It is however evident that the protection given by the euro against market pressures is rapidly wearing off. The Greek crisis is worsening, growing concerns about external imbalances and debt sustainability have fuelled capital flight, and sovereign interest rates are rising in Southern Europe.
– ECB clearing mechanisms mean that no speculative attack by private investors could cause the 'sudden death' of the eurozone;
– Market pressures, however, could starve it to death – and rather quickly.
To minimise this risk, Paul Krugman has proposed three solutions:
– A credible bank rescue for troubled banks,
– Sufficiently large official intervention in Spanish and Italian bonds to keep yields manageable, and
– Inflation in Germany that is high enough to redress intra-eurozone competitiveness imbalances without imposing deflation to the south – a approach which is bound to be self-defeating in any case.
The European 28-29 June 2012 summit some progress. It sketched a common approach for resolving banking crises, made a little progress on defining a credible framework to stop contagion in the sovereign bond markets, but it made no progress towards a higher eurozone inflation rate target.
There is still a great deal of work to be done.
Stopping sovereign bond market contagion
The most urgent challenge is to find a more credible way of reducing the spreads on the Spanish and Italian bonds. The eurozone's current plan is insufficient; allowing the existing rescue funds (EFSF and ESM) to buy bonds on the open market will buy time but will not fix the problem. These funds just do not have enough financial firepower to make a long-term defence credible.
The basic problem is the existence of two equilibriums.
– The good equilibrium is where trust is high, so interest rates and low and the current stock of debt is sustainable – a fact that underpins the trust.
–The bad equilibrium where trust is low, interests rates are high and the current stock of debt looks unsustainable – thus justifying the lack of trust in governments' ability to service the debt without restructuring.
With trillions of euros invested in eurozone government bonds, even small shifts in the likelihood of the good versus the bad equilibrium can product massive sell-offs.
What is needed is progress towards some form of Eurobond and/or a stronger commitment to help Spain and Italy to return to a good 'low-rates/solvent' equilibrium.
Proposals: Pros and cons
Several proposals have been developed:
– Proposal one: Convince the ECB to cap spreads of government bonds.
The ECB would intervene as a lender of last resort in the sovereign bond markets.
– Proposal two: Mandate the EFSF/ESM to commit to purchasing new debt issued by Spain and Italy as soon as market interest rates reach a predefined level.
To be credible, this option should require an increase of the EFSF/ESM resources, either directly or by granting it a banking licence so it could borrow from the ECB.
– Proposal three: Agree on an adjustment program with Spain and Italy to provide the funding to refinance their debt as well as their deficits.
This option would also require an increase in the ESM resources.
A number of observations can be made regarding their relative merits.
Proposal one presents a very important advantage: its funding is guaranteed given the ECB’s unlimited capacity to purchase bonds in sovereign debt markets. Moreover, its implementation would be fast and easy as the ECB would be fully in charge of the interventions. The ECB’s commitment should have a strong effect on markets and convince many investors to regain trust in Spanish and Italian bonds, thereby limiting the volume of the ECB interventions. From this perspective, the potential impact of this proposal on the ECB’s balance sheet could be low.
Proposal two follows the same logic as proposal one, but replaces the ECB by the ESM as the lender of last resort to address concerns that proposal one would blur the boundaries between the responsibilities of monetary and fiscal policy and threaten the independence of the ECB. The price to pay for that would be an increase in the resources of the ESM.
It is unclear whether the reduction in the funding costs of Spain and Italy would reassure investors completely about the future of the euro. Whilst it is likely that a significant part of the current spreads on Italian and Spanish bonds is the result of fear in the markets, the adjustment process needed to improve the fundamentals of Spain and Italy could get out of control. In these circumstances, it is possible that some (or many) investors decide to take the opportunity of offloading their Spanish and Italian bonds as a precautionary measure, thereby shifting the sovereign risk from private investors to the ECB/ESM.
The key shortcomings of Proposal one (ECB cap) and Proposal two (EFSF/ESM cap) as well as the associated moral hazard risk could be addressed by following Proposal three (Italian and Spanish structural adjustment programmes).
Obviously this would only work provided that the resources can be mobilized for this purpose. In addition, beyond issues of national sovereignty, the negotiation of a program would need to deal with serious policy questions relating to the speed of adjustment, the nature of the austerity measures and structural reforms as well as the policy mix within the eurozone.
Spain versus Italy and the UK
To understand better the constraints facing Spain and Italy, consider these charts:
Sources: IMF WEO April 2012 and Bruegel REER database.
–The real exchange rate chart shows Spain has lost competitiveness since the adoption of the euro.
The situation has slightly improved since 2008 but its real effective exchange rate remains overvalued. Italy has experienced the same trend but less strongly.
–The debt-to-GDP ratio chart shows that Italy’s main problem is its high government debt.
In response to this vulnerability, Italy has managed to limit the rise in its budget deficit and its primary surplus is expected to reach 3 per cent in 2012.
–The real growth chart shows worrisome trends for Italy and Spain; GDP is projected to fall by almost 2 per cent this year.
This trend could lead both countries into a debt trap – the debt ratio’s numerator rising with automatic stabiliser spending and its denominator falling with recession. The Spanish situation is all the more difficult to handle that its unemployment rate has exploded since 2008. These observations underline the importance of rebalancing the eurozone priorities from austerity to growth.
–The contrast in the charts with Britain is instructive; despite a higher government debt ratio, Spain is paying higher yields.
One possible explanation is that members of a monetary union issue debt in a currency over which they have no control. Financial markets can drive these countries into default (the bad equilibrium may be self-fulfilling) in contrast to nations who have issued debt in a currency that the can produce in unlimited qualities (thus they always have the liquidity to avoid sovereign).
A complementary – and more conventional – explanation for the UK-versus-Spain yields is that investors are concerned about the consequences of the loss of the exchange rate as an instrument of economic policy for Spain. Whereas the UK has managed to deal with the financial and economic crisis by allowing a large real effective sterling depreciation (19 per cent between 2007 and 2011), Spain did not.
It is reasonable to assume that this development and the difficulty to improve competitiveness through internal devaluation have become a serious source of concern for investors.
A macroeconomic strategy for the eurozone as whole
The unaddressed competitiveness issues create uncertainty about Spain’s and Italy’s ability to pull through without restructuring of some kind. This dampens the chances that proposals one or two will work. Competitiveness is also a fundamental problem in its own right – one that must be addressed during the negotiation of an adjustment program with these countries.
One may think that there is no alternative but to muddle through the adjustment process and inevitable pain. This is a risky gamble. The results of the election in Greece have given a serious warning about the limits to people’s acceptance of austerity-only.
From this perspective, it would be a good thing if an adjustment program for Spain and Italy would be dealt with within the framework of a macroeconomic strategy for the eurozone as a whole. This objective can best be achieved through a loser monetary policy and a lower value of the euro. By adopting this approach, the ECB would follow the IMF’s recommendation to support further growth in the short term as well as Krugman’s advice to let inflation rise in the eurozone in order to allow for larger inflation differentials between surplus countries (especially Germany) and deficit countries (especially Spain).