25 October 2011

Charles Wyplosz: Resolving the current European mess

The debate is now whether it is more urgent to solve the sovereign debt crisis or the banking crisis. The obvious answer is that these two crises are deeply entangled and that both crises must be solved simultaneously. Debt defaults will impose punishing costs on banks, while bank failures will require costly bailouts that will push more countries onto the hit list. Spain, Italy, Belgium, and France are on the brink. Quite possibly, Germany might join the fray if some of its large banks fail. This should dispel any hope that Germany will bankroll governments and banks. German taxpayers are revolting against more bailouts, but they may not realise that they cannot even afford to be the white knight of Europe. From this, a number of conclusions follow.

Conclusion 1 is that current policy preoccupation with widening the role of the EFSF and enlarging its resources is bound to disappoint and trigger yet another round of market panic.

The current plan is for banks to seek fresh capital from the markets, with EFSF resources as a backstop. Conclusion 2 is that this plan will not work. Markets are worrying about the impact of contagious government defaults on banks. They will not buy into banks that are about to suffer undefined losses.

Conclusion 3 is that there is no such thing as a voluntary PSI. Banks are not philanthropic institutions; they always fight any potential loss to the last cent. If not, they would have bailed out Lehman Brothers without the US Treasury guarantee that they were denied.

This brings us to Conclusion 4 – in order to avoid a massive financial and economic convulsion, some guarantee must be offered regarding the size of sovereign defaults. Crucially, the country-by-country approach officially followed is unworkable. The current exclusive focus on Greece is wholly inadequate. Markets look at Greece as a template. Whatever solution is applied to Greece will have to be applied to other defaulting countries. Adopting an unrealistically short list of potential defaulters will only raise market alarm and result in failure. Such a list is difficult to establish on pure economic grounds (should Belgium and France be added to Italy and Spain?) and politically explosive (governments cannot provoke a default by including a country in a near-death list). The only feasible solution is to guarantee all public debts, thus avoiding both stigma and lack of credibility. Finland, Estonia and Luxembourg would do the eurozone an historical service by requesting to be part of a debt guarantee scheme.

What kind of guarantee scheme is needed? An example is provided in Wyplosz (2011). In a nutshell, all sovereign debts must be partially guaranteed (eg up to 60 per cent of each country’s GDP, or up to 50 per cent of the nominal value). The scheme would backstop debt prices by setting a floor on potential losses. It would lead to less panicky debt pricing by the markets. In turn these market prices would serve as a guide to debt renegotiation between sovereigns and their creditors. By depoliticising the process, it would make defaults as orderly as possible under the circumstances.

Who can offer such a guarantee, which is effectively a price guarantee? A price guarantee only operates if markets know beyond doubt that the guarantor can and will buy any bond that trades below the announced target (which in this case is a floor). The total value of eurozone public debts stands at some €8,300 billion (more than three times the German – or Chinese – GDP). This is beyond any enlargement of the EFSF. This is beyond current and future IMF lending resources, currently some €400 billion. The unavoidable conclusion is that the ECB is the only institution in the world that can backstop public debts and make reasonably orderly defaults possible. The current ECB position – “we have done what we can, now it is up to governments” – dramatically misses the point. Of course, the ECB may be concerned about taking on such a momentous task; an imaginative solution is for the ECB to provide the commitment through the EFSF.

Finally, how can the two rescues – of sovereign debts and banks – be carried out simultaneously, as required? If Greece defaults, its banks, pension funds, and insurance companies will fail in large number. It seems that Greece will not be able to bail them out. Assume, just as an example, that Greece defaults on half of its public debt (about 70 per cent of its GDP). Assume that bailing out its banks, pension funds, and insurance companies costs 30 per cent of GDP. The government can do the bailout and still come out with a debt that is lower than now by 40 per cent of GDP. Greece can afford to borrow what it needs to bail out its financial system. The solution then is that the ECB – directly or indirectly via the EFSF – partially guarantees the existing stock of debts and fully newly issued debts simultaneously. Obviously, the guarantee of future debts cannot be given without absolute and verifiable assurance of fiscal discipline in the future.

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