- By Phil LevyPhil Levy is Senior Fellow on the Global Economy, The Chicago Council on Global Affairs, and teaches strategy at Northwestern University’s Kellogg Schoool of Management.
This week, global economy mavens are waiting once again for European leaders to emerge with a panacea. Tradition dictates that financial panaceas should be presented on Sunday evenings, before Asian markets open. The Europeans actually scheduled their panacea accordingly, but whiffed. The cure-all was rescheduled for Wednesday.
There has been much gnashing of teeth and rolling of eyes over eurozone leaders’ repeated inability to solve their financial crisis once and for all. U.S. Treasury Secretary Tim Geithner traveled to Poland last month and told a gathering of European finance ministers to Just Do It. Oddly enough, the gathered Europeans did not really appreciate the admonishment.
So President Obama joined in and added further encouragement: "In Europe, we haven’t seen them deal with their banking system and their financial system as effectively as they needed to." Quoth the coverage: "Obama didn’t specify what steps should be taken."
And therein lies the problem. There has been a presumption that if only German Chancellor Merkel and French President Sarkozy could stop bickering and summon the political resolve, they could take the decisive set of actions to put everything right. The rest of the world can best help, the reasoning goes, by shouting exhortations at Europe to just try harder.
But what, exactly, are Europeans being urged to do? The grand fix must address a knot of interconnected problems. First, there is the issue of Greek debt; it’s huge and the Greeks can’t pay it. That leads to worries about what will happen with other larger highly indebted countries around Europe’s periphery; such worries mean that lenders demand higher interest rates and worry turns to panic. This sovereign debt crisis, in turn, stirs fear in those who hold all that debt; since many of the debt holders are European banks, that stirs fear in pretty much everyone — or it should.
Now consider some candidate solutions.
1. The leaky lifeboat solution: start bailing.
This was Europe’s first response, with the creation of the European Financial Stability Facility (EFSF), with a lending capacity of roughly $600 billion. Although Greece’s debt is huge relative to the size of the Greek economy, it is certainly small enough to be handled by the fund. Why not just pay it off and be done with all this? There are three problems. First, that wouldn’t solve Greece’s problems. Although the country has significantly cut its budget deficit, it would still need to borrow even if its old debt were wiped out. Second, there is the moral hazard of rewarding miscreants. Cutting budget deficits is painful and politically treacherous; if Europe will ultimately pick up the tab, why go through the agony? Third, Greece is not alone. Ireland, Portugal, Spain, and Italy have all drawn the suspicion of bond markets. To cow those markets into submission would take a bailout fund of trillions of dollars, not just hundreds of billions.
Could Europe just swallow hard and provide the cash? Obstacle: the borderline state of French finance. France currently has a AAA credit rating, but has substantial debt of its own. If it were to join Germany to backstop such a large fund, its credit rating could be downgraded, as Moody’s warned last week. Without a top credit rating behind it, the finances of the bailout would not work.
2. Haircut (or decapitation)?
What if Greek bondholders had to accept only a fraction of their money back? Actually, bondholders agreed to such a "haircut" in a July deal, in which they agreed to take roughly 20 percent less than they were owed. Now that looks insufficient; European negotiators are asking for a 60 percent cut.
The very prospect of such a large slice knocked 17 percent off the share prices of Greek banks (heavy holders of Greek debt). The bigger the cut, the bigger the hit taken by other European banks and the worse the fears about how other countries’ debt crises will be resolved.
3. A lever and a BRIC
Perhaps a little financial imagination will do the trick. Why not lever the existing fund, the EFSF? Just as a 20 percent down-payment, plus some borrowing, can let you buy 100 percent of a house, perhaps the EFSF billions, if used to guarantee that the first 20 percent of lenders’ losses would be covered, could have a much bigger impact. Perhaps flush countries like China, looking to place some cash, could be enticed to come in. Thus, $600 billion could let you wield $3 trillion.
The invaluable Wolfgang Munchau critiques:
Leveraging … massively increases the probability of a loss for the triple A-rated member states, who ultimately provide the insurance. If a recipient of the guarantee were to impose a relatively small haircut — say 20 per cent — the EFSF and its guarantors would take the entire hit. Under current arrangements, they would only lose their share of the haircut.
Further, if lenders to Greece are set to lose 60 percent of their money, how reassuring would a 20 percent guarantee be when contemplating new loans to Italy or Spain? The Chinese are not stupid.
4. Just back the banks
The main economic worry is that debt defaults will crush bank balance sheets and bring a reprise of the September 2008 financial crisis. Why not address the banking problem directly and then let all the indebted Euro sovereigns take care of themselves?
There are plans to recapitalize European banks, but there is substantial disagreement about how much money is needed. The answer depends on just how dire a scenario one wants to contemplate in terms of debt writedowns. Estimates have ranged from around $100 billion to over $500 billion. Further, voter’s don’t always react well to bank bailouts. And, in Europe, banking is an issue dealt with on the national level.
As part of an effort to fix European banks, they are being asked to raise capital (or rather the ratio of funds on hand to money lent out). This could well prompt cuts in bank lending, which would slow the European economy, which would increase spending and cut tax revenue, which would in turn … Well, nothing good.
5. Desperate measures
One drastic step, reportedly espoused by Sarkozy, is for the European Central Bank (ECB) buy up (monetize) the unloved debt of the wayward member states. Aside from the fact that the ECB is explicitly forbidden from doing so, monetizing debt is a traditional ingredient in creating a serious problem with inflation. Paul Krugman dismissed this worry yesterday, noting that "money creation isn’t inflationary in a depressed economy."
If this were a one-off liquidity crisis, that might make sense. But with chronic imbalances, it could be very hard to limit the money printing. And the Germans have a thing about inflation (and rules), which could explain Chancellor Merkel’s firm "Nein!" to the idea this week.
That exhausts the possibilities for quick fixes. Beyond that, there are options like the implausible "hold tight and hope for growth" or the dubious "join together in a political and fiscal union."
Or European leaders could face up to the underlying structural problems of the euro and step back from the current level of integration. Not that such a move would be easy. It would be not so much "rip the Band-Aid off" as "sever the gangrenous limb." It’s not hard to see why they are approaching such a decision tentatively and looking askance at those who urge them to Just Do It.