Europe’s Next Grand Bargain
by Shane Fitzgerald
In the last year alone, the force of the Eurozone debt crisis has pushed reluctant EU policymakers across a series of political Rubicons – Greece has been bailed-out, a temporary eurozone rescue mechanism has been installed, that mechanism has been activated for Ireland, and agreement that a permanent replacement scheme is needed has been reached.
In keeping with Jean Monnet’s dictum that ‘Europe will be forged in crises, and will be the sum of the solutions adopted for those crises’, each of these measures, even the agreement on the need for a permanent financial facility for troubled states, was compelled by overbearing market pressures. Together they amount to a major change in the way the EU functions.
But despite Angela Merkel’s protestations of the ‘primacy of politics’ over markets, European leaders’ actions have until now been continuously undermined by events that seemed to be moving too fast for the cautious and complex EU establishment to get a grip on.
Now, after a period of relative calm over Christmas and the early new year, those market pressures are threatening a return. But Europe is thankfully better placed to face them down and to forge from its various statutory and ad hoc policy instruments a framework that might better serve it during the next, inevitable, crisis.
It is clear from the European press in the first weeks of 2011 that national leaders, lawyers and learned members of the transnational policy establishment have been knocking their heads together – crafting a variety of proposals that might finally allow the EU to get ahead of what has been a very debilitating and demoralising period.
The debt crisis poses short, medium and long-term threats to the EU and exposes a variety of institutional shortcomings. The most immediate threat arises from the fact that, albeit for very different reasons, Greece and Ireland are teetering on the brink of insolvency. Years of accumulated debt and the risk of contagion in a highly leveraged and interconnected European financial system mean that Portugal, Spain and other large countries could still slide towards them on the cliff edge. The implications of this for the nascent global economic recovery would be dire.
A central prong of the European response to date has been the European Financial Stability Facility (EFSF), a €440 billion special purpose vehicle designed to shock and awe markets into accepting that Europe was not about to let a member state default anytime soon. The EFSF, drawn down for the first time to assist in the Irish bailout, has a somewhat tenuous basis in European law, which means that it must be replaced by something more permanent when it expires in 2013. This opens up all sorts of tricky vistas including Treaty changes and the inevitable constitutional challenges to those changes. However, despite the difficulties, the general sense is that the replacement of the EFSF with a permanent European Stability Mechanism (ESM) is doable. A more pressing concern is that the current arrangements may not be fit for purpose in the interim.
The EFSF suffers from what Spiegel calls a ‘fundamental credibility problem’. Despite the assurances of national leaders that the structure of the Facility and the penalty interest rates it would charge would prevent lenders from booking losses and in fact make them money in the long run, it is increasingly difficult to see how severely stressed economies such as those of Greece and Ireland will be able to pay back their EFSF loans without some sort of financial relief. In a recenteditorial, even the normally conservative Economist called for the debt of ‘plainly insolvent’ European countries to be restructured.
For the moment, probably only Greece is ‘plainly insolvent’ but Ireland and Portugal could yet join the club if decisive action is not taken. The costs of prevarication, the Economist noted, have become painfully clear:
The burden on the countries that have been rescued is enormous … The Irish will toil for years to service rescue loans that, at Europe’s insistence, pay off the bondholders of its defunct banks. At some point it will become politically impossible to demand more austerity to pay off foreigners.
The political and economic rationales for some sort of restructuring for Greece and Ireland are therefore clear, especially when contrasted with the extreme alternative solution of large-scale fiscal transfers from the core of the Eurozone to prop up peripheral economies. European solidarity is one thing, outright subsidy of bankrupt states is another. In contrast, forcing losses on reckless international banks, even where this might require further bailouts down the road, is far less politically toxic.
But European politicians and central bankers (and indeed their international counterparts) will still balk at the notion of allowing an EU member state to default.
Luckily, there are options which lie between the two extremes of debt default and fiscal transfers. One idea that seems to be gaining currency is that of voluntary debt forgiveness by way of bond buybacks. The logic is as follows: Because of continuing uncertainty, Greek and Irish bonds are currently trading at a sizable discount to their face value. The EFSF would front money to a troubled country to try to buy back its bonds from investors at a price that is above the market value but below the face value. Investors could choose to accept the offer or to hold on to the bonds in the hope that their value will rise (while accepting the risk that they could lose more money if the country heads towards insolvency).
Although he denies it formally, the man credited with putting this plan on the table is Klaus Regling, head of the EFSF. He developed a similar procedure for rescuing the Philippines from a financial crisis in the mid-1980s. The plan also has obvious similarities to the ‘Brady Bonds’ which allowed US banks to reduce their exposure to heavily indebted Latin American countries, giving those countries the breathing space they needed to recover their economies. There is an appealing elegance to the idea, but it seems unlikely that by itself such a programme could provide relief on a scale that could make the difference for struggling states.
Just as the crisis poses threats on different timescales, the debate around reform of Europe’s support schemes and economic governance coalesces around short, medium and long term elements.
There are for example a lot of competing arguments as to what the EFSF should be doing now, what it should be doing if things get worse in the coming months, and what model it should be providing for the ESM which will succeed it in 2013.
More broadly, the first ‘European Semester’ of economic surveillance began at the start of 2011, the economic governance proposals of the Van Rompuy Task Force are winding their way through the European legislative process now, new bank stress tests are due in the summer, and a Treaty change to allow the establishment of the ESM must be ratified by 1 January 2013. Tomorrow (4 February 2011) we will find out the contents of a Franco-German ‘competitiveness pact’ and get an idea of how receptive other member states are to the proposal.
On the support schemes, in the short-term – and however honourable the intention – it is difficult to argue that Ireland and Greece have so far been given that crucial breathing space by their European partners. Indeed, in the run-up to a February general election, leading Irish voices have been arguing quite the opposite. In an interview with the Financial Times, Fine Gael’s Michael Noonan (a strong candidate for Minister for Finance in the next Government) insisted that Ireland was paying too much for money from the EFSF and would seek to improve the terms of the overall assistance package. He also said that a new government would seek to renegotiate the terms of those senior bank bonds not covered by the 2008 government guarantee. The Labour Party, Fine Gael’s almost-certain partners in the next government, have been similarly critical of the EU-IMF deal and would like to reopen the Memorandum of Understanding that sets out Ireland’s tough austerity programme for the years ahead. Meanwhile the nationalist Sinn Fein party, set to make significant gains in this election and to put a lot of pressure on Labour from the left during the campaign, indulges in outright bravado, saying it would tell the IMF ‘to go home and take their money with them’.
Ensuring the sustainability of Ireland (and Greece)’s debt commitments is clearly in Europe’s common interest. But, fresh mandate or no, it is very hard to see how unilateral renunciation of international agreements by either country can have a positive effect. Writing in the Irish Independent, Brendan Keenan notes that:
The depth of the crisis is forcing European governments to abandon caution and enter unknown territory. The risks are so high that no one can step out of line. They must hang together, or they will surely hang separately.
As the IMF said last week, the euro crisis could set off a second global crash as bad, or worse, than that of 2008. It is fantasy to think any small country will be permitted to add to that risk by acting alone.
If Ireland’s problems are Europe’s problems, as a lot of different people are now insisting, then they will not be resolved without consultation, compromise and collaboration with European partners. The EFSF was constructed in great haste and the support packages introduced at a time of overwhelming pressure. But EU leaders have since demonstrated a willingness to revisit the terms of the Greek and Irish loans as part of a broader ‘grand bargain’ that also addresses longer-term and wider issues.
In the medium-term, because it is recognised that the EFSF is not big enough to ‘bail-out’ Portugal or Spain, voices are calling for the amount of guarantees to be raised. Other options are replacing some of the guarantees with capital contributions that could be ‘leveraged up’ by the facility or allowing it to extend ‘precautionary’ credit lines to faltering economies that have not yet tipped over into rescue territory. Ireland and Greece’s interest rates and loan durations could certainly be reviewed as part of any such major reconstitution of the Facility.
In the longer-term, the establishment of a permanent ESM will be countenanced by Germany and other ‘core’ states only as part of a deal that would correct what they see as fatal weaknesses in peripheral economies.
Already in train are far-reaching reforms that should substantially strengthen fiscal and economic coordination in the Eurozone. In a recent speech, ECB President Jean Claude-Trichet demanded a ‘quantum leap’ forward in European economic governance. Forced debt reduction, shorter deadlines for reining in deficits and semi-automatic sanctions were all on his wish-list. Recalcitrant states should face “[c]ountry missions, fines, reduced access to EU funds, and other pecuniary consequences.”
This was ambitious and controversial stuff. After presumably intense lobbying, a more limited set of proposals was adopted as a package by the Commission in September and approved by the European Council in October 2010. European Parliament rapporteurs have since been busy reviewing each of the package’s six texts and in late January presented their draft reports to the Parliament’s Economic and Monetary Affairs Committee, which is now conducting crucial deliberations.
This package, when passed, will certainly go some way to addressing the institutional shortcomings exposed by the crisis. But it does not cover as much ground as Trichet and others would like. Hence the recent flurry of briefings about debt brakes, competitiveness clauses, fiscal frameworks and other structural reform demands emanating from Brussels, Frankfurt and, in particular, Berlin.
Chancellor Angela Merkel is using her bargaining power as head of Europe’s largest and most influential economy to demand that financial support schemes for weaker states be linked to strict rules that will promote fiscal cohesion and competitiveness within the Eurozone. Controversially, Germany is seeking ‘coordination’ of traditionally sacrosanct (and Treaty-guaranteed) national competences in areas such as social services, retirement ages, wage agreements and taxation. There is a suspicion that Germany and France are using the crisis to force through long-held agendas, particularly in the area of tax harmonisation, that have little to do with Europe’s financial and consequent sovereign debt crises.
These debates are set to play out during a series of EU and Eurozone summits over the coming weeks, the goal being to announce a comprehensive ‘grand bargain’ at the latest at the European Council Summit on 24-25 March.
In his own bid to finally draw a line under the crisis, the President of the German Central Bank, Axel Weber, has suggested transforming the international support to Greece and Ireland into sets of 30-year loans, Reuters reports. The Greek newspaper To Vima has published more details of a plan reportedly promoted by Weber behind closed doors at the World Economic Forum in Davos. The three-stage plan involves Brady Bond-style buybacks of debt as discussed above, an extension of loan terms by the EU and IMF from three to 30 years, and an invitation to major bondholders to extend the maturity of their bonds to between 15 and 20 years. To Vima estimates that these measures could result in the reprofiling of about two-thirds of Greece’s total debt by the end of 2011.
It is not clear the extent to which Weber and Merkel’s proposals are endorsed by political establishments in Berlin and elsewhere. But after an unpleasant year in which harried politicians poured vast quantities of political and financial capital into unforgiving bond markets, the wide scope of such proposals indicate that policymakers are finally determined to demonstrate the primacy of politics through their actions as well as their rhetoric.
Given how far Europe has travelled in recent months, perhaps a ‘new normal’ is allowing leaders to think previously unthinkable thoughts. Maybe desperate times call for such unthinkable measures. It is certainly the case that only radical solutions will overcome what is still a deeply grave and volatile situation.