Reflecting on his experience with the multiple financial crises of the 1990s, then-Secretary of the Treasury Larry Summers wrote that policymakers facing a crisis tend to go through a process reminiscent of the five stages of grief (Summers 2000):
- The process starts with denial that a crisis could be taking place.
- This is followed by anger, with a tendency to assign blame (speculators, rating agencies, etc.).
- Then there is the bargaining (with the markets, seen as potential saviours).
- Fourth comes despair, leading eventually to the decision to call for help (IMF, EU).
- It is finally only in the fifth stage – acceptance – that the way is opened to a credible plan.
As this crisis escalated to its climax in early May, the European Council seems to have been stuck between the first two stages. At first its position was that no crisis could arise because it (the European Council) was ready to intervene. Then it insisted that Greece had a credible programme in place and blamed the spread of the contagion to Portugal and Spain on immoral speculation.
Our own evaluation of Spain’s fundamentals indicates that the country does not face an intractable insolvency problem. But this is irrelevant in a crisis. Markets do not give policymakers the time to work their way through five stages of grief. When contagion was spreading and even Italy no longer seemed totally immune, it became crystal clear that the cost of further delay would be a full-blown financial crisis with incalculable costs.
At that point, the European Council finally recognised the problem and put together an impressive rescue package with potentially €600 billion in loans available for countries with potential funding problems.
Scale of the Eurozone’s problems
However, the EU authorities seem to have only partially recognised the nature and scale of the problem the Eurozone has to face. The key point is simply that a banking crisis tends to become a sovereign debt crisis and vice versa. This poses a particular challenge for the Eurozone, which has an integrated banking market while sovereign debt is national.
A liquidity crisis is in principle a problem for monetary policy and would call for a massive intervention by the ECB. However, the lender-o-last-resort function always falls in the grey zone between monetary and fiscal policy – particularly in a systemic crisis when the border between solvency and liquidity problems is blurred.
In the US, this does not matter as the Fed and the Treasury stand shoulder-to-shoulder, each one providing a guarantee for the other. It is different in the Eurozone, where the ECB cannot and should not act simply as the agent of the (national) fiscal authorities. In the context of the EU’s rescue package, the ECB decided to buy directly bonds in those markets it considers ‘dysfunctional’. This is a dangerous and slippery slope. There might be grounds for limited interventions when markets break down, in the sense that bid/ask spreads are so wide that trading stops, but a large-scale operation to shore up public finances in selected member countries constitutes a frontal attack on a key principle of the Maastricht Treaty.
Moreover, we need to keep in mind a simple but enduring truth: a liquidity problem postponed is a problem solved, but a solvency problem postponed is a problem made intractable. Using the ECB to prop up troubled countries will only magnify the problem over time.
So what can be done at this point?
The experience of the US at the peak of the crisis in early 2009 has shown that a combination of stress tests coupled with forceful intervention can quickly reduce the perception of counter party risk – a risk which is lethal for financial markets. But more action is needed.
- All EU supervisory authorities should conduct tough stress tests of their banks.
In the creditor (Northern) member countries, the tests should focus on the exposure to Southern Eurozone member countries. Specifically, they should assess the adequacy of capital and reserves to cover losses arising in adverse scenarios in terms of growth and risk premia which will impact the ability of both sovereign and private sector debtors to service their debt.
If the stress tests reveal that some institutions could not survive a default in any of the problematic countries, they should be forced to accept a recapitalisation and transfer their claims at a discount to the government or to the bad banks, where they exist. In this way, further problems could be ‘ring-fenced’; governments will no longer be condemned to throw good money after bad should the adjustment programs in Greece (and Portugal or Spain?) not work.
The table below shows that all forms of credit by Eurozone banks to governments amount to about 130% of capital and reserves. This illustrates the old rule that a sovereign default and a banking crisis represent two sides of the same coin – an excess level of debt in the system.
Table 1. Exposure of euro area banks to government as % of capital and reserves, 2009
Fortunately, the public debt of the three countries most at risk (Greece, Portugal and Spain) amounts to only about 14% of all public debt in the Eurozone. The overall exposure of Eurozone banks to the public sector in the three countries under speculative attack is thus large in absolute terms (about €400 billion) but even a 50% loss should be manageable, amounting to about 10% of aggregate capital and reserves of the banks in the Eurozone.
- Give markets a clear signal that Europe would be able to deal with a sovereign risk crisis in a structured way. The EU cannot continue to invent rescue packages over weekends under the pressure of an impending meltdown of the financial system.
We have argued previously for the creation of a European Fund to be financed by contributions from the countries representing the greatest risks, i.e. those with the highest deficits and debts. Such a fund is now urgently needed.
While there is no time to build up its capital in the manner we originally suggested (Gros and Mayer 2010a,b), a starting capital is already available. Eurozone countries have already pledged hundreds of billions of euros for Greece and other countries under the European Stabilisation Mechanism.
This ‘Mechanism’ is for the time being only a ‘special purpose vehicle’, but it should be developed into a new institution, which would not only manage the Eurozone’s contribution to various rescue packages and supervise their conditionality. This institution should also be a key element of the still-to-be-defined framework of fiscal policy for the Eurozone. Last, but not least, this institution, with its considerable financial backing, could also be used to organise a smooth insolvency of a member state should an austerity programme fail.
This last point is key for the credibility of the framework for fiscal policy that should now be drawn up as quickly as possible. As long as no member country is allowed to go insolvent because financial markets cannot absorb the losses, the Eurozone can survive only if all member countries behave in a cooperative and responsible manner. Experience has shown that this cannot be taken for granted.
Gros, Daniel and Thomas Mayer (2010a). “Towards a Euro(pean) Monetary Fund,”, CEPS Policy Brief, 8 February.
Gros, Daniel and Thomas Mayer (2010b), “How to deal with sovereign default in Europe: Towards a Euro(pean) Monetary Fund,” VoxEU.org, 15 March.
Summers, Lawrence H. (2000). “International Financial Crises: Causes, Prevention, and Cures”, The American Economic Review, Vol. 90, No. 2, Papers and Proceedings, pp. 1-16.