23 October 2011

Wolfgang Münchau: Europe is now leveraging for a catastrophe

A leveraged EFSF is attractive to politicians for the same reason that subprime mortgages once appeared attractive to borrowers. Leverage can have different economic functions, but in these cases it simply disguises a lack of money. The idea is to turn the EFSF into a monoline insurer for sovereign bonds. It is worth recalling that the role of those monolines during the bubble was to insure toxic credit products. They ended up as a crisis amplifier.

Technically, the EFSF monoline insurer would provide a first-loss tranche insurance for government bonds up to an agreed percentage. It sounds like a neat idea, until the recipients of the insurance realise their sovereign bonds have turned into hard-to-value structured products. One of the factors that will make them hard to value is the incalculable probability that France might lose its triple A rating. In that case, the EFSF would automatically lose its own triple A rating – which is derived from that of its guarantors. The EFSF’s yields would then rise, and the value of the insurance would be greatly reduced. The construction could ultimately collapse.

Leveraging also 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.

The simple reason why there can be no technical quick fix is that the crisis is, at its heart, political. The triple A-rated countries have left no doubt that they are willing to support the system, but only up to a certain point. And we are well beyond that point now. If Germany continued to reject an increase in its own liabilities, debt monetisation through the European Central Bank and eurobonds, the crisis would logically end in a break-up. There is no way the Member States of the eurozone’s periphery can sustainably service their private and public debts, and adjust their economies at the same time.

Each of Germany’s red lines has some justification on its own. But together they are toxic for the eurozone. The politics is not getting any easier. The behaviour of the Bundestag underlines the political nature of the crisis. Last month’s ruling of Germany’s constitutional court strengthened the role of parliament. But it also reduced the autonomy of the German chancellor, who now has to seek prior approval by the Bundestag’s budget committee before negotiating in Brussels. This power shift will not prevent agreements, such as the one currently negotiated, but it will make it harder to coordinate policy in the European Council on an ongoing basis.

The way eurozone leaders have been handling the crisis ultimately vindicates the German constitutional court’s conservatism in its definition of what constitutes a functioning democracy. Policy coordination among heads of state is both undemocratic and ineffective. A monetary union may require more than just a eurobond and a small fiscal union. It may require a formal, if partial, transfer of sovereignty to the centre – that includes the rights to levy certain taxes, impose regulation in product, labour and financial markets, and to set fiscal rules for Member States.

The biggest danger now is the large number of politicians drawing red lines in the sand, and the lack of even a single EU authority willing and capable of cutting through them. Given the multiple uncertainties, there is no way to attach any precise probabilities to any scenarios. But clearly, the chance of a catastrophic accident is bigger than merely non-trivial. The main consequences of leverage will be to increase that probability.

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© Wolfgang Münchau