While perhaps it is just an August effect, the broad quality of the analysis of European crisis-resolution efforts has been disappointingly poor, with a message the often does not go much beyond self-satisfying statements about the stupidity of European policy makers.
To make sense of more recent developments, I think it is critical to go back to the previous Franco-German summit at Deauville in October. The Deauville accord put in place plans for the permanent bailout mechanism to replace the EFSF in 2013. Understandably, debt restructuring was envisioned for countries needing new programmes under the ESM to limit both contingent liabilities and moral hazard. Unfortunately, however, this attempted strengthening of market discipline proved devastating for the creditworthiness of countries where any doubts existed about their ability to stabilise debt levels. Ireland can be seen as the first casualty, first getting sucked in and then actually seeing its bond yields rise steadily as the extent of default risk under the new arrangements became more evident. The ambivalence about default among key Irish opinion makers did not help. We then saw Portugal get sucked in as doubts emerged that it too might get sucked into the “black hole” of an EU/IMF programme given the limited nature of the exit options. The realisation that the structures that had been put in place were effectively a machine for self-fulfilling debt crises really came home as the creditworthiness of Italy and Spain began to ebb away.
The July 21 summit was a welcome attempt to move away from this “market discipline” regime. Although you would hardly know it from the commentary, and recognising there is a long way to go, the summit has been highly successful from an Irish perspective. The combination of the interest rate reduction, lengthened maturities and a more open-ended commitment to countries without imposing debt restructuring has led to a dramatic fall in Irish bond yields. 10-year yields have fallen from over 14 percent to under 9.5 percent. Even more dramatically, 2-year yields have fallen from 23 percent to under 9 percent. Clearly, the measures taken at the summit were not enough to stem the doubts about the creditworthiness of Italy and Spain, and their yields continued to drift upwards in the days following. Subsequent intervention by the ECB – really the only entity with the firepower to make a credible commitment to a sufficient backstop – has been quite successful in shifting from a bad equilibrium where expectations of default change the fundamentals and risk becoming self-fulfilling.
None of this is to say we are anywhere near out of the woods. More bad luck has come with increasing signs of a significant global slowdown, which jeopardises debt sustainability for many countries. There are also lingering doubts that the ECB and other major central banks have the stomach and political support to do what is necessary to act as backstop for financial systems, though I believe these doubts will prove unfounded.
Having this strengthened backstop is effectively to move decisively towards what Peter Boone and Simon Johnson label a “moral hazard regime.” It is no surprise that the governments of countries taking on more risk to backstop the system want strengthened fiscal discipline to replace market discipline as far as possible, not least because of the constraints of domestic politics. This is what the Paris summit was all about, although the efforts may have been a bit clumsy and there is a long way to go to workable institutions. Commentators here might ask themselves how they would react if Ireland was in the stronger group and taking on a large contingent liability relating to weaker countries. European crisis-resolution mechanisms are moving in the right direction as the nature of the trade-offs is better understood. We could have a more constructive and informative debate if we spent less time harping on about the stupidity of others.