The Sunday Business Post carries an interesting opinion piece by Paul De Grauwe in today’s paper. Although articles are not available on the paper’s website until the Monday after publication, Cliff Taylor has kindly given us early access to article.
The European Stability Mechanism will not not lead to more stability
After much hesitation and a lot of pressure exerted by financial markets, European leaders finally decided at the end of March to set up a permanent financial support mechanism which was given the name of European Stability Mechanism (ESM). From 2013 on, Eurozone countries will pool financial resources to be disbursed to member-countries in times of crisis. This historic decision illustrates the painful and slow way the Eurozone moves in the direction of more political integration in Europe.
Will the establishment of the ESM shield the Eurozone from future crises? My answer is unambiguous. It will not. In fact it is worse than that. Some of the features that have been introduced in the functioning of the ESM will make it more difficult for a number of countries, in particular Ireland, to attract funds in private markets. These features will have the effect of increasing rather than reducing volatility in the financial markets.
The first feature in the operation of the ESM is that the conditions to obtain funding will be quite harsh. The ESM will apply a relatively high interest rate (200 basis points above the funding rate). In addition, countries that apply for financing will be subjected to a tough budgetary austerity program as a condition for obtaining finance. Thus, with each recession, when countries are more likely to be forced to turn to the ESM they will be forced to reduce spending and to increase taxes. Investors who anticipate this, will with each recession, raise the interest rate on government bonds, thereby making the recession worse.
This has important implications. One major social achievement of European countries is the existence of automatic stabilizers in the government budgets. This means that when a recession occurs, and the government budget deficit increases, the hardship for those hit by the recession (the unemployed who obtain unemployment benefits) is reduced. The new financing mechanism that is being set up in the Eurozone will rob countries of their capacity to protect those hit by the recession. This is a major setback that will reduce the social and political basis that is needed to keep the Eurozone alive.
There is a second feature of the working of the ESM that is likely to increase rather than to reduce volatility in the financial markets. From 2013 on, all members of the Eurozone will be obliged to introduce “collective actions clauses” when they issue new government bonds. The practical implication of this is the following. When in the future, a government of the Eurozone turns to the ESM to obtain funding, private bondholders may be asked to share in the restructuring of the debt. Put differently, they may be asked to take some of the losses. This may seem to be a good decision. Bondholders will be forced to think twice when they invest in government bonds, as these bonds may not be as secure as they thought.
The intention may be good; the effect will be negative. In fact we have already seen the effects. When the German government made the first proposal to introduce collective action clauses at the European Council meeting of October 2010, the immediate effect was to intensify the crisis in the Eurozone sovereign bond markets. Interest rates on government bonds of Greece, Ireland, Portugal and Spain shot up almost immediately. Since then these interest rates have remained high.
This should not have been surprising. When private bondholders know that in the future their bonds will automatically loose value when a country turns to the ESM, they will want to be compensated for the added risk with a higher interest rate. In addition, each time they suspect that a country may turn to the ESM for funding they will “run for cover” and try to avoid the loss in the value of their bond. They will do this by immediately selling their government bonds. But this selling activity will raise the interest rate on these bonds, and will make it more likely that the government will have to ask for support from the ESM. Thus the mere fear of losses will precipitate a crisis, making these losses more likely.
Thus the collective action clauses will make the government bond markets more fragile and more sensitive to speculative fears. Instead of more stable government bond markets in the Eurozone we will have more volatile ones.
This is quite unfortunate. Especially because the existence of a financial support mechanism in the Eurozone is a great idea and a significant step forwards in the building of an integrated Europe. Unfortunately, by introducing restrictions and conditions, the ESM has been transformed into an institution that is unlikely to produce more stability in the government bond markets of the Eurozone.