08 August 2011

Paul N Goldschmidt: The financial crisis - the ball is now clearly in the Governments' court

The fleeting positive "opening" of European stock markets and the significant reduction in borrowing spreads in the sovereign debt market should come as no surprise after the intense behind the scene activity of the weekend, prompted by the downgrade of the US sovereign rating, which galvanised authorities into action.

While the official communiqué of the G7 vowing to take “all necessary measures” to prevent the crisis from spreading will, in all probability, have had very little if any impact, the ECB’s announcement that it was ready to purchase Italian and Spanish bonds marks a radical new departure. Reading between the lines one must conclude that specific undertakings were made by heads of State and Governments of the eurozone in order to convince President Trichet to enter markets decisively.

Indeed, only the ECB was equipped with the necessary tools to intervene immediately, but it was abundantly clear from last week’s press conference that the ECB was reluctant to assume “alone” the responsibility for crisis prevention measures. The unmistakable “displeasure” of the ECB President was apparent in his several references to “…the heads…” where it was left to auditor to fill in the omission either by the politically correct words “of State and Governments”, or the less flattering qualification of “irresponsible”. The irritation of President Trichet was also noticeable in his unequivocal affirmation that ECB policy was determined entirely on “the basis that the Governments would indeed implement rapidly all the undertakings agreed in Brussels on July 21st”, in the face of obvious market incredulity.

The reversal of the ECB’s position implies that the Governing Council has received the “necessary assurances” over the week-end; some declarations on the speeding up of the legislative approval process by Germany and France and new budgetary measures in Italy and Spain accredit such a hypothesis. In addition, commitments must have been made for the rapid transfer from the ECB to the EFSF of the management and financing of distressed sovereign “bond purchases”.

If a temporary respite in the unfurling of the crisis has been achieved, its length may be as short as a few hours if US markets respond negatively to the downgrade, ignoring the developments in Europe or, as long as a few weeks/months, provided that the market considers that the “downgrade” has already been fully discounted.

Two main elements will be the drivers of future market developments:

• First the manner in which the US downgrade will impact over time the economic outlook: a general upward adjustment of interest rates (implied by greater “risk”) will be a further impediment to growth; on the other hand, the absence of such an adjustment would signal a lack of confidence in economic recovery. In this regard, the recent “Washington “debt compromise”, which  severely limits Government policy options to stimulate the economy, will weigh heavily in the balance. Clearly, a double dip recession in the US would impact adversely European prospects of recovery and make the budget austerity required all the more painful, if indeed at all possible. Markets may anticipate such an outcome, leading to further price deterioration adversely impacting consumer confidence and spending. In such a scenario, the more the European Governments and Monetary Authorities show their determination to restore public finances while maintaining inflation below but close to 2 per cent, the more the prospects for growth will appear compromised and the fear of a “depression” gain in credence.
• Second, the capacity of EU Governments – and eurozone ones in particular – to keep up a sufficiently credible momentum in the pace of reform implementation. It will be of particular importance to ensure that the objectives are clearly defined and that they benefit from the unanimous support of all the actors (Governments, Monetary Authorities, and Parliaments). At the first sign of dissension, markets are likely to sanction severely the process provoking the systemic crisis that has been, so far, narrowly avoided. This second requirement will prove particularly difficult to achieve but will be the litmus test as to whether Governments have the necessary political courage to adopt bold and unpopular measures regardless of the electoral calendar.

To satisfy markets, reforms will need to address as a priority the creation of a credible framework for the financing of “crisis intervention”. This means both a “lending facility” to Member States in need and a “market intervention facility” to purchase securities in order to stabilise bond markets, roles that have been assigned to the EFSF. This implies assigning sufficient resources (borrowing authority) and the structuring of a credible guarantee mechanism to ensure market acceptance of EFSF securities. Limiting liability for EFSF’s debts to the remaining (and possibly shrinking) number of solvent EMU Members will no longer be deemed sufficiently credible.

It is unavoidable that designing an optimal structure will involve “EU Treaty” amendments. In the interval, the ECB can assume – as it has started to do – the EFSF’s “market intervention” role with the clear obligation of “passing the parcel” to the restructured EFSF/ESM at the end of the ratification process.

In parallel other fundamental Treaty amendments enshrining a considerably enhanced degree of economic and political integration need to be initiated. This may lead to a “two speed” EU in which existing Members of EMU would agree to a significant further transfer of sovereignty or, alternatively, be offered to exit the single currency in an assisted orderly fashion. This difficult and delicate process would have to be handled with great care and flawless determination. It would offer the prospect of a new concrete political goal, the absence of which is highly damageable to the integration process and to public opinion support.

An additional reason why implementation will be scrutinised thoroughly, is that the mechanism should not be abused by the banking sector to “unload” vast quantities of sovereign debt. This type of behaviour by banks became clear when the latest financial reports were released, mentioning, in several instances, the significant “reduction” since last December of credit exposures towards countries in difficulty (e.g. Deutsche Bank in the case of Greece). It should therefore be obvious that an important part of the market pressure on these issuers was the result of “sound risk management” by institutions rather than wanton behaviour of speculators!

If the purchase of sovereign debt by the ECB/EFSF turns out to be the preferred exit route for bank’s overexposure to sovereign issuers, especially if the EU economy falters and risks increase, then, in all likelihood, the mechanism will turn out to be another example of the transfer of private debt onto the shoulders of future taxpayers. In that case resources, whatever their amount, are unlikely to be sufficient as investors play musical chairs, waiting anxiously for the music to stop.

Rhetoric is far from sufficient to keep markets quiescent: a comprehensive and credible plan must be negotiated in minute detail over the next few weeks even if only implemented in stages for practical purposes. Politicians – held hostage by the banking sector – are largely responsible for letting matters deteriorate further since 2010; it is now up to them to restore confidence and avoid the worst.

Paul N Goldschmidt, Director, European Commission (ret); Member of the Thomas More Institute

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© Paul Goldschmidt