Europe’s Forward Step – But No End to Volatility

What did the euro leaders decide at 4 a.m. on Thursday morning? Given the lack of details, it might be too early to tell. But the announcement at the Euro Summit1 takes Europe closer than ever to a “comprehensive deal” that addresses all the relevant problem areas: Greece, the faltering European banking sector2, institutional reform in Europe and – implicitly at least – that EU bazooka that is supposed to prevent the spread of contagion from the periphery to the core of Europe.

For Greece, a High Price for Help

For Greece, the new deal includes a voluntary bond exchange with a nominal discount of 50 percent on notional Greek debt held by private investors3. Endorsed by the Institute for International Finance (IIF)4, t he association that speaks for the banking sector, it has garnered preliminary approving comments from the International Swaps and Derivatives Association (ISDA), which suggests that it will be ruled a voluntary transaction that will not trigger sovereign credit default swaps (CDS)5. The aim of the write-down is to achieve a gross Greek debt/GDP ratio of 120 percent by 2020, while the European Central Bank (ECB), through euro area credit enhancements, has agreed to continue to fund Greek banks following a short spell in technical default. Thus a lot of the tail-end risk that many experts said would flow from a dramatic debt restructuring seems to have been lifted in European debt markets and banking systems. Moreover, since most Greek debt is governed by Greek national law, which can easily be changed, the participation rate of private bondholders will probably be quite high in this nominally “voluntary” bond swap. Hold-out strategies will be costly and difficult, except perhaps for holders of bonds of the shortest terms.

A 120 percent gross debt ratio by 2020 does not mean that Greece is unambiguously solvent even by that date. Some uncertainty will continue to cast a shadow over Greece. Unlike the goals called for in the earlier deal of July 21, however, this accord provides Greece with a “fighting chance” to regain market access through a long process of tough austerity, structural reforms and continued official sector support. Indeed, a lower debt burden will likely increase Greece’s incentives to comply with such measures as demanded by the International Monetary Fund (IMF), especially in the future after Prime Minister George Papandreou steps down. The German Bundesbank is of course skeptical6, expressing concern that Greece will walk away from its commitments. But that skepticism seems misplaced. The future will still be extremely difficult for Greeks. The fact that it is no longer hopeless should actually encourage Greek compliance.

All industrialized nation sovereign defaults are ultimately political decisions about willingness to pay. In the euro area it is not a domestic but a euro area choice. The 50 percent write-down, or haircut, significantly improves the political and fiscal solvency of Greece in the eyes of euro area creditor nations. Real losses – rather than a 21 percent slap on the wrist – have now been imposed on reckless private lenders to Greece, and moral hazard for them has been checked. This will prove politically invaluable in the future when euro area politicians justify to their critics this decision to continue to support Greece.

There will be no similar haircut for the debt owned by the official sector. But while the IMF will obviously remain whole, the euro area sovereigns will participate in another way to secure longer-term Greek solvency. The euro area leaders state this clearly, when they say: “We reiterate our determination to continue providing support to all countries under programs until they have regained market access, provided they fully implement those programs.” The euro area participation won’t be a haircut at the same time as the private sector, but the continued concessional financing of Greece is a functional equivalent. This has the clear political advantage that euro area politicians can continue to claim (as they have misleadingly done to their publics so far) that “Greek assistance is a loan, not a transfer,” while appearing tough on reckless bankers.

The commitment to continue financing Greece (and Ireland and Portugal) is clearly aimed at preventing contagion caused by the Greek sovereign debt restructuring. Besides this effort at “ring-fencing” Greece from contaminating the rest of the region, the euro area/IMF funding commitment will likely ensure that Greece is seen as a unique case and that there will never be another debt restructuring for Greece or any other country in the euro area.

Ironically, however, another aspect of the Greek deal – its voluntary nature – might have the opposite short-term effect. It has an obvious appeal to the self-respect of all euro area leaders (not least the ECB) to be able to deny that a default has taken place.7 Yet the fact that this deal did not trigger sovereign credit default swaps (CDS’s) despite a 50 percent nominal loss of the debt will likely rattle the entire CDS market. Euro politicians hostile to this derivative class will not shed any tears. But the trading market of some euro area peripheral sovereign bonds could freeze up if the CDS market disappears. Many holders of Italian sovereign debt may be much less likely to do so, for example, if they cannot hedge that exposure with a relatively cheap CDS on Italy. They could therefore sell their Italian bonds — sparking another type of contagion in the euro area.

If “moral hazard” for banks has been reduced in this deal, what about “political moral hazard” for Greece now that its debt has been reduced? That would not seem to be a problem. Greece has effectively been reduced to a “Mandate Area” governed by the Troika of the IMF, the ECB and the European Union and its now permanent monitors on the ground. Greece, which has endured military juntas in the past, is not about to savor that prospect or recommend it to anyone else. Lisbon and Dublin will likely think twice about pursuing write-downs accompanied by the cost of losing a large chunk of national sovereignty.

For Banks, Progress on Recapitalization

As for banking recapitalization, the scale called for by European leaders falls well short of making the euro area system solid and well capitalized. The decision to require banks to value their total sovereign bond holdings at mark to market (M2M) looks like it was designed to reduce the adverse impact of the Greek sovereign debt restructuring, while accelerating the longer-term Basel III-related recapitalization process of the system.

Another important factor was the decision effectively approved by euro area leaders to allow for mark-to-market gains on core euro area sovereign bonds to be counted against losses of peripheral bonds. Accordingly, German banks (with lots of German government bonds, or Bunds) and UK banks (with lots of UK government bonds, or Gilts) can escape serious recapitalization efforts8. French banks (with lots of French government bonds, which are probably still mostly trading above par) can also face a manageable balance sheet, sparing their regulators the impairment of the French AAA-rating. Most of the effects of the recapitalization will instead come in the periphery (minus Ireland), although in both Portugal and Greece funds earmarked in the existing IMF-programs look sufficient to protect them from trouble. The bank losses for most of the Greek banking system look likely to lead to bank nationalization, however, as was the case in Ireland earlier. Such could also be the fate for the most troubled Portuguese and Cypriot banks.

Since banks can be expected to freeze dividend payments until they recapitalize, relatively few EFSF funds are likely to be pumped directly into the euro area banking system. In fact, most Spanish and Italian banks should be able to raise sufficient capital privately or through national channels.

Instead, the EFSF should be mobilized for the other part of the euro area banking rescue plan, a new “term funding guarantee scheme” led by the European Banking Authority (EBA) in conjunction with the European Investment Bank (EIB) and the European Commission. 9 This instrument will be a much more appropriate role for the EFSF, because national government funding guarantees of this kind (if they were extended by Italy, for example) will be viewed as quite worthless for banks and unlikely to reopen funding markets to them. This initiative shows an understandable concern among policymakers, following the failure of the French-Belgian bank Dexia, that the problem of large undercapitalized banks facing large refinancing demands should be addressed urgently. There is clearly a role here for a pan-European solution, perhaps modeled on the U.S. Federal Deposit Insurance Corporation (FDIC)’s Temporary Liquidity Guarantee Program from November 200810, which for a sliding fee allowed U.S. banks to issue FDIC-guaranteed bonds of a maturity of three years.

In sum, the announced measures to stabilize the euro area banking system are a further step on a long road of slowly accelerating recapitalization efforts. Because of the large size of the European banking systems and because European sovereigns have their own solvency problems, however, euro area governments are unlikely to put up sufficient amounts of capital themselves to instill confidence in the banking system, as the United States did in 2008-9.

For the EFSF, a Shell Game

As for how euro leaders plan to use the European Financial Stability Facility (EFSF), the announced options of applying “EFSF leverage” should be seen as a shell game — a distraction designed to provide political cover for the ECB to continue operating its Securities Market Program (SMP). No “handover” from the ECB to the EFSF is contemplated (policymakers know that it would be a political disaster), and the ECB will continue to be the ultimate defender of euro area financial stability. The ECB’s crucial part in Thursday’s deal is obvious, and so are the political reasons why it went unannounced. The central banks will continue the SMP and other temporary non-standard measures as the ultimate backstop against financial calamity.

The details remain murky, but it is clear that none of the two EFSF options presented by the leaders have any legs. EFSF option one, “to provide credit enhancement to new debt issued by Member States, thus reducing the funding cost” is meaningless from the perspective of systemic euro area financial stability. Indeed it will merely sell such credit enhancement to Italy at the expense of a stretched French AAA-rating. When the overlap between the insurer and the insured is as big as it is in the euro area, the financial effects will be minimal.

Then there is the additional issue that, from an EU Treaty perspective, bond insurance provided by the EFSF might be as illegal as direct purchases of bonds by the ECB. Article 125 of the European Union treaty states:

The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.

Thus in principle the treaty rules out both the ECB and inter-government assumptions of commitments of other governments. The ECB might of course be happier to let governments break the EU Treaty rather than to do so itself. But two wrongs rarely make a right, and they do not in this case.

Given the inevitable devastating spillover from a hypothetical Italian sovereign default, it is doubtful that EFSF guarantees from the other euro area members would be credible11. Could France actually pay, if Italy defaulted?

The EFSF has now announced12 that the insurance (termed a partial protection certificate, or PPC) will be a detachable and separately traded instrument. This should of course help prevent a segmentation of national bond markets into insured and uninsured parts. However, in a euro area plagued by Italian non-compliance, this PPC detachability raises the question whether Italian bonds might some day be stripped again of this EFSF-funded benefit over Italian recalcitrance. Would an EFSF-funded Italian PPC be any more reliable than Prime Minister Silvio Berlusconi’s promises?

EFSF Option two calls for it “to maximize the funding arrangements of the EFSF with a combination of resources from private and public financial institutions and investors, which can be arranged through Special Purpose Vehicles (SPV).” This provision is built on the pipedream that such willing and very deep-pocketed private and public investors exist. Make no mistake, they don’t! Contrary to recent speculation and discussions with the Chinese, the idea that the current Chinese leadership would hand over meaningful resources to an EFSF-SPV is delusional. The Chinese have a well-trodden history of never actually committing to buying risky European peripheral assets. They might pledge a token contribution, but it would require hundreds of billions of dollars or euros to have an impact. Such a step would also entail a major change in the way China allocates its foreign exchange resources, undercutting or at least confusing China’s longer-term exchange rate policy. Far reaching change of this nature is not likely to be something the outgoing Chinese leadership will be announcing.

The “reverse Robin Hood” spectacle of poorer emerging markets bailing out rich Europeans might be something that some people would savor. But as witnessed internally in Europe with Slovakia, which revolted against the plan to aid Greece, it will not fly in democratic countries. Only a similarly wealthy country like Japan or maybe Saudi Arabia would be possible investors. But again — not to the tune of hundreds of billions.

It is moreover highly unlikely that the IMF could participate directly in such an SPV. The IMF generally can only lend directly and against policy conditionality to individual governments, not to an SPV set up by a collection of governments. It looks unlikely that the SPV can qualify on either account. In the 1970s the IMF set up an “oil facility” to lend to deficit countries. But the idea of the IMF acting as a conduit in that way for EFSF SPV investments suffers from a lack of support by the pivotal “surplus country” of today — China . Moreover, would the U.S. approve of a scheme that effectively sidelined Washington and empowered Beijing? Probably not.

Politically, though, the SPV option has its attractions. However chimerical, it will enable EU leaders to tell other G-20 leaders in Cannes next week that they are looking for ways to raise funding for their problems. By making a gesture of turning to other countries for help, EU leaders can advise colleagues to “put up or shut up” if they start complaining about the mess they have made in their own backyard. Echoing Treasury Secretary John B. Connally back in the 1970s when the U.S. went off the peg to gold, they can say, “The euro is our currency, but your problem, too.”

For all these concerns about the financial impotence of these two EFSF options, it is fortunate that they do not really matter. Their principal real role is to provide political cover for the ECB to keep the SMP in operation. The newly-ratified EFSF lending capacity is fixed at €440 billion, but that capacity became a damp squib once the ECB refused to provide leverage for it. (In the same way, the Troubled Asset Relief Program, or TARP, would have been insufficient in the U.S. in 2008-09 without the support of the Federal Reserve using it to set up its own lending facility.) But the talk of a leveraged EFSF has retained its political significance. It is hard to imagine euro area leaders carrying out the masquerade of characterizing the EFSF as a bazooka, as it would have left the ECB completely politically naked, and in that way probably more unlikely to be willing to continue its SMP.

The ECB, meanwhile, will not want to look like it is taking instructions from governments. Accordingly, the entire “EFSF leverage sideshow” is part of the ECB’s demands directed at euro governments to keep the SMP operational. This process is somewhat similar to the ECB’s final acceptance of continuing to accept default rated Greek collateral only after it received euro area credit enhancement guarantees.

For the Euro Area, New Powers to Persuade – and Continuing Volatility

The most important aspect of the euro area agreement is the implication for the institutional deepening of the euro area. The euro area summit statement makes it clear that Spain and Italy are now de facto subject to a “mini IMF program.” Prescriptions include labor market reforms, pension system adjustments and constitutional balanced budget amendments — something all the euro area is committed to by the end of 2012). Policy compliance by Spain has been strong (and will surely continue after the Spanish elections in November). Compliance by Prime Minister Berlusconi, on the other hand, obviously remains an open question.

Nonetheless, events in Italy this week suggest that the EU now has the institutional capacity to coerce even large member states into compliance with reform implementation. This marks a profoundly important step forward the institutionalization of the euro area and a big step forward. As always in the EU, it took a crisis to bring the unthinkable to reality.

This week’s euro area summit and the surrounding events show that the EU, and euro area especially, is evolving into a “reactive fiscal entity.” That is not the same as a full-blown centralized and predictable fiscal union (like the U.S.), where a central authority can demand compliance from constituent parts. It is, however, an entity where the center has the ultimate capacity to force recalcitrant large member states (Italy) to comply with its fiscal/reform demands through a drawn-out process of overlapping political, economic and financial pressure. Such economic and financial pressure can only be mustered in an emergency, making the euro area an inherently unstable and volatile economic and political entity until a much longer-term process of fiscal integration and unity is gradually completed.

As a “reactive fiscal entity,” the euro area has proven itself capable of avoiding large-scale economic disasters. But relying on crisis-induced pressure on national governments must be handled carefully. Indeed, the euro area may become dependent on a certain crisis mood and financial market pressure to solve its problems, which will in turn create new problems, dashing hopes of businesses and investors for a predictable policy environment. Volatility will alas be a permanent part of the euro area until a deeper integration becomes politically feasible.

It is evident that the role of the ECB is paramount. It remains the only euro area institution with the capacity to act forcefully to stabilize regional financial markets. Until much deeper European integration is complete, the ECB wields the only bazooka in town. It is thus ironically not in the ECB’s interest to end the current financial volatility in the euro area quickly. Seen from Frankfurt, it is more important to ensure that the current crisis is not wasted, and that the right reforms are carried out under pressure.

Reading the public statements of the outgoing ECB president, Jean Claude Trichet, and his incoming successor, Mario Draghi – as well as the comments of other ECB leaders — makes it clear what the ECB wants. Its goal is not merely to reduce Italian bond yields to 150 basis points over Germany or stabilize the euro area banking system. It wants enforceable fiscal rules originally envisioned by the failed European Stability and Growth Pact (SGP), along with deep structural pro-growth reforms in the periphery (noticeably Italy) — and ultimately a further fiscal integration (economic union) for Europe. Before this happens, the ECB will not “go big” and try to end the financial crisis preemptively.

To achieve these long-term goals and ensure that leaders like the hapless Berlusconi actually implements his promises in Italy, the ECB is clearly willing to continue the economic pressure. Anything else would be seen from Frankfurt as bailing him and others out and freeing errant countries from taking tough but necessary decisions.

The ECB will clearly employ the SMP to prevent spreads from skyrocketing — 6-6.5 percent looks like the de facto ceiling for 10 year secondary market yields for Italy and Spain. But we should not expect Italian or other countries’ bonds to fall much. A further narrowing of spreads will come only in response to reform implementation, and not from Frankfurt’s intervention. In the short term, a further deterioration of Italian spreads – at least partly attributable to calibrated ECB interventions to make sure Berlusconi understands – is indeed probable. In the end, Il Cavaliere will likely be forced to out of office or towards reform13.

Some might say that the ECB’s strategy of keeping financial markets guessing about its intentions derives from its narrow definition as a “conditional lender of last resort,” and that it is a passive strategy that prevents confidence from returning to markets and risks sending Europe back into a shallow recession. A new euro area downturn now looks likely and the ECB might try to fight it. But the ECB clearly does not share some commentators’ doom and gloom scenarios predicting the imminent collapse of the European economy. And we do not know what the political implications of a recession would be.

Since early 2010, peripheral euro area voters have made a mockery of simplistic political-economy voting intention models, although many commentators still rely on them. But voters in Ireland and Portugal this year did not choose political populists in hard economic times. Rather they elected governments openly campaigning for the implementation of tough IMF programs. Similarly, Spanish voters look set to return the traditionally pro-reform center-right Partido Popular (PP) party to power in November. Were Berlusconi to resign early and call for a new election in the first half of 2012 during a recession, maybe Italians would finally elect fiscally responsible and pro-reform leaders or accept a new technocratic pro-reform government. That is a bet that Draghi, newly ensconced in Frankfurt, might just be willing to take — and he will certainly not be rushing to cut interest rates.

This week’s euro area summit will not end the euro area crisis. But it will likely have helped limit some of the catastrophic downside risk. The euro area might just have gotten the capacity to finally discipline its large member states, but only through the reactive use of a combination of political, economic and financial crisis pressure spearheaded by the ECB.

The situation is not without irony. Governments normally fight financial crises and market panics by a credible commitment of a large sum of money to instill confidence in the private sector. The euro area however is not a country and still has no government with that same capacity. Instead, the EU/euro leadership can only solve its crises ultimately by prolonging them.



2. See EBA website at–Communications/Year/2011/The-EBA-details-the-EU-measures-to-restore-confide.aspx

3. It should be noted that the €30 billion the euro area is providing to fund the collateral for the new Greek bonds logically should be counted against the 50 percent reducing the effective value of the haircut for private investors. However, the details remain murky about the precise structure at this point. Since the Greek government is nominally liable to repay the EFSF at least half of that (€15 billion), it is not clear where in the official sector this extra bill will end. Presumably, economic developments will ultimately decide, as euro are policymakers can change the terms among themselves in the future.




7. I am here reminded how my PIIE colleague Michael Mussa has often stated how the IMF political leadership would emphasize that there had been “no legal default” in relation to the Brady Bond Plan in the late 1980s and 1990s.

8. The Bank of England’s decision to restart its quantitative easing program recently will surely now be praised by the principal shareholders of large UK banks, including of course the UK Treasury with its majority stake in Royal Bank of Scotland.



11. Daniel Gros correctly compared it to acquiring a 20 percent loss insurance on your house against a nuclear meltdown next door. See

12. See EFSF Q&A at

13. I have described the ECB’s crisis leveraging strategy in more detail here:

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