Confused signals by various euro area leaders speaking to different constituents, and with different agendas, will always mar the run up to important EU Summits. French (and some EU) officials will, as a negotiating tactic, try to talk up market expectations and, thereby, increase their ability to push Europe − especially Germany − into concessions with threats of “market disappointment” at the summit itself. At the same time, German officials will inevitably try to lower expectations in an effort to placate domestic skeptics and minimize the expected costs.
However, Angela Merkel is fundamentally right that markets should not expect miracles during the EU summits in the coming week ahead of the self-imposed deadline at the Cannes G-20 on November 3rd. The reason is simple. The euro area suffers from not just one but several acute crises: a “competitiveness crisis” across the southern periphery, a “banking crisis” increasingly visible well beyond Ireland, a “fiscal crisis” centered on Greece but with clear manifestations in several member states, and finally a “design crisis,” for it has become evident that the euro area, as it was designed in late 1990s, was under-institutionalized and not built to last. Despite market clamor for “decisive action,” the fact that the correct euro area diagnosis consists of multiple ailments immediately makes it clear that a single silver bullet solution does not exists for Europe.
So what should we reasonably expect EU and euro area leaders to accomplish this weekend? Among the four euro area emergencies, it is immediately clear that no short-term (inside the euro area at least) solution exists to the “competitiveness crisis”, as only several more years of far reaching structural reforms will restore the export capacity of the southern periphery. On this issue therefore, EU leaders must mostly stay the course and focus on implementing existing pro-competitiveness reform commitments.
It is equally clear that no short-term fixes exist for the euro area “design crisis,” as any credible solution will require potentially large changes to the EU Treaty and, consequently, a new multi-year treaty ratification process. At most, therefore, we can hope that EU leaders will announce the formation of a new “Delors Commission/Inter Governmental Conference” to begin the work of drafting the required changes to the euro area institutional architecture.
On the other hand, EU leaders must achieve substantial progress in solving the “fiscal crisis,” specifically with Greece. In light of recent deteriorating global and Greek economic data, the up to 21 percent haircut on privately-held Greek government debt agreed on July 21st is insufficient. What is instead needed is a larger haircut, probably in the 40-50 percent range. Ultimately, what is needed is a private sector participation that makes it politically credible in the euro area donor countries to stand behind Greece going forward. In other words, it must be made clear to the markets that this is the “one and final Greek debt restructuring” that will ever take place.
Moreover, it will be necessary to further extend the ring-fencing of the “unique case of Greece” with renewed euro area commitments to Portugal and Ireland, both of which has shown full political commitment to their IMF program targets. This could, for instance, be done by extending to Portugal the “comprehensive strategy for growth and investment” that in July was initiated for Greece, including access to EU structural funds and EIB loans with reduced national co-payments. For Ireland, this could include using the new EFSF flexibility to offer Dublin EFSF refinancing of the country’s very expensive (up to 11+% coupon rates) “Promissory Notes,” which were issued by the Irish bad bank NAMA to finance the takeover of bad loans from Ireland’s collapsed banks. Ultimately, this would save Ireland very substantial interest expenses and effectively neutralize any remaining political risk that Dublin, in following the Greek example, would ever want to impose haircuts on its senior bank creditors. In both cases, the aim is to convince markets that indeed the euro area political promise to make Greece a “unique case” is credible. Only this will end potential contagion from the Greek debt restructuring.
Related hereto, it is now clear that the ECB will not participate in any TALF-like structures to provide liquidity and leverage to the EFSF. Consequently, a bond insurance scheme for new primary market issuances for Italy and Spain is probably the most sensible route leaders can take. However, it will be critical to specify the political conditionality that beneficiary countries of EFSF bond insurance must adhere to. This may not entail a loss of sovereignty as large as with a regular IMF program, but for this initiative to become the necessary functional equivalent of an IMF flexible line of credit (e.g. lowering cost of government financing without requiring actual co-financing), conditionality must still be rigorous and pro-growth oriented. Meanwhile, with the EFSF oriented towards the primary bond markets, the ECB’s Securities Market Program (SMP) must remain in place and able to deal decisively with any secondary market panic. Keeping it in place as the euro area’s final line of defense will be the ECB’s key (but probably unannounced) contribution on October 23rd.
Lastly, EU leaders must act decisively on the “banking crisis” by forcing euro area banks to increase their core tier 1 capital to at least 9 percent within no more than 6 months, after which compulsory government/EFSF equity capital injections will be implemented. Crucially, leaders must insist that this ratio is estimated based on the banks’ risk capital as of last week. This must be done in order to avoid self-interested bankers merely reducing future lending (the denominator) and, therefore, precipitating a euro area credit crunch to appear more financially robust. Banks’ contemptible attempts at such economic hostage taking must be forcefully rejected by leaders, with banks instead compelled to increase their capital ratios through new capital (the numerator) only.
In summary, EU leaders will not be able to end the euro area crisis by the time they meet their global peers in Cannes on November 3rd, but European citizens, as well as financial markets, should expect them to take several big steps in the right direction.
Dr. Jacob Funk Kirkegaard is a research fellow at the Peterson Institute for International Economics in Washington, D.C. and is a frequent contributor to AICGS publications and events.
This essay appeared in the October 21, 2011 AICGS Advisor.