Goldschmidt draws the attention of Authorities to the need to resist the temptation of a return to "business as usual", but rather, in light of the systemic risk posed by the Sovereign debt crisis, to consider it their duty to anticipate the responses that might become needed.
Introduction
If there is a lesson to be learned from the financial crisis, on which there is a broad consensus, it is that operators, consumers, regulators, supervisors, legislators and governments were totally unprepared and had to improvise much of their responses.
A great deal of credit must be given to monetary and political authorities for their handling of the crisis which, in the immediate aftermath of the Lehman failure, prevented the collapse of the financial system. In addition, there was immediate and salutary recognition of the need for fundamental reform of the global financial system in order "to prevent the repetition" of circumstances that lead up to the crisis.
While there has been significant progress in setting up "crisis prevention mechanisms", including a fundamental restructuring of the legislative/regulatory/supervisory framework at the disposal of responsible "Authorities" in the EU and USA, most of the measures have focused on curing the shortcomings leading to the latest crisis or dealing with its consequences.
This approach – while indispensable – is totally unsatisfactory and insufficient.
Firstly because, with a lessening of the immediate dangers of an implosion of the financial system, many of the proposed reform measures have been significantly watered down leading to a consensus built on the lowest common denominator. The strong revival of nationalistic and protectionist sentiment – at global as well as at EU level - is totally incompatible with the need for a fair, efficient and transparent "global financial playing field" and weakens, from the outset, the effectiveness of the commendable efforts made so far.
Secondly, if there is any lesson to be drawn from history, it is that financial crises will occur periodically and that they rarely have similar causes.
The purpose of this paper is to draw the attention of Authorities on the need to strongly resist the temptation of a return to "business as usual", but rather, in light of the systemic risk posed by the Sovereign debt crisis, to consider as their duty to anticipate, well ahead of time, the responses that might become needed, should these new risks materialise.
It is my strong conviction that such forward planning constitutes the most effective “prevention”, because a thorough understanding of the hardships involved in dealing with such a crisis – should it occur - will focus the attention on the need to take sooner rather than later the bold measures considered politically difficult as long as the hope of economic recovery is put forward as the most likely outcome.
1. The new systemic risk environment.
The main development capable of leading to a new systemic financial crisis centres, since 2010, on the EMU Sovereign Debt crisis.
In earlier papers, I have drawn attention to the incestuous relationship between the European banking sector and governments that have become financially mutually dependant on each other. Nowhere is this more obvious than in the attempt to shift the burden of "saving the European banking system" onto the shoulders of the taxpayers of the borrowers (Ireland). In addition, solidarity between EU/EMU Member States is being severely tested as evidenced by the wrangling over terms and conditions, in particular the iniquitous level of interest demanded by the lenders. President Obama, in his recent joint press conference with Chancellor Merkel, insisted on the need for the Europeans to "get their act together", as failing to do so would have incalculable consequences for the whole world.
The ECB has taken a very firm position, expressed by President Trichet, refusing to consider any form of default of an EMU Member. This attitude seems very sensible as long as the consequences of such an event remain uncertain, as the subsequent instability of the banking sector and of the CDS market would considerably increase the risk of contagion.
The reverse position, shared by many respected analysts, envisages some form of restructuring, and is expressed in particular by German authorities whose support is required whatever the outcome. This public display of acrimony, in such a sensitive area, is extremely damaging and can only increase uncertainty as well as the risks of derailing the necessary orderly process. In the circumstances, it is hardly surprising that markets remain - justifiably - sceptical of the EMU's capacity to deal effectively with the overt problems of Greece, Portugal and Ireland (not to mention the latent more significant challenges facing Spain or Italy), without resorting to some form of restructuring.
Economic hardship, resulting from the severe recession that followed the financial crisis, has provoked growing social tensions, not only in countries subject to the harsh EU/IMF conditionality or in those who, like Spain, have taken voluntary austerity measures, but also in the better off Member States whose populations are encouraged to resent and resist fiscal transfers (except under patently unacceptable terms), thus discarding the rational arguments in favour of protecting their own currency.
There is no escaping the conclusion that nationalistic and populist rhetoric and sentiment is gaining traction throughout Europe as demonstrated by the growing appeal of the National Front in France, the electoral success of the “New Finns”, the reliance of governments on the support of populist "euro sceptic" parties in Holland and Denmark and surprisingly, simultaneously with the decision of the Commission to recommend the opening of formal negotiations, indications that the outcome of the Croatian referendum on EU Membership is far from certain. Furthermore, governments are yielding to the pressure of public opinion in putting into question two of the most significant achievements of the EU: the rules of Schengen Area on free mobility of people, and the financial solidarity among EMU participants.
In light of these developments, the risk of an implosion of EMU (which would lead to the end of the EU) can no longer be considered an aberration but, on the contrary, even if it remains a low probability, it must be taken seriously into account.
2. Measures to be considered by the EU.
Considering that one of the flagship reforms of the European financial architecture consisted in establishing the European Systemic Risk Council (ESRC), whose purpose is to anticipate the emergence of excessive risk in terms of "credit exposures", "imbalances", etc. particularly in the banking sector, one should question why this new "Authority" has not made the EMU "Sovereign Debt crisis" the top priority on its agenda!
Its total silence so far on this question reflects the inherent flaws in its basic structure and the inbuilt conflicts of interest between the functions exercised by the vast majority of its "statutory" voting members (weaknesses pointed out shortly after publication of the Commission's proposals in the spring 2009). It is indeed difficult to imagine how the ESRC, dominated by the Governors of the EU Central Banks (with an EMU inbuilt majority) could analyse objectively and independently the risks implied by the credit exposure of their respective banking sectors to EU sovereign borrowers; how could the 17 Governors of the ECB take positions independent of the ECB Board to which they belong? Similarly, the ESRC remains on the sidelines of the controversy surrounding the new round of bank "stress tests" where the question of sovereign debt exposures (differentiated treatment of trading versus banking book positions) is very much at the heart of assessing the risks.
If the ESRC is unable to address objectively the problem of Sovereign debt exposures and make appropriate recommendations as mandated by its charter, its credibility and usefulness will be questioned and markets will react accordingly. The efficiency of other reforms would also be scrutinised, and in particular the inability of the EU to agree on a single regulatory/supervisory framework, at least for the eurozone.
3. Measures to be considered by the EMU (EU) Member States.
The uncertainty surrounding the capacity of EMU to meet the challenges it faces creates the obligation for Member States to envisage the possibility of an implosion of the Eurozone and to develop, well in advance, a comprehensive set of measures that would have to be implemented immediately, in such circumstances.
Indeed, if between the signing of the Maastricht Treaty and the introduction of the euro, several years allowed the painstaking preparation and resolution of the numerous hurdles leading to EMU, similarly, the breakup of the eurozone would also create significant problems which deserve equally careful prior consideration.
The main difficulties would arise from the need to ensure continuity in daily life transactions and to re-denominate contracts in the new national currencies that would succeed the € (whether in one, several or all EMU participating Member States). The cardinal legal principal of the "continuity of contracts" that presided over the "smooth" substitution of "tributary national currencies" by the € at the start of EMU, could not be simply reversed.
As lengthy negotiations under the pressure of events are totally unimaginable, without leading to a collapse of financial markets, governments should have considered ahead of time the emergency measures that would have to be implemented overnight. These are likely to include exchange controls, the possible freezing/restrictions of/on bank accounts and the use of credit cards, as well as the promulgation of a set of rules concerning the treatment of contractual financial obligations. Establishing sufficient "legal certainty" in the new processes would be of paramount importance. This should cover contractual obligations of the State, of Nationals as well as of foreign nationals towards each other, as well as determining the applicable law in the inevitable event of litigation.
Though the circumstances are totally different, the process recommended can be readily compared to the famous 1944 Belgian "Gutt Plan", carefully drawn up by the Belgian Government in exile in London and implemented within weeks of the liberation of Brussels by the allies. This drastic monetary reform initiative, resented by the population emerging from four years of painful occupation, was a key factor in the more rapid initial recovery of Belgium after the war as compared with its neighbours.
In light of the catastrophic consequences of a breakdown of EMU on all its members, including the strongest among them, it behoves every government to have studied carefully the measures that would have to be implemented to avoid even greater hardship and chaos to their citizens.
This precautionary exercise would, undoubtedly, lead to the inescapable conclusion that implementing at present further significant reforms affecting EMU and the global financial regulatory/supervisory architecture is a far cheaper price to pay than letting EMU unravel, even in a more or less controlled fashion.
As was the case in preparing for EMU, most of the analytical work should be left to "specialists", leaving the choice between possible workable options to the body politic. Their conclusions should give the political authorities sufficient ammunition to convince their respective public opinions that further EU integration is the only reasonable solution to the current crisis and far less dangerous – economically, socially and in terms of human freedoms - than the nationalist, protectionist and populist alternatives proposed by irresponsible demagogues.
In October 2008, the world got away, by the skin of its teeth, from falling into a depression even deeper than in the 1930's. The price that was paid for saving the system was a colossal "transfer" of the excessive indebtedness accumulated in the financial system from the private to the public sector.
There is limited room left to deal with a crisis that would hit a weakened fragmented public sector. The bright side of the coin is that, if properly marshalled at EU level, there are still ample resources that can be mobilised. Today the euro remains a fundamentally sound currency despite the structural weaknesses of the eurozone. Strengthening EU solidarity through deeper integration is the single most important precondition for dealing successfully with the crisis.
It would be highly irresponsible to rely mainly on a still problematic economic recovery to exit the crisis satisfactorily and totally unforgivable – after Fukushima - to wait for the aftershocks of a "force 10 financial quake" (default) to pick up the pieces after the ensuing tsunami (contagion) had devastated the financial system.
It is high time to put into practice the time honoured saying:
"He who wishes peace should prepare for war"!
Brussels, June 11th 2011
Paul N. Goldschmidt
Director, European Commission (ret.); Member of the Thomas More Institute
© Paul Goldschmidt
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