Wolfgang Munchau has another thought provoking piece in Monday’s FT. While he believes that the announcement of the ECB’s OMT programme has stabilised things for the near term, he remains pessimistic that the crisis – which he sees as fundamentally one of solvency rather than liquidity – is on a path to being resolved.
Although I share many of Wolfgang’s concerns, my take is a bit different. My starting point on the solvency issue is also quite pessimistic. Defining state solvency is not easy. A necessary condition is clearly that the debt to income ratio is not on an explosive path. In terms of levels, we see that some countries (Japan being the most dramatic case) appear to be able to roll over debt and fund deficits even at debt to GDP ratios in the region of 200 percent. On the other hand, low-income countries can struggle to be creditworthy with debt to GDP ratios of 20 to 30 percent. Lacking their own central banks that can lend to governments in their own currency in extremis, euro zone countries with high debt/deficits and weak/uncertain growth prospects have been revealed not to be creditworthy. In a very real sense these countries would not be solvent without official sector support – and are unlikely to become so for some time. The important question then is whether official sector policies can be designed to allow countries to be robustly creditworthy. Designing these policies faces a double credibility hurdle: that the support will be there (if only as a backstop) if countries meet the conditions for eligibility; and that it is credible that the countries availing of the actual/backstop support can meet the conditions.
The requirements for effective official support policies seem to be the following: (1) Supports must be reliable – countries must be able to rely on the support being there without forced PSI as long as they continue to meet the conditions. Where PSI is deemed to be unavoidable, this should be recognised early and done decisively so that it can be taken off the table to the maximum extent possible. (2) The conditions must be reasonable – taking into account underlying growth prospects and the negative impacts of fiscal adjustment on growth, the required adjustments must not push the political capacities of governments to push through large adjustments beyond the breaking point. (3) The conditionality must be flexible – unanticipated adverse growth outturns should not lead to requirements for ever larger adjustments. And (4) the link between banking-sector losses and state debt must be broken.
Euro zone crisis resolution policies are moving slowly in this direction, although there is some way to go on both reliability and flexibility in particular.
Following the IMF’s new analysis on the likely size of fiscal multipliers in a liquidity trap, there is a need to revisit the appropriate conditionality regarding fiscal adjustment. But where the current policy stance leaves huge uncertainty over whether the crisis will be resolved, this must also act as a huge break on growth. (I discuss this further in an Irish Times piece last week.)
Of course, the policy mix described above is a big ask for stronger countries, either directly or through the ECB. They are being asked to take on large risks and put a lot of faith in the willingness of countries to meet the conditions. The development of the necessary crisis resolution and prevention policies must be seen as a two-way process, where all euro zone countries submit to tighter rules on budgetary management and more intrusive surveillance (see Mario Draghi’s recent comments in an interview here). Much of the debate in the run up to the fiscal treaty referendum seemed to completely miss this point, reaching its nadir in complaints about a “blackmail clause” regarding access to the ESM.
I believe the crisis can be resolved. But only if the stronger countries recognise the kind of ongoing official support regime that is required to robustly restore creditworthiness, and all countries recognise the necessary pooling of sovereignty that is required to make this regime politically feasible.