Eurozone crisis: Europe's choice to punish or protect
- 26 September 2011
- From the section Business
It has been clear for some time what the outlines of a potential deal to save the euro would be.
But, contrary to what the more breathless newspaper headlines have suggested, there was no comprehensive deal on the table in Washington this weekend for ministers to discuss, let alone sign up to.
First things first: officials have, more or less, accepted the need for a bigger write-down of Greek debt and more capital for Europe's banks.
There are plenty of devilish details to sort out. But you can sort them out without requiring a major philosophical shift on the part of the European Central Bank (ECB) or Germany. All that is required is that eurozone leaders grasp the urgency of the situation, which, supposedly, they now do.
However, the same cannot be said of the proposals for the eurozone rescue fund, the European Financial Stability Facility (EFSF). My bet is that this will happen, in some shape or form. But not without a fight. There is also the small problem that it might not be constitutional.
On the banks, Europeans had one good reason to hate the IMF's estimate of the losses banks had faced as a result of the crisis. In coming up with the 300bn-euros ($400bn; £260bn) figure, fund staff had added up all the "mark-to-market" losses which European banks would have made on their sovereign debt holdings for countries like Greece or Italy.
But, by design, the calculation did not take any account of the very large gains that had been made on the same banks' holdings of, say, British or German sovereign debt, whose value has soared over the same period (the counterpart of that dramatic fall in yields).
This was unfortunate. It gave eurozone ministers an excuse to quibble with the details of the IMF's analysis, instead of finally accepting the basic argument which the fund, the US and the UK have been making for over a year: Europe's banks need more capital. Arguably, they were under-capitalised even before the Greek crisis hit.
They need even more capital now. That much is now widely accepted by the Germans and pretty much everyone else. Again, the details of how to do it are tricky, and the amounts are disputed. But the principle has been agreed. It will happen.
You might expect me to say the same about beefing up the EFSF; after all, didn't they already expand it once? But the change under discussion is not one of scale - it is one of design. And the design change gets to a fundamental question of principle about the bailouts which has dogged the eurozone's response to the crisis from day one.
A bit of explanation. As I reported on Thursday, US Treasury Secretary Tim Geithner went into the Washington meetings saying that eurozone leaders were planning to use the European rescue fund, the EFSF, to leverage a lot more resources.
He had brought his own suggestions along these lines to the meeting of finance ministers in Poland the previous week. Key to the US approach is the idea that the EFSF takes "first loss" on investments. This, in the Americans' view, was crucial to the success of its Tarp programme and similar US efforts to normalise markets in late 2008 and early 2009.
Changing the design of the EFSF in this way does not entirely get round the problem I discussed in my blog of 15 September that the more countries you bail out, the fewer countries are left in the EFSF, the less money there is in the pot.
But the "first loss" idea would give the EFSF much more bang for its remaining euros. It also would move away from a situation in which European governments are basically telling private investors that when it comes to losses, the official sector will be last in, first out. Typically, governments persuade investors to return to a market by promising exactly the opposite.
The European Commissioner, Olli Rehn was very "slowly slowly" when I put this proposal to him later on the same day. So were most other officials I spoke to.
The problem, they said privately, was that ministers couldn't talk openly about a new solution to the crisis when the old one had not even been passed by national parliaments. This was a particular issue, naturally, for Germany, which faces a key vote on the changes to the EFSF on 29 September.
Perhaps. But, to get back to my earlier point, it is not just the timing that is tricky for the Germans. It is also the principle. Because they fundamentally and deeply believe that investors should not be let off the hook. And nor should governments.
More Greek write-downs might seem to be letting the Greeks off the hook. But German officials know that Greece has been punished by the past two years, and will continue to pay a heavy price, even if their debt stock is halved. And they know that private investors will suffer more from a default now than they would in a few years' time, when nearly all of Greek sovereign debt might be in the hands of governments and public institutions.
The problem with the EFSF proposal is that it clearly and transparently lets investors and governments off the hook, at least in the eyes of German officials. Investors are shielded from losses, and governments like Italy are protected from market pressures which, deep down, most German officials think they rather deserve.
Naturally, this is not the way German officials put it. But it helps explain why it has been so hard to resolve the crisis and so hard to convince investors that Germany and others really will do "all that it takes" to save the euro.
Mr Geithner said this weekend that the eurozone needed to "take the catastrophic risk" out of markets. This is not simply about avoiding a disorderly Greek default, catastrophic though one might be. It is about resisting once and for all the temptation to use the collapse of the single currency as leverage to make irresponsible governments behave.
As long as you use the potential collapse of the European financial system and, probably the single currency, as leverage to punish governments whose policies you've always disapproved of, nothing will work. Nothing you say about saving the single currency will be believed. That is the simple message that US officials have been trying to get across to their European counterparts since the early summer.
Economists talk about needing to make a distinction between "solvency" and "liquidity" crises - and they say part of the problem, in the eurozone, has been the inability to distinguish between the two. Insolvent countries should get managed write-downs; "innocent" victims of market runs should get unlimited liquidity.
That is true as far as it goes. The trouble, especially in the eurozone, is that the world is not so simple. "Bad" governments can suffer from liquidity crises, and even "good" (or fairly good) governments can become insolvent, given a sufficiently hostile external environment, for a sufficiently long time. (Oh yes, and the country with the deepest pockets can also have a different definition of "good" and "bad" than everyone else.)
To save the euro the ECB may have to offer almost unlimited support to countries in both categories. Germany, along with other core members of the eurozone, may have to promise in good faith to take the first loss, without suggesting under its breath that it will never be allowed to happen. And they may have to do all this without getting a lot of promises in return.
None of this will come easy. But the message that was sent to eurozone leaders in Washington was that even a beefed-up rescue fund will not resolve the crisis if this basic reality has been fudged.
Update: Anyone who thinks that a new-style European rescue facility (EFSF) is now a done deal might want to consider the public comments of Germany's finance minister and its key monetary official late on Sunday in Washington.
The Wall Street Journal today quotes Wolfgang Schaeuble saying that "we won't come to grips with economies de-leveraging by having governments and central banks throwing - literally - even more money at the problem".
Asked about the EFSF, he said the fund could only work within the legal framework of the EU treaties, and the agreement governing the bailout fund. He said neither sets of rules would permit the facility to be leveraged along the lines proposed by the US.
Jens Weidmann, the new President of the Bundesbank, later said leveraging the bailout fund by allowing it to borrow from the ECB amounted to the monetary financing of government budgets, which is explicitly forbidden by the Maastricht Treaty.
German officials have said "never" before in this crisis, especially in the lead-up to a key parliamentary vote, and later been forced to accept the inevitable.
Nearly everyone I spoke to in Washington during the meetings thought the same would happen again with regard to the EFSF. But for all the reasons I discuss, it isn't going to be easy.