Cheap ECB cash could prove to be the worst form of bailout

Over on Telegraph blogs, we argue:

Stemming the crisis through cheap central bank money sounds so easy. The logic goes: Italy and Spain have economic problems which cause markets to push up their borrowing costs, which now have reached "irrational" levels as fear has taken hold. If left unchecked, this could threaten the Eurozone and Europe’s economy. The European Central Bank, it is said, has "unlimited" ability to create credit or cash and act quickly. Hence, it must “stand behind the currency” and save the euro – and Europe.

So when the ECB today announces that it will intervene further in the crisis, probably by buying up short term government debt, many bankers and politicians will love it. Bankers because it avoids losses (at least for a bit), politicians – including British ones – because it might just save their skins at the polls.
But for Europe’s long-term economic future, this is also why large-scale ECB intervention is so risky. Europe has for decades lived beyond its means and needs to adjust if it wants to thrive in this century and the next. Faced with economic reality, there’s still hope that over a number of years (if domestic politics allows it – a big if admittedly) countries like Spain and Italy will finally push through much-needed reforms and achieve the 20-30 per cent internal devaluation needed to become reasonably competitive with Germany inside a currency union. And Europe as a whole would be better off.

But bailouts – whether by government or the ECB – can, at best, buy time. At worst, however, they act as an outright disincentive for necessary reforms. This risk was eloquently highlighted by Professor Leszek Balcerowicz – former Polish Finance Minister (and central bank head), famous for implementing the Polish structural reform plan following the fall of communism – at an Open Europe event last week. All bailouts, he said, come with "moral hazard". But if mishandled, ECB bond-buying could actually turn out to be the worst form of Eurozone bailout, as it completely de-links the bailout cash from reforms needed, creating a moral hazard problem of massive proportions (in addition to creating a number of other problems such as undermining the rule of law and making ECB susceptible to political influences). We’ve seen the signs already. As ECB board member Jörg Asmussen noted recently, "There cannot be a repeat of the mistakes with Italy in the summer of last year, when the ECB bought Italian sovereign bonds and the time was unfortunately not used for necessary adjustment measures".

And ECB money doesn’t come from a magic tree. From June 2011 to April 2012 its exposure to weaker Eurozone economies increased by 106 per cent, from €444 billion to €918 billion, and has only continued to rise since then. If ECB head Mario Draghi acts on his promises of unlimited intervention, this exposure could increase exponentially. At the end of the day, someone has to pay for this. Whether taxpayers (who ultimately back central banks) through write downs and losses (and resulting recapitalisation of the ECB) or savers through higher inflation in the stronger parts of the eurozone economy (bound to happen sooner or later).

As the ECB itself knows, it’s very difficult to counter these risks. Once the ECB taps are opened, it’s incredibly hard to turn them off without causing huge market distortions and creating an even graver crisis than the one that the original intervention was meant to stave off. That is why the ECB is right to insist on countries committing to reforms (through an intergovernmental decision) before it bails them out. Perhaps that mix could work for struggling Eurozone countries. But there's also a huge risk that Europe, in the long-term, will pay a very high price for what is only (at best) a short-term fix.

An EU banking union within a year? Don't think so.

In an interview in today's FT, Commission President Jose Manuel Barroso is raising the stakes in the talks on a 'banking union' in the EU and/or eurozone, involving an EU-wide deposit guarantee scheme, a rescue fund paid for by financial institutions and giving an EU-wide supervisors the power to order losses on banks, without the approval of national authorities. The Commission, keen to get back in the game following the shift in focus to national capitals in the wake of the crisis, says it'll present a proposal for a banking union at the EU summit at the end of June.

According to the FT, Barroso said all of this could be achieved within the next year and didn't necessarily require an EU Treaty change. He said, "there is now a much clearer awareness" in national capitals, including Berlin and London, that Europe needed to press ahead with more integration "especially in the euro area."

Barroso noted,

“We have a chancellor of Germany that is indeed proposing a political union for Europe, which is extremely ambitious. We have a French president that has been highlighting the need for a more European approach regarding crucial issues like growth and investment. And we have a British government – and this is indeed a very interesting development – that while stating its willingness to stay out of the euro, assumes as indispensable and desirable to further integration in the eurozone.” 

Good marks for optimism. In reality, though, there's no way a banking union will be up and running within a year. Even if he was hinting at an agreement in 2013, that too is optimistic - at least on the chunkier stuff. A number of member states still have huge reservations. The UK won't be part of a banking union regardless, and anything requiring unanimity and/or Treaty change may be used by Britain to re-heat demands for safeguards over UK financial services, which Osborne has already floated. Other non-euro members also have reservations, with the Swedes opposing a banking union based on cross-border liabilities on a point of principle and the fear of moral hazard (unlike the Treasury, which seems happy for the eurozone to do this as long as the UK is not on the hook).

Merkel will face resistance from various corners: the Bundesbank, the legal class (hello Treaty change), its financial supervisors BAFIN, the media and a host of backbench MPs. This will have to go through the German Parliament, which per definition takes time. And as for the French, we're not entirely sure that Hollande quite has his head around what a banking union would involve - and that France's position is somewhat fluid at the moment.

And remember, a proposal by the Commission for limited cross-border bank deposit guarantees has been stuck in the Brussels machinery for two years, at the hands of resistance in member states.

This will be a drawn-out one.

Why you should think twice before criticising Slovakia

In today's Wall Street journal, we look at Tuesday's vote in Slovakia - here's the full piece:

Richard Sulik has emerged as Brussels's public enemy number one. As leader of Slovakia's Freedom and Solidarity party, or SaS, Mr. Sulik has consistently and vocally opposed euro-zone bailouts. SaS parliamentarians' refusal to back changes to the European Financial Stability Facility led to the collapse of the Slovak coalition government on Tuesday—a powerful illustration of the far-reaching political impact of what some still think is only an economic crisis.

Mr. Sulik's opposition to paying for what he describes as other people's mistakes led Germany's Handelsblatt this week to label his anti-bailout movement a "central European tea party." Yesterday Slovak lawmakers reached a deal to pass the EFSF expansion in a fresh vote before the end of the week. But at what cost?

There are strong arguments in favor of approving the changes to the EFSF, especially if it will be used to strengthen Europe's banks. But consider this: In 2010, Slovakia's GDP per capita was €11,692, while Greece's was €19,822. Going into this crisis, average earnings in Slovakia stood at €8,700 per year, while in Greece they were around €23,900. Meanwhile, the average Slovak pension was €250 per month, compared to €830 a month in Greece. True, the Greek government has made efforts to adjust the country's entitlement culture, but you can see why sympathy for Athens is in short supply in Bratislava.

There is another and arguably more compelling reason why Slovaks should question the need to cough up in the name of so-called European "solidarity," though. Certainly, Slovakia has benefited from euro-zone membership and from EU funds, largely financed by taxpayers in countries such as Germany, Finland, the U.K. and the Netherlands. But Slovakia has also paid a price. Over the last two decades, the country has undergone painful structural reform on the path from communism to a market economy, and later to EU and euro-zone membership. By streamlining its tax code, labor market, social welfare and pension systems, it reduced unemployment, attracted foreign investors and created a base for long-term economic growth.

The immediate effects of reform have not always been easy to swallow. Between 1999 and 2001, the liquidation and restructuring of Slovakia's publicly and privately owned banks cost the economy between 11% and 15% of GDP, leaving the banking sector almost completely in the hands of foreign owners. But for the most part it worked, and Slovakia's financial system emerged stronger than it was before.

Having walked this difficult road, Slovakia is now being asked to provide loan guarantees to bail out countries that failed to enact similar reforms. You don't have to be a paid-up member of the Austrian school of economics to see the potential for moral hazard on a huge scale.

First, banks in several triple-A economies, including Germany, continue to live under the protection of sovereign bailouts and ECB liquidity. They have not been forced to restructure and recapitalize, even though this is an absolutely necessary part of any long-term solution to the crisis. Second, the sovereign bailouts have transferred private-sector risk to the books of taxpayer-backed institutions. In combination with the cheap and plentiful liquidity that the ECB has provided to European banks, this has created perverse incentives, possibly leading banks to chase profits through higher yields on peripheral sovereign debt and thereby increasing their exposure to the crisis. The toxic mix of moral hazard and political failure has left Europe fighting for survival on two fronts, facing both a systemic banking crisis and an increasingly desperate fiscal crisis.

Are sovereign governments learning these lessons? In an ironic twist, the Slovak parliament rejected the EFSF amendments on the very same day that the EU and the International Monetary Fund signaled that Greece would receive the next tranche of its original bailout, even though the country has clearly failed to meet its austerity and deficit targets. Although this is probably necessary to avoid a disorderly Greek default, we desperately need to move away from a situation where assistance trumps reform.

Moving forward, it is encouraging that euro-zone leaders are now considering ways to manage a hard Greek default, while finally looking at ways to recapitalize euro-zone banks. But as EU leaders look for clever ways to leverage the EFSF, possibly quadrupling it in size, without increasing the existing loan guarantees, and as the euro zone reluctantly moves towards more fiscal integration, it must keep one vital lesson in mind: Conditionality is king. Failing to impose costs on those responsible for the crisis, particularly the banks, not only sows the seeds for future economic problems but also fuels political divisions. The euro zone can ill-afford more of either.