Saving Private Euro: What if Spain falls?

The approach taken so far to save the euro – fiscal austerity, structural reform and concessional financial assistance, and stronger surveillance of economic and budget policies – has failed as a strategy to restore calm in financial markets. Existential doubt about the euro survival has resurfaced. In reaction, the political debate on solutions to solve the Eurozone crisis has shifted in new directions in recent weeks:

• It is now widely recognised that the current policy mix in the Eurozone is not sustainable. Fiscal tightening in the peripheral countries has no chance of delivering the budget-deficit targets as long as macroeconomic policy in the Eurozone will not be rebalanced to boost growth.
• There are more and more advocates of a “banking union”, which could involve different layers: a common deposit guarantee, a pan-European resolution fund, and a single supervisor for the large and complex cross-border banks (see for example Praet 2012). Such a framework would reduce the risks of bank runs and mutualise the costs of bank recapitalisation.
• There is a growing consensus in support of jointly guaranteed Eurozone bonds to finance the borrowing requirements of individual countries. This solution would reduce the financing costs of peripheral economies and break the adverse feedback loop between market concerns, fiscal deficits, and economic growth.

While a political agreement on growth measures is underway, it is unlikely to be sufficiently aggressive to counteract the contractionary impact of fiscal austerity. Transforming the Eurozone into a monetary and banking union would provide a proof of political commitment to save the euro. It is doubtful however that the first steps in that direction will be sufficiently ambitious given the required transfer sovereignty and resources to a federal authority. A deal on Eurobonds and the resulting mutualisation of sovereign debt also seems impossible without moving towards a true political and fiscal union.1

While the new architecture of the new European monetary union is taking shape, the distance to get there appears dangerously long in light of the growing tensions in the markets. Given that the slow pace of political decision-making, what can be done to win the race with the markets?

Remove the maximum lending capacity of the ESM

The most serious danger to the euro is that Spain would be forced to ask for a full financial bailout. While the Eurozone might have just enough resources to finance a full-fledged adjustment programme with Spain, no money would be left to help another country. This would fuel alarm on financial markets because of a perception that Italy would follow if Spain falls. In other words, rather than calming markets, a bailout of Spain would bring the Eurozone even closer to the breakup point if it were not encompassed within a global and ambitious response to the market concerns.

A solution to eliminate any concern regarding the financial resources available to help Spain and Italy would be to remove the maximum lending volume of the European Stability Mechanism (ESM), which has been set at €500 billion,2 and to grant it a banking license. These new provisions would allow the ESM to borrow on the capital markets a multiple of its subscribed capital (€700 billion) and have access to ECB re-financing, thereby enabling the ESM to get the resources needed to participate in a bailout plan for Spain and Italy. This participation could take the form of purchasing government bonds issued by these countries on the primary market. If needed, these bonds could then be used as collateral for ECB loans. The financial support to the countries concerned would be conditional on the adoption of a macroeconomic adjustment program supported by the International Monetary Fund. In the absence of a federal finance ministry capable of enforcing mutually agreed adjustment measures, it seems indeed unrealistic to expect that Spain and Italy receive large-scale financial support without economic conditionality. This said, the adjustment programmes should find the right balance between fiscal discipline, structural reform and economic growth.

The idea of granting a banking license to the Eurozone rescue fund is not new.3 However, the previously-developed proposals were more ambitious to the extent that they aimed at creating a liquidity backstop to deal with a generalised breakdown of confidence and liquidity. The proposal developed here is more modest since its objective is to ensure that the ESM lending capacity is large enough to provide financial assistance to all countries that request it. In other words, the goal is not to build a big “bazooka” to reassure markets and trigger sharply lower spreads on peripheral bonds. Rather, it is assumed that market confidence will only come back if the peripheral countries address the roots of their fiscal problems and find ways to substantially improve their competitiveness.

The Treaty establishing the ESM foresees that the adequacy of the combined lending capacity of the ESM will be assessed and increased if appropriate, prior to its entry into force. The worsening of the Eurozone crisis justifies making this assessment and agreeing on a change to the Treaty. The European Central Bank (ECB) should be invited to participate in the discussion in order to obtain its support.

Until now, the idea of registering the ESM as a bank has met strong resistance from the European Central Bank (ECB) and Germany. Over and above the fact that the proposal developed here is not to grant the ESM an unlimited access to ECB re-financing, a series of other arguments can be offered to persuade policymakers of its merits.

Limited risks for the ECB

Granting the ESM a banking license could be considered to be identical to an operation of sovereign debt monetisation that would lead to an excessive increase in the ECB balance sheet. Several arguments can be used to address these concerns.

• The proposal would pose a danger for the ECB if it were to create the perception that it is willing to accommodate irresponsible fiscal policy by monetising government debt. In reality, by contributing to the financing of countries prepared to correct their fiscal and competitiveness problems, the ECB would encourage economic adjustment and not fiscal profligacy.
• By switching to fixed-rate, full allotment liquidity policy, and by implementing its three-year long-term refinancing operations, the ECB has shown its willingness to respond to the banks’ liquidity needs and accept the resulting impact on its balance sheet. The proposal seeks to extend the ECB liquidity provision towards the ESM, in a limited and controlled way.
• The potential impact of the proposal on the ECB balance sheet should not be a particular concern for important reasons:
  • The expansion of base money would not compromise the ECB’s ability to keep inflation under check since it does not mechanically lead to excessive monetary expansion. The refinancing of the ESM will be felt on the money supply (M3) when the money created to finance the ESM will move into the broader economy. This will only occur when credit conditions in the Eurozone normalise. At that time, the ECB will be able to use its full range of standard and non-standard policy measures to support price stability.
  • The potential impact on M3 will be limited by the fact that the ECB loans to the ESM will have a money multiplier significantly lower than loans to banks. Indeed, the ECB money will not be used to generate bank deposits and credits in series but to allow program countries to service their debts held with institutional investors, knowing that these investors will use the proceeds in the context of their portfolio’s investment management. In the current circumstances, it is unlikely that this portfolio rebalancing could influence significantly investment and consumption decisions.
  • Recent ECB research confirms that following the significant excess central bank liquidity in Japan in the period between 2001 and mid-2006, there was no strong acceleration of either broad money or inflation (ECB 2011).
  • Reducing uncertainty regarding the future of the Eurozone and solving the funding problems of the sovereigns will contribute to break the vicious circle between the sovereigns and the banks, reignite the interbank money markets, reduce the dependency of banks on ECB loans, thereby taking pressures off the ECB balance sheet.
• The importance of nonlinearities in the economy provides a rationale for a particular form of risk management approach to monetary policy to act pre-emptively when there is an increase in the probability of significant financial deterioration in the economy (Mishkin 2011). As a Eurozone breakup has become a distinct possibility, the ECB should follow Mishkin’s advice and prepare for timely, decisive, and flexible action.

Limited risks for Germany

The proposal developed here aims at ensuring that the approach to deal with the Eurozone crisis through adjustment and financial help could be pursued further. For this to be possible, the lending capacity of the ESM should be increased in line with the potential financing requirements of the peripheral countries of the Eurozone. This can be achieved in a proportionate manner, without mutualising sovereign debt, creating conditions for moral hazard, or giving up on price stability. The solution does not require increasing the capital stock of the ESM; it therefore allows decoupling the evolution of the sovereign debt of the core countries from the financing of the peripheral economies.

This solution would allow offering Spain and Italy financial assistance, albeit under strict economic policy conditionality. As soon as these countries graduate from the adjustment programmes, they will reduce gradually their financial liabilities towards the ESM. The proposal would therefore not result in a permanent system of fiscal transfers from richer members to poorer members, and thus should be acceptable to the German constitutional court.

A glimmer of hope for the Eurozone

The above proposal will not solve all the problems of the Eurozone. There are still many pressing concerns that need to be addressed to restore confidence in its future, notably as regards the social and political sustainability of the required supply-side reforms needed to strengthen the competitiveness in peripheral economies with a fixed exchange rate, and the distribution of the adjustment efforts over time and between the periphery and the core. Still, if Spain falls tomorrow, the European leaders will need to ready to address the concern that Italy would be next in line. If they can reach agreement on a comprehensive solution along the line proposed above, we could see some light at the end of the tunnel.

References

Delbecque, Bernard (2011), “Capping interest rate to stop contagion in the Eurozone”, VoxEU.org, 17 October.

Gros, Daniel (2011), “August 2011: the euro crisis reaches the core”, VoxEU.org, 11 August.

European Central Bank (2012), “The relationship between base money, broad money and risks to price stability”, Monthly Bulletin, May.

Mishkin, Frederic S (2010), “Monetary Policy Strategy: Lessons from the Crisis”, 67-118, in Approaches to Monetary Strategy – Lessons from the crisis, ECB conference November 2010.

Praet, Peter (2012), “European financial integration in times of crisis”, speech at the ICMA Annual General Meeting and Conference 2012, Milan, 25 May.

Weidmann, Jens (2012), “What path to a sustainable fiscal union?”, speech at the 2012 ZEW Economic Forum in Mannheim, 14 June.

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1 See Weidmann (2012) for an official German perspective on this issue.

2 This amount includes the outstanding stability support of the European Financial Stability Facility.

3 See Gros (2011) and Delbecque (2011).