Another week and another bout of hysteria, as banks warn about the risk of a Euro-breakup due to the upcoming banking crisis. May be that’s to over do it, but clearly it increases the ever unquantifiable risk of that happening. The question, however, remains, as always, whether a break up would be better for anyone, and the answer as always is a resounding “No”. A Euro-zone break up has enormous transition costs, reintroduces trading and financial costs (and inefficiencies) and abandons countries to the fortunes of a small central bank, exposed to morally hazardous national governments while navigating turbulent international finance waters, still holds. Arguments in favour of such a breakup fail to see this point.
So let’s stop talking about how the Euro-zone collapses and lets start spending some energy understanding how it will not. Whoever understands this has a better chance to see the moment where the markets hit the trough before others, who will expect them to continue sinking. For the average person, who doesn’t participate in financial markets, at least this knowledge should give you some peace and perspective from the hysteria we are living in.
So here’s what happens:
Calling the fire brigade: National and European Reforms
As Buiter put it a long time ago, the prolonged duration of the crisis can (at least partially) be understood as a game of chicken between the ECB and the national governments of the EU. Indeed, the (majority of ) national governments would prefer the ECB to monetise debt away, taking on all the burden of solving the crisis. The ECB could do that as it clearly is not liable in foreign currencies or through indexed liabilities (therefore granting it a virtually infinite ability to “throw money” at the problem). The ECB however, fears the inflationary risks of such an action, as well as the dependency and moral hazard it might create. Therefore, it would prefer the countries to take on the responsibility to put their (and their neighbours’) house in order and deal with the problem fiscally.
However, this is no longer possible. Not since Italy, Spain, Belgium and France (and possibly even Germany) are at play. These are too big to be dealt with fiscally. So the ECB has to intervene. However, it still wants credible commitments to avoiding the problems it has. This is why we are hearing so much talk about treaty change on top of the strict conditionality already imposed. Ideally, the ECB would prefer to have a single fiscal interlocutor to deal with (original source) It would be able to make more credible commitments to fiscal sustainability. May be the ideal plan (neatly summarised here) is a step too far, far too soon. May be the ideal plan is a bargaining trick (here also). Nonetheless, in its absence it will accept institutionalised commitments, with the threat that it will withdraw financial support in secondary markets if countries begin to show signs of wavering. It doesn’t want to do. It says it won’t do it. But frankly if they bailed out Greece, Portugal and Ireland of course they will (continue and likely increase their) bailout the rest.
Putting out the fire: Assistance programmes all around
So how do you convince them? You make any assistance of the ECB contingent on a programme of assistance. You also make sure that you reform EU institutions so that the SGP becomes much more credible and it punishments become automatic. It looks more or less like it is now, but with EU reforms passed at the Council and European Parliament levels. They will not do large scale politically burdening intergovernmental conferences. The negotiations and ratification take too long. They’ll fast track it, instead. When do you know this step is over? Lookout for the (emergency) EU council meeting that concludes with the signing of the ESM treaty.
Getting rid of the Pyromaniacs: ECB becomes lender of last resort (LoLR)
What happens then? The ECB will throw open the gates and floods the markets at the first sign that the treaty change is not enough to keep yields down. The ECB’s Securities Market Programme will simply explode. This will bring down yields and if countries continue to behave well and do their foremost to keep to their international financial commitments, the ECB will continue to support them. If they don’t the severely exposed position of the ECB will make that much more reactive, dumping sovereign debt into the market and pushing yields up, like it did to Italy.
Conclusion – Slow and late but steady
This is a relatively pressing issue, and I wouldn’t be surprised if it were dealt with before Christmas. After all a banking crisis is looming. As banks begin to announce their losses and some will become threatened with bankruptcy, the race to this process will accelerate at an ever growing pace. Of course this will be a costly bailout. By the time the ECB finds its jurisdiction in a stressful enough environment and the countries accept this deal, the crisis will have exploded towards the banking sector, with a much larger cumulative cost. But that’s the cost of democracy, which are still trumped by its long term benefits, much like the EU. In the mean time, lookout for the signs of changing times and don’t forget that the world is still spinning and business proceeds as usual.