You can always trust the Americans, Winston Churchill said, because in the end they will do the right thing, after they have exhausted all other possibilities. For the last 18 months, this has been Europe’s method for confronting its sovereign debt crisis as well: it has taken the necessary decisions, but always as a last resort.
Once again, on July 21, the eurozone’s leaders proclaimed that what was previously unthinkable was, in fact, necessary. They gave up the pretense that Greece is solvent; admitted that excessive interest rates could only make the problem worse; agreed to extend more and longer-term loans; called for private lenders to bear some of the burden; guaranteed that even if Greek government bonds are rated in selected default, Greek banks would not be cut off from access to liquidity; recognized the need to support economic growth; and agreed to broaden the scope of the European Financial Stability Facility, making it a more flexible tool for intervention.
For Germany, France, the European Central Bank, and other players, these about-faces have a cost in terms of reputation, political capital, and legal leeway. July’s decisions were sufficiently wide-ranging for everyone to be able to claim success. But the players will have to have to explain why red lines were crossed. All, no doubt, will claim that this is the last time.
Is that true? Have the last taboos been broken? Or will another crisis summit need to be convened soon with even bolder measures and denials?
In the case of Greece, there is real aggiornamento. In place of an equation without a solution, European leaders have substituted another, which no longer seems unsolvable. By deciding to provide cheaper loans and agreeing to a debt reduction, they have started reducing the burden. Unfortunately, the bail-in of private lenders is too limited in size and it is to be feared that the official sector will have to bear the burden of future debt reductions. But at least the taboo of private debt restructuring, which had been hanging over discussions for months, was broken.
A reduction in public debt will not make Greek companies more competitive or create jobs for the unemployed – even though it will help. Many believe that, if Greece is to recover, it will be necessary to break the real euro taboo and reintroduce a national currency.
The certain outcome of this would be immediate devaluation, much beyond what restoring competitiveness requires. When Argentina broke its link to the dollar in 2002, the peso lost four-fifths of its value.
But financial claims in Greece are denominated in euros. Forced conversion would destroy much of the value of savings, and the resulting currency mismatches would unleash a wave of bankruptcies (in Greece or the rest of the eurozone, depending on the exact terms of the conversion). Even before the shock, there would be a bank run as savers moved their assets, causing the financial system to collapse.
Moreover, far from being supported by such a move, the rest of the eurozone would be weakened, as speculators would start testing the true value of the German, French, or Portuguese euro. All of this renders adjustment within the eurozone preferable, despite the many difficulties that it presents and the costs it may involve.
For the eurozone as a whole, the measures announced in July will not dispel the concerns about other countries, particularly Italy and Spain. One of the most striking vulnerabilities revealed during the last few months is the correlation between banking crises and sovereign-debt crises.
In Greece, the parlous fiscal position is a threat to the banks, whose portfolio of government securities is twice the size of their capital. The same fear pervades Italy. In Ireland, it was the banks’ losses that brought the government to its knees. Spain’s government has been weakened for the same reasons. Regardless of which party is in power, the logic is the same: financially distressed states weaken the banks, owing to the falling value of government securities, while distressed banks weaken states, owing to anticipated bailout costs.
This vicious cycle results from the refusal to diversify and share risks. In the United States, banks that are incorporated in Delaware feel no obligation to hold bonds from that state. Instead, they hold federal securities. And it is the federal government in Washington, DC, not the state of New York, that is responsible for bailing out Wall Street. This does not eliminate all risks, but it diffuses them and implies that, in the face of financial hurricanes, calls can be made on the central bank.
Europe is not a federal state, but the eurozone’s resilience would be greatly boosted if deposit insurance were pooled – which would obviously require changes in banking supervision – and if banks diversified their bond holdings so that they were more representative of the eurozone as a whole (through Eurobonds, for example).
Europe has cautiously started to move in this direction by broadening the scope of its financial facility. But the pooling of risk remains taboo. It is not clear if this taboo will remain unbroken by the end of the crisis.
Once again, on July 21, the eurozone’s leaders proclaimed that what was previously unthinkable was, in fact, necessary. They gave up the pretense that Greece is solvent; admitted that excessive interest rates could only make the problem worse; agreed to extend more and longer-term loans; called for private lenders to bear some of the burden; guaranteed that even if Greek government bonds are rated in selected default, Greek banks would not be cut off from access to liquidity; recognized the need to support economic growth; and agreed to broaden the scope of the European Financial Stability Facility, making it a more flexible tool for intervention.
For Germany, France, the European Central Bank, and other players, these about-faces have a cost in terms of reputation, political capital, and legal leeway. July’s decisions were sufficiently wide-ranging for everyone to be able to claim success. But the players will have to have to explain why red lines were crossed. All, no doubt, will claim that this is the last time.
Is that true? Have the last taboos been broken? Or will another crisis summit need to be convened soon with even bolder measures and denials?
In the case of Greece, there is real aggiornamento. In place of an equation without a solution, European leaders have substituted another, which no longer seems unsolvable. By deciding to provide cheaper loans and agreeing to a debt reduction, they have started reducing the burden. Unfortunately, the bail-in of private lenders is too limited in size and it is to be feared that the official sector will have to bear the burden of future debt reductions. But at least the taboo of private debt restructuring, which had been hanging over discussions for months, was broken.
A reduction in public debt will not make Greek companies more competitive or create jobs for the unemployed – even though it will help. Many believe that, if Greece is to recover, it will be necessary to break the real euro taboo and reintroduce a national currency.
The certain outcome of this would be immediate devaluation, much beyond what restoring competitiveness requires. When Argentina broke its link to the dollar in 2002, the peso lost four-fifths of its value.
But financial claims in Greece are denominated in euros. Forced conversion would destroy much of the value of savings, and the resulting currency mismatches would unleash a wave of bankruptcies (in Greece or the rest of the eurozone, depending on the exact terms of the conversion). Even before the shock, there would be a bank run as savers moved their assets, causing the financial system to collapse.
Moreover, far from being supported by such a move, the rest of the eurozone would be weakened, as speculators would start testing the true value of the German, French, or Portuguese euro. All of this renders adjustment within the eurozone preferable, despite the many difficulties that it presents and the costs it may involve.
For the eurozone as a whole, the measures announced in July will not dispel the concerns about other countries, particularly Italy and Spain. One of the most striking vulnerabilities revealed during the last few months is the correlation between banking crises and sovereign-debt crises.
In Greece, the parlous fiscal position is a threat to the banks, whose portfolio of government securities is twice the size of their capital. The same fear pervades Italy. In Ireland, it was the banks’ losses that brought the government to its knees. Spain’s government has been weakened for the same reasons. Regardless of which party is in power, the logic is the same: financially distressed states weaken the banks, owing to the falling value of government securities, while distressed banks weaken states, owing to anticipated bailout costs.
This vicious cycle results from the refusal to diversify and share risks. In the United States, banks that are incorporated in Delaware feel no obligation to hold bonds from that state. Instead, they hold federal securities. And it is the federal government in Washington, DC, not the state of New York, that is responsible for bailing out Wall Street. This does not eliminate all risks, but it diffuses them and implies that, in the face of financial hurricanes, calls can be made on the central bank.
Europe is not a federal state, but the eurozone’s resilience would be greatly boosted if deposit insurance were pooled – which would obviously require changes in banking supervision – and if banks diversified their bond holdings so that they were more representative of the eurozone as a whole (through Eurobonds, for example).
Europe has cautiously started to move in this direction by broadening the scope of its financial facility. But the pooling of risk remains taboo. It is not clear if this taboo will remain unbroken by the end of the crisis.
Jean Pisani-Ferry is Director of Bruegel, an international economics think tank, Professor of Economics at Université Paris-Dauphine, and a member of the French Prime Minister’s Council of Economic Analysis.
