Category: European economy

The EU Stabilisation Plan

After the excitement of the weekend’s EU announcement, the question most people will ask is “will it work?” I think the answer to this question depends on what we mean by “work”.

There are obvious parallels here with the banking crisis. As markets began to doubt the solvency of many institutions, including the Irish banks, access to short term liquidity dried up for these institutions. Governments provided various liability guarantees to help these banks regain access to markets (ours being the most extensive) but these guarantees did not change the underlying solvency picture. Ultimately, the problem of insolvent banks had to be dealt with via costly recapitalisation measures, a process that we in Ireland have yet to complete.

The size of the funds announced in the EU deal are large enough to most likely ensure that, for a while, no EU country will fail to roll over its sovereign debt. In that sense it will most likely work. But it doesn’t change the fiscal reality.

Last week’s €110 billion Greek deal wasn’t well received by the markets because it still seemed to imply a Greek default was on the way. Last night’s announcement is being well received but then it doesn’t actually come with a concrete fiscal restructuring plan for Portugal, Spain or Ireland, so the plan can be taken good news without having to question any dubious underlying assumptions about fiscal sustainability. If the time comes when this fund is tapped but the markets don’t buy the stabilisation plan announced, the situation could unravel again.

Most of the thoughtful reaction elsewhere points to it being a long and complicated road ahead. The Baseline Scenario guys give their reaction to the plan here. Arthur Beesley also has a nice piece in the Irish times here.

European Stabilisation Mechanism Announced

The European Union has announced an agreement among heads of state to address the mounting sovereign debt crisis. Here’s Commission President Barroso’s statement. The meat of the announcement is the following:

First the Commission will present a concrete proposal for a European Stabilisation Mechanism to preserve financial stability in Europe. This proposal the Commission will make will be presented to the ECOFIN meeting next Sunday, the day after tomorrow (9 May).

Much of the speculation about the content of this proposal revolves around the ECB. Some media stories (such as this one) are discussing an extension of the ECB’s liquidity operations, which is fine but doesn’t go to the heart of the soverign debt problems.

Other stories (such as this Reuters story carried by the Irish Times) point to the ECB purchasing sovereign bonds.

“You have this ‘no monetary financing’, but you are allowed to buy in the secondary market, so what’s the difference?” an official involved in European banking supervision told Reuters. “Buying in the secondary market, you take the pressure, and so you push people in the primary market.”

Analysts have estimated the ECB might buy some €200 to €300 billion of bonds, about 20 to 30 per cent of estimated annual new issuance in the euro zone.

This point that the ECB can actually do this is correct. The wording of the no monetary financing clause (article 123 clause 1 of the current version of the consolidated Treaty on the functioning of the EU) is as follows:

Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.

I suspect the direct purchase phrase was put in to make it clear that public debt instruments were fine for use in ECB repurchase agreements with banks. But the wording does not rule out secondary market purchases.

Exactly what effect this type of intervention would have would depend on how it was implemented. If it was simply a once off purchase of a load of Spanish, Portuguese or Irish debt, I can’t see how this would have much effect since the underlying stock of debt would remain the same.

If, however, the operation took the form of secondary market interventions right after primary market issues, then it would have an effect. For example, the Irish government could issue debt to some banks who could then immediately sell these bonds on to the ECB, perhaps for a small profit. the only risk for the banks being the small probability of being left with the hot potato at the moment of a default.

This would pretty much be breaking the spirit, if not the letter, of the Treaty. But, we’re in this territory already. The existing Greek bailout is being legally justified on the basis of this clause in Article 122:

Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council, acting by a qualified majority on a proposal from the Commission, may grant, under certain conditions, Community financial assistance to the Member State concerned.

Greece, apparently, is suffering from a natural disaster or an exceptional occurence beyond its control.

Note the rumoured scale of this operation. If the rule of thumb relating to ECB capital subscription is applied again, Ireland would have to supply over €4 billion to this fund.

EU Spring Forecasts

The EU Commission released its Spring Forecast today. The abstract states that:

The economic recovery is underway in the EU, although it is set to be a gradual one. The economic recession came to an end in the EU in the third quarter of last year, in large part thanks to the exceptional crisis measures put in place under the European Economic Recovery Plan, but also owing to some other temporary factors.

The speed of recovery is forecast to increasingly vary across EU countries, reflecting the extent of the housing-market correction needed, the size of the financial-services sector and the degree of internal and external imbalances.

Once you get beyond the positive start they do admit that there is significant uncertainty. Also it is hard to get excited about an EU unemployment rate of 10% and debt of 80% of GDP.

For Ireland they paint a positive picture for 2011 with 3% GDP growth and a slight reduction in the unemployment rate.

Jacques Melitz on Greece and the Euro

I have never really understood the idea that the Greek fiscal crisis is “a threat to the euro” but have generally sensed the tide running against me on this one as serious people warn darkly about the wider repercussions of a Greek default. Still, I find the arguments in this new CEPR Policy Insight paper from Jacques Melitz (“Eurozone Reform: A Proposal”) to be pretty convincing.

Melitz argues that much of the damage to the Euro caused by the Greek crisis has been due to the inaccurate focus by EU officials on the centrality of fiscal discipline. Some quotes:

The European problem is largely self-inflicted. There have been repeated affirmations by the ECB and government officials in Eurozone member countries that fiscal discipline and the Stability and Growth Pact are the very foundation stone of the Eurozone. This can only mean that Greek default is a big problem for the euro. On this view, the Eurozone is partly a victim of its own self representation …

So far as I can see, there is little reason why Eurozone should view government defaults with any greater alarm than any other central bank management in the world would view government defaults within its territory. To the contrary, the Eurozone is particularly well armed to deal with such defaults, since its own central bank has no large central government to contend with, the Maastricht Treaty guarantees the central bank’s independence and member governments are explicitly forbidden to bailout one another …

Accordingly, must not the official doctrine change? Should it not be that nothing so manageable as a Greek government default can upset Eurozone? In the event of a Greek government default, the system would assure the stability of the Greek financial sector, and concern itself with any bank runs or bank failures in the country, but not with the Greek government’s difficulties. In step with this doctrine, government bail-outs will never be contemplated. The Stability and Growth Pact will continue to serve as a code of good fiscal conduct for all members of the EU. But if any individual member government engages in irresponsible fiscal conduct, contrary to the Pact, its taxpayers and the creditors will bear the consequences.

Melitz argues that rather than institutionalising bailouts, there should be EU-level financial supervision of banks under the auspices of the ECB to allow for more efficient containment of the effects of fiscal default on financial stability.

Greek Bailout Unveiled

So finally we see the terms of Greece’s impending bailout. €30 billion to be made available from EU countries (€500 million potentially from Ireland) at an interest rate of about 5%. Apparently, a further €15 billion is available from the IMF. To my mind, the interest rate is a bit lower than might be expected for an emergency bailout that should be acting as a serious incentive to get the Greek fiscal house in order. The operation certainly seems to be slanted towards carrot rather than stick.

What next? Peter Boone and Simon Johnson discuss this issue and are not confident that Greece can emerge from the crisis with access to private debt markets. They worry about Portugal being next. We worry about something else.