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August 1, 2011 2:52 pm
The latest instalment of the drama that is the eurozone periphery sovereign debt crisis and European Union-wide banking sector crisis demonstrates that fiscal federalism is not going to happen.
Nor will its primitive sibling, an open-ended, uncapped transfer Europe with creditor or donor countries in control of public spending, taxation and privatisation in debtor or beneficiary countries. The core euro area donors would walk out and the periphery financial beneficiaries would refuse the required surrender of national sovereignty.
This leaves two roads for the eurozone.
The first is to disband. The second is to move to a ‘You Break it You Own it’ Europe where insolvency of a sovereign is settled between the taxpayers of that sovereign and its creditors, without any permanent financial support from any other nation’s taxpayers. Likewise, threatening insolvency of systemically important banks (‘sibanks’) and other ‘sifis’ is first visited on these institutions’ unsecured junior and senior creditors. Their claims are written off or converted into equity before any taxpayer money goes in.
The agreement between European leaders in July permits us to discern the outline of things to come. The imminent ratings default of Greece sets an important precedent. I expect Greece to move into and out of ratings default several more times before solvency is restored, with a cumulative net present value (NPV) loss to creditors of between 65 and 80 per cent.
I likewise expect that other euro area sovereigns, most likely Portugal and Ireland, will experience ratings defaults. The new European Stability Mechanism (ESM) that will replace the European Financial Stability Facility will have a sovereign default resolution mechanism. For sovereigns deemed insolvent, debt restructuring will be a pre-condition for access to ESM funds.
Private sector creditors share the burden of sovereign debt restructuring. Private sector involvement, so far on a supposedly voluntary basis, is on the map. I expect that before the end of the Greek programme, there will be deep coercive debt restructurings for Greece and other periphery sovereigns – without that it seems inconceivable their debt burdens can be lowered to solvency-consistent levels.
The agreement appears to be a rather poor deal for Greek solvency, a better deal for its private creditors, and a plus for Portugal and Ireland because of lower interest rates and longer maturities on the official facilities.
The official creditors (including the EFSF and European Central Bank) will end up taking significant NPV losses on their exposures to the periphery. This one-time partial ex-post transfer Europe is the price for the continent’s political and institutional lack of readiness. There will have to be a full accounting for the extraordinary quasi-fiscal and political role played by the ECB in the crisis.
Arrangements for handling cross-border sibanks and other sifis will be created. These include one EU regulator, a cross-border sibank and sifi resolution regime, an EU ‘Tarp’ as recapitaliser of last resort and EU deposit insurance regime and fund.
Adequate liquidity support will be provided to illiquid but most likely solvent sovereigns. Like banks, sovereigns, even when fundamentally solvent, are at risk of a ‘run’ that could precipitate a default. Their assets (the NPV of future taxes and the NPV of future spending cuts) are long-term and highly illiquid. Their liabilities are often short-term.
Like banks, sovereigns need a lender of last resort. For domestic currency-denominated liabilities, this is normally the national central bank. In the euro area, some combination of the EFSF (enlarged to at least €2,500bn) and the ECB will be needed. Until September at the earliest, the EFSF does not have the tools or resources to provide liquidity to sovereigns. After September, the tools may be there, but the size (€440bn) is still laughably inadequate.
If the markets truly reject Italy or Spain, nothing except the ECB re-opening the securities market programme and buying Spanish and Italian sovereign debt in a potentially open-ended and uncapped way stands between these sovereigns and a disaster that could destroy the eurozone.
Don’t expect much from strengthening the preventive arm of eurozone fiscal sustainability management. The enhanced Stability and Growth Pact will still be a paper tiger. The strongest incentives for preventing unsustainability are the certainty of pain and, should unsustainability occur, the absence of a bail-out. The institutions to make a no-bail-out rule credible have to be in place.
So the EU and the euro area blunder higgledy-piggledy into a future that fits its unique nature as neither a nation state nor an intergovernmental arrangement but something with features of both. It won’t be pretty but it will work, after a fashion, and it can survive.
Willem Buiter is chief economist at Citigroup and a former member of the Bank of England’s monetary policy committee
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