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September 18, 2011 6:02 pm
The European Central Bank can do a lot more than it is doing to help resolve the crisis. In the past few weeks, the ECB has expanded its programme of sovereign bond purchases and helped to plug a dollar funding gap for eurozone banks. It will also need to cut interest rates.
Soon, the ECB will come under pressure to monetise debt. The ruling of Germany’s constitutional court and a shocking rise in anti-euro sentiment in the German government make it unlikely that the European Union will end the crisis by means of a eurobond and a fiscal union in the short run. That leaves the ECB as the last line of defence for the euro. Can this work?
On a purely technical level, it does not really matter whether you create a eurobond, or whether the ECB buys all the debt. The ECB’s liabilities are a hidden eurobond. Contrary to what various Germans in the ECB’s governing council may have been saying, we are not in this situation yet. The ECB’s securities markets programme runs to about €150bn, not really a macroeconomically relevant number. One can argue that it helped stabilise the financial system, and thus the transmission mechanism of monetary policy. But once you raise this level to, say, €1,000bn, you will have crossed the line. By then, you are undertaking a fiscal operation.
The ECB would be ill advised to go that far without a political agreement on how the eurozone should work. In fact, an unconditional ECB bail-out could be dangerous, just as a eurobond would be if not accompanied by a fiscal union. You would resolve the short-term crisis, but the underlying imbalances would persist, and cause a further build-up of debt. It would delay a break-up of the eurozone, but would make it more probable in the long run.
So if neither eurobonds nor ECB bond purchases are going to solve the crisis, what are the alternatives? Willem Buiter and Ebrahim Rahbari of Citigroup have written an excellent analysis, going through the various scenarios, and dismissing most of them. They conclude the most likely outcome will be a fudge, well short of full fiscal union. This will see crises resolved by a combination of default and resolution regimes. It would contain a few elements of a fiscal union, such as a bank resolution regime, joint bank supervision, and sovereign default procedures, but it would be qualitatively different from anything we know.
I agree that this is very much the direction the EU will take. In Berlin, there is now a consensus among senior policymakers that Greece is very likely to default inside the eurozone, but not right away. By the time it happens, the European financial stability facility will be empowered to protect European banks directly. Those who advocate this approach clearly hope that the improved institutional set-up will be sufficient to deal with contagion.
The EU will go down this path because it is the easiest to get onto. I doubt, however, that it will get them anywhere – because the crisis has now spread to Italy. The EFSF and its successor, the European Stability Mechanism, have been set up to handle small countries. They are not big enough to handle large countries. Besides, Italy does not have a short-term funding gap, but a long-term solvency problem. With debt of 120 per cent of gross domestic product, a potential real economic growth rate of around 1 per cent, and a long-term interest rate of 5-6 per cent, Italy’s debt sustainability is in doubt. A monetary union, which solves crises through a combination of default and backstops for the financial sector, would hardly solve Italy’s problem.
The concept of a default union could work in a monetary union with a strong core and a weak periphery, but not in one where weakness has encroached into the core. The Buiter/Rahbari scenario could have worked if the European Council had set up the institutions necessary for crisis six months ago. A periphery that includes Italy and Spain is too big to save with the current limited liability process, and too big to default without causing an enormous financial crisis.
The spread of the crisis to Italy is why I believe a eurobond and a fiscal union are the only way out. Even a long-term process with the ultimate goal of a eurobond could be sufficient. But it must be credible. If it is, then the EFSF or even the ECB may buy as many bonds as it takes to stabilise market interest rates.
The chances that we are moving in that direction have recently diminished. The ruling of the German constitutional court has raised legislative hurdles, while political hostility is rising. We are moving away from what I consider the only effective solution to the crisis. This means, by extension, that we are moving closer towards an involuntary break-up.
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