Europe’s leaders are missing an important point as they argue over the size of the euro area’s bailout fund: If they want to save taxpayers’ money, bigger is better.
Euro-area finance ministers will need to fight yet another fire when they meet in Copenhagen today. This time around, the concerns are focused on Spain and Portugal. As before, the problem is a lack of credibility. Markets aren’t convinced that Greece’s latest bailout will be the region’s last. They still don’t know which other governments might default, how much money European banks will lose as a result, and whether the euro area can hold together.
Only a full and honest reckoning, together with a show of overwhelming force, can dispel this corrosive uncertainty. As Bloomberg View has argued, Portugal can pay only about 60 percent of its debts and Greece will need another round of debt relief. To restore confidence in the common currency once those losses are taken, euro-area nations -- with the help of the European Central Bank -- would have to demonstrate the ability to raise a war chest of at least 3 trillion euros ($4 trillion). That, by our estimate, is the amount needed to cover the financing requirements of struggling governments over the next several years (about 2.5 trillion euros) and guarantee the recapitalization of banks.
Expensive as such a large rescue fund may seem, it has an advantage akin to that of nuclear deterrence: If it’s big enough, it need not be used. If Europe’s leaders can demonstrate enough firepower to guarantee the solvency of governments and banks, investors would probably have the confidence to provide most of the necessary loans and capital themselves. That’s what happened with U.S. banks, for example, when the government guaranteed their recapitalization in 2009.
So far, Europe’s approach has been completely different. Germany and other wealthy nations have committed just enough to keep Armageddon at bay, but not enough to fully restore confidence. As a result, they have had to make good on their commitments, replacing the money of fleeing investors with official funds and exposing taxpayers to losses.
The European Financial Stability Facility has already promised about 200 billion euros to Greece, Portugal and Ireland. Such official loans account for an increasing share of the debts of these governments, so any future defaults will fall more on taxpayers. Meanwhile, the ECB has propped up the market for bonds of sovereigns such as Spain and Italy by accepting them as collateral for more than a trillion euros in longer-term, low-interest-rate loans. That’s a giant subsidy to the banking system that will leave taxpayers holding the bag if things go wrong.
These efforts have calmed markets, but haven’t brought borrowing costs down far enough to make struggling governments’ finances bearable in the long run. Spain, for example, must pay an interest rate of 5.4 percent to borrow money for 10 years -- 3.6 percentage points more than Germany. Were it to end up paying that rate on all its debts, the risk premium -- a direct reflection of investors’ concerns about a default or a breakup of the euro -- would cost Spanish taxpayers about 20 billion euros a year. That’s roughly equivalent to what Spain spends on justice, defense, public security and foreign policy combined.
The to boost the euro area’s bailout capacity at today’s ministerial meeting aren’t nearly ambitious enough to solve the problem. German Chancellor Angela Merkel has signaled that she would support adding the EFSF’s existing loan commitments to the new 500 billion-euro European Stability Mechanism, boosting the funds’ combined lending ability to about 700 billion euros. By adding the EFSF’s 240 billion euros in unused capacity, the total could be increased to almost 1 trillion euros.
Merkel faces real political constraints from a German electorate that’s reluctant to make more sacrifices to bail out less-disciplined economies. But such a meager response, combined with a lack of debt relief for insolvent sovereigns, all but guarantees that governments will have to turn to the rescue funds for support. As a result, European leaders’ frugality could prove very costly to the taxpayers whose interests they claim to defend.
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