example, Spanish banks at the end of 2010 had 230 billion euros of government debt from troubled countries, though less than 7 percent of those assets were marked to market.
The lame stress tests conducted by the European Banking Authority this year found no capital problems and ignored the possibility of a sovereign default. As a result, the tests failed to convince markets of the banks’ solvency. A European version of the U.S. Troubled Asset Relief Program would have been an obvious way to address the capital shortage, and the European Financial Stability Facility appeared poised to take on this task, provided its size was increased.
But three things changed. First, the stability fund was increased by too little to credibly tackle all the problems.
Second, it is now clear that even this smaller version faces major opposition in several countries. Ultimately, it probably will be approved, but there is no chance it would survive another round of parliamentary votes if it needed to be rescaled.
Third, and most important, the markets have concluded that Spanish and especially Italian sovereign debt should carry a substantial risk premium. Italy’s sovereign borrowing costs are now 3.5 percentage points above those for Germany. It is doubtful Italy can afford to keep paying such high rates for very much longer. Thus, Europe can no longer just worry about what to do about bank’s losses on existing assets.
Insuring Italian Debt
Any satisfactory outcome to the crisis must also ensure that buyers can be found for Italian debt at prices the country can afford. This is a major challenge, as Italy needs to borrow hundreds of billions of euros each year.
Worse yet, a dysfunctional policy-making process is exacerbating the crisis. The only common aspect of the decisions so far is that they have been temporary. European politicians haven’t decided at any point what they wanted the final outcome to be. Doing so would have allowed them to better determine the incremental steps needed to achieve the long-term result. Instead, each pledge of “no more bailouts after this one” limits future options.
The demise of the stability fund is a consequence of this myopic approach. At first, the fund’s mandate was restricted to attract support from member states. Later, when the scope of action was broadened, the amount of money was restricted as a way to make the new mandate more palatable to opponents. The result was a series of compromises that amounted to throwing the baby out with the bath water.
Issuing joint euro bonds was another option that could have raised capital to shore up the banks and perhaps make funding costs manageable. Again, politicians resisted; in addition, Germany’s Federal Constitutional Court created serious roadblocks by requiring parliamentary approval for any rescue. The euro-bond option now appears to be off the table.
This leaves only one realistic option: The European Central Bank must be prepared to buy any new debt, potentially in huge amounts. It can also continue to help fund weak banks by letting them use dodgy collateral in exchange for fresh lending. Naturally, this scares orthodox central bankers, who view printing money to buy government debt as the road to hyperinflation. This fear is likely to be particularly acute among German monetary officials: Juergen Stark cited his opposition to the purchase program as the reason for his resignation from the ECB board this month.
The path to full-scale ECB financing would probably begin with a failed government-bond auction, maybe by Italy, which has such high funding needs. In response, the politicians would determine that their only immediate recourse is “bridge financing” from the ECB. The central bank would be promised that a new entity -- possibly a modified version of the existing stability fund -- would be created to eventually take these assets off its books. At the same time, the politicians in the vulnerable countries would promise broad reforms to improve growth and reduce spending.
But even under this scenario, uncertainty remains: What will happen, say nine months later, when it’s time for the debtor countries to implement the painful reforms and for the creditor nations to hand over the money to relieve the ECB of its assets?
It’s likely that governments won’t have prepared taxpayers for these sacrifices and a revolt could ensue. In the debtor countries, the politicians could simply fail to deliver unpopular reforms, as we have seen in Greece.
If this happens, the ECB would be required to become a semi-permanent source of financing. It could very well refuse to adopt that role. Another possibility is that Germany and some other countries leave the euro.
If that decision is made, however, it will be in the midst of an emergency, and not as part of a carefully studied, democratically debated process.
(Anil K Kashyap, professor of economics and finance at the University of Chicago Booth School of Business and director of the Booth Initiative on Global Markets, is a contributor to Business Class. The opinions expressed are his own.)
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