It is an old cliché that the European Union only advances in the wake of a crisis. Recently though, it has seemed like every time the EU takes action its response is deemed too little too late.
Last week’s agreement on a second Greek bailout fits this pattern. While the initial reaction to the deal was positive, markets soon soured, and Spanish and Italian borrowing costs have since risen significantly. But this deal could yet prove to be a decisive turning point for the EU and the future of the single currency. For the first time, European leaders have recognized some of the institutional failures of the current design of the Eurozone and put in place reforms that could – in time and with further modifications – stabilize the financial sector and end the contagion.
Despite itself, the EU is slowly being dragged towards a fiscal union. The immediate consequence of the agreement reached late last week was to stave off a disorderly Greek default and the contagion that would then have swept over the European banking sector. But the most significant decision to come out of the meetings was to broadly expand the scope of the European Financial Stability Mechanism. In this new, enhanced EFSM lies the seed of a fiscal union.
To be clear, the plan announced last week does not solve all of the underlying problems facing the Eurozone. The haircut imposed on Greek creditors was not large enough to make the country’s debt burden sustainable. Many European banks still need to be recapitalized. Peripheral Europe still does not have a clear path to growth. Portugal and Ireland, despite being granted lower interest rates and longer maturities on their program loans, could require more help down the line. And as mentioned above, borrowing costs have gone up, and not down, for Spain and Italy.
With so much left undone, it is not surprising that the markets remain skeptical. But consider the new powers that the EFSM has been granted. It will be able to act preemptively to halt contagion; purchase sovereign debt in the secondary markets; recapitalize financial institutions through direct loans to national governments; and make loans even to non-program countries. Never before has an EU institution been given such far reaching powers to support financial stability.
Klaus Regling, the head of the EFSM, was quoted yesterday by the German tabloid Bild denying that the EU would become a transfer union. Don’t believe him. The EFSM is poised for real fiscal authority.
There are of course, a couple of caveats. First, the EFSM will need the approval of the ECB to intervene in the secondary markets. Second, when the EFSM takes action to recapitalize banks, it will disburse loans, not equity investments. Third, and more seriously, the EFSM has not been given enough money to actually carry out the duties it has been charged with.
But these shortcomings can be addressed. On the first point, central banks are ultimately responsible for the stability of the financial sector and when faced with the real threat of a liquidity crisis will support efforts to halt the contagion. The EFSM will not be held hostage to political posturing if its support is really needed.
The second point is a bit more intractable. The mess that Ireland finds itself in, after all, is that not only were its banks too big to fail, they were too big to save. Once the Irish government assumed the contingent liabilities of its banking sector, the size of Ireland’s sovereign debt (which had hitherto been tiny by European standards) grew so large that many observers doubted the country’s ability to pay. A financial crisis was thus turned into a sovereign debt crisis.
When banks that are too big to fail are insolvent, what they require is new equity capital. During a systemic crisis, only fiscal authorities – that is, governments – are able to provide the necessary capital. But if the government in question finds itself locked into a currency union without control over its own monetary policy, it too might find itself dependent upon private capital markets in order to raise the money needed to recapitalize the banks. If markets refuse, or only offer loans at punitive interest rates, then there can be no rescue. The banks will collapse, spreading contagion across borders.
That is why the EFSM has been given the authority to extend loans to sovereign governments to recapitalize banks. The EFSM will, as Willem Buiter has pointed out, need more money if it is to carry out this authority. In time (probably sooner rather than later), this money will be found. But wait, you say, even if the EFSM is topped up, if it merely provides loans to governments, won’t we risk a repeat of the Irish scenario, replacing a financial crisis with a sovereign debt crisis? Yes, precisely.
But recall now the other major component of last week’s agreement – a restructuring of Greek sovereign debt. The EU now has a model for sovereign debt restructurings. This model will be used again, certainly for Greece and very likely for Ireland and Portugal. As the EFSM (and the ECB) buy up sovereign debt on the secondary markets, they will be on the hook for future restructurings. The costs associated with these restructurings (or defaults, if you prefer) are thus being transferred from the investors who made unwise loans, to European taxpayers, who ultimately must put up the money for the EFSM (and for recapitalizing the ECB, if it comes to that).
The economic logic driving the Eurozone crisis is implacable, a sort of unstoppable force. You cannot have a monetary union without at least some forms of common fiscal authority. This doesn’t necessarily mean a single EU Finance ministry with the power to tax and spend. But it does mean a common resolution authority with the power to recapitalize the financial sector.
The problem of course, is that the unstoppable force of the economic logic is coming up against the immovable object of politics. European politicians are not technocratic executives who can take decisive action without regard to their own electoral future. They have been handed a very difficult task – to do what is necessary even if it means falling upon your sword. There is very little popular support in ‘core’ Europe for a fiscal union. Many of the European leaders you see today won’t be tomorrow. That is why Europe is slouching towards a fiscal union.
Ben Carliner is a Fellow at the Economic Strategy Institute. Prior to joining ESI, Mr. Carliner worked as a financial journalist in New York for Project Finance International. Mr. Carliner has also worked for Barron’s Business and Financial Weekly and WBAI Radio in New York. He holds a B.A. from the University of Wisconsin-Madison and an M.A. in International Political Economy and Public Policy from the University of Texas-Austin. The original article can be found on Ben Carliner’s blog.