The eurozone crisis: Markets, governments and voters

© European Union, 2011

Below are some thoughts on the ongoing crisis that we sent out a while ago:

Fears over the eurozone debt crisis have sent markets into free fall over the last few days, and although recently announced US employment data may give markets some short-term reprieve, these fears are likely to continue. At the heart of this crisis is one simple, but yet politically hugely complicated problem: the eurozone is left without a lender of last resort. EU leaders agreed on 21 July that the eurozone bailout fund – the EFSF – rather than the European Central Bank, should have the mandate to act as the backstop and provide cash for struggling governments and banks. However, they did not equip the EFSF with the necessary cash to do so, due to political constraints, leading to huge uncertainty on the markets with EU leaders sending out mixed signals. Therefore, the deal may in fact have made things worse in the short-term.

This illustrates the impossible choice that the eurozone faces between appeasing markets that want more fiscal union and ignoring voters who strongly oppose it.

What could happen now?

On paper, two main things could help to soften the immediate crisis – but both look politically impossible:

1) The ECB stepping up: The markets want the ECB to start buying Spanish and Italian bonds. Buying Irish and Portuguese bonds – which the ECB did yesterday – is almost pointless since these countries are already getting government-backed bail-outs (via the rescue packages), meaning they are already off the markets. In contrast, Spanish and especially Italian bond markets are liquid. In fact, The ECB’s intervention yesterday may have made the situation worse by half-heartedly intervening, raising expectations, in turn leading to apprehension over it not purchasing Italian and Spanish debt. This created a jump in the cost of borrowing for these two countries.

Why it is politically problematic: In order for the buying to be effective, the ECB would have to buy bonds on a massive scale – not miles away from the Quantitative Easing (QE) pursued by the Federal Reserve in the US and the Bank of England. Given that the ECB already has an exposure of €444bn to the PIIGS, such a move would send it into unchartered territory, and completely into the realm of fiscal policy – which is against its own rules and the promises given to German voters in the 1990s. Several key players in Germany would strongly oppose such a move. The complexity of this is illustrated by the fact that several members of the ECB’s Governing Council even voted against the comparatively modest decision yesterday to start buying Portuguese and Irish government bonds. In any case, in return for taking on this role and the risk it involves the ECB would want a large say over fiscal policy in the eurozone, and would likely push for massive austerity. This would lead to the central bank being heavily involved in political decisions, an undemocratic situation which everyone wants to avoid.

2) Radically increase the size of the bailout fund: The current size (€440bn) of the eurozone bailout fund, the EFSF, is far too small to cover Italy and/or Spain. Italian bond market is €1.6tr and Spain's is around €600bn, with both having large amounts of debt maturing over the next few years. To be effective, the EFSF lending capacity would have to be at least quadrupled, and to have any impact in this crisis, it needs to be doubled, at least.

Why it is politically problematic: Since a Triple-A rating needs to be guaranteed for the EFSF, the entire burden of this increase would in reality fall on the six Triple-A rated countries, which will be forced to provide loan guarantees amounting to over a quarter of each of their GDPs. This, in turn, could impact negatively on their own financial position and rating. Such an arrangement cannot be agreed without completely ignoring voters in these countries, who are vehemently opposed to putting more cash on the line. Any increase would need to be ratified by national parliaments, and given the noise the Dutch, Finnish and German parliaments have made over the existing loan guarantees, which have been on a far smaller scale, this is unlikely to happen. These parliaments have not yet ratified the increase in the size and scope already agreed by EU leaders in July and earlier this year.

How long will Spain and Italy be able to hold up?

Italy and Spain can withstand rising yields for a short period (a few months). But in the longer term, such yields will significantly add to their deficits and will force further austerity – which will be very unpopular domestically and which risks killing off any growth prospects. Rising costs also feed through to the countries’ banking sectors, which could face increasing costs leading to a tightening of credit in the economy.

Both countries suffer massively from low growth and poor competitiveness, with Italy in particular lacking a credible plan for how to get out of its snowballing debt problem – interest payments on debt outstrip growth meaning debt continues to grow relative to GDP. Italy and Spain will somehow need to find a way to make the long-term changes necessary to boost their growth and competitiveness, within the restraints of a flawed currency union.

So is there anything the eurozone can do to stop contagion in the short term (before it’s too late)?

If radically expanding the EFSF and a proper liquidity role for the ECB are ruled out due to political constraints, what, then, can eurozone leaders actually do? The brutal truth is: not that much.

Eurozone leaders have wasted so much time and manoeuvring room on completely failed policies, i.e. the bailouts. A restructuring of the Greek, Irish and Portuguese economies now look like a more attractive option. Far from stemming contagion, every day they wait, the more painful the necessary restructuring becomes, as markets get more jittery, bond spreads increase, in turn putting more pressure on government funds as the crisis sucks in more countries.

The existing EFSF funds could be used to help provide a backstop for European banks and to recapitalise them. The ECB could continue its bond buying on a short term basis but needs to develop a plan for how to wind down this programme in the long-term.

There is now even talk of a eurozone bout of QE. However, it is not clear whether the ECB could ever do this effectively, since, any increase in money (either electronic or hard currency) has to go through the ECB Governing Council, meaning it needs the approval of the National Central Banks (NCBs) of Triple-A countries such as Germany, Finland and the Netherlands, who are unlikely to agree to it. Even if it were approved, the actual distribution mechanism would need to be through NCBs, according to the member states' share in the ECB, meaning that Germany could get a huge bout of QE which it does not necessarily need or want.

Is the endgame drawing closer?

The impossible short-term choices, pitting the need to soothe the markets against national democratic restraints, perfectly illustrate the flaw that was inbuilt in the eurozone from the very beginning. The choice that was always inevitable is therefore drawing closer: appease markets but run over voters and create a full fiscal union - or break up the eurozone.