05 December 2011

Charles Wyplosz: Do eurozone leaders finally ‘get it’? Not quite yet

This week's announcements by Chancellor Merkel and ECB President Draghi that the eurozone is taking steps towards a closer fiscal union seem to be calming markets and restoring confidence in the decision-making of eurozone leaders. This column argues, however, that the devil is still in the detail.

Fiscal discipline

Enforcing fiscal discipline is indeed essential, both in the long run for the euro’s survival and in the short run for markets to start relaxing. But the problem is that the proposed model is one of centralised enforcement. The Stability and Growth Pact has been a tragic failure, in part because it sought to apply top-down pressure on sovereign governments. Merkel is clinging to this approach, which is the German federal model, but even in Germany this model is not working too well (some lenders went bankrupt and had to be bailed out, and this may happen again). Moreover, the German chancellor wants significant transfers of sovereignty, which have dubious democratic appeal. Neither the Commission, which is volunteering for the job, nor the European Court of Justice, whose competence in judging excessive deficits is questionable, are obvious recipients of such fiscal authority.

This is why many countries will block the proposed Treaty revisions. The alternative of circumventing opposition by pushing through bilateral agreements among the willing, apparently under consideration, is bound to be extraordinarily divisive. 

Decentralised discipline

Decentralised discipline is a model that has worked well in the US. Each state has its own fiscal stability rule, backed by its own constitution and enforced by its own supreme court. The point is that the policymaker mindset seems to remain stuck in the centralisation track, which requires further integration that may not pass the hurdle of increasingly eurosceptic public opinions.

Debt restructuring

The second attempt at a voluntary private-sector-involvement (PSI) scheme is bound to follow the fate of the previous one. Debt-restructuring arrangements negotiated by banks and their own governments on behalf of the other governments, those that lost market access, are highly unlikely to serve the interests of the latter. This is yet another version of the centralised view, which seeks to disempower hard-pressed governments. The decentralised alternative is that each government enters into direct negotiations with its creditors. In the absence of collective action clauses, the process is unlikely to be orderly, but it does not have to be disastrous either.

Bank restructuring

An important step was already taken in October when policymakers finally admitted their dark little secret that many eurozone banks are too weak to function. The numbers that have been floated since then show that, once again, policymakers are bent on solving yesterday’s problem, not tomorrow’s. Debt restructuring will hurt many banks – some of them may even fail. Proper policy planning should aim at restructuring banks sufficiently enough for them to be able to absorb the forthcoming blow or, in some cases, to take them over. It is about time for governments to call the large banks’ bluff and moot plans to take them over if they are unable to function as banks.

ECB intervention

There are two ways in which the ECB can intervene. The one that seems under consideration is large-scale bond purchases. Unfortunately, this is bound to lead to a huge increase in the ECB’s balance sheet and to major risk-taking by the central bank on behalf of the eurozone taxpayers. A more effective, and much less risky, approach is a partial guarantee of all eurozone public bonds. The beauty of a guarantee is that it is virtually costless if it is credible, and a central bank is infinitely credible when it guarantees a finite volume of assets, no matter how large it is. The guarantee must be partial for two reasons. First, the ECB must avoid bailing out the bondholders. Second, the guarantee should not stand in the way of debt restructuring. 

Conclusion

For the fist time since the eurozone crisis, governments and the ECB are focusing their attention on the necessary steps. This is not luck nor virtue; it is simply that all the wrong solutions that have already been tried have failed, many of them repeatedly. Now Europe’s leaders can start detailing the right course of action, but these details matter enormously. Hold your breath; we may be getting there.

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