Publications
Partners
EARLIER this week, a group of almost 100 prominent Europeans
delivered an open letter to the leaders of all 17 eurozone countries.
The letter said, in so many words, what the leaders of
Europe now appear to have understood: they cannot go on “kicking the can down
the road.” And, just as importantly, they now understand that it is not enough
to ensure that governments can finance their debt at reasonable interest rates;
they must also address the weakness of Europe’s banking system.
Indeed, Europe’s banking and sovereign-debt problems are
mutually self-reinforcing. The decline in government bond prices has exposed
the banks’ undercapitalisation, while the prospect that governments will have
to finance banks’ recapitalisation has driven up risk premiums on government
bonds.
Facing the prospect of having to raise additional capital at
a time when their shares are selling at a fraction of book value, banks have a
powerful incentive to reduce their balance sheets by withdrawing credit lines
and shrinking their loan portfolios.
Europe’s leaders are now contemplating what to do, and their
next move will have fateful consequences, either calming the markets or driving
them to new extremes.
All agree that Greece needs an orderly restructuring,
because a disorderly default could cause a eurozone meltdown. But, when it
comes to the banks, I am afraid that the eurozone’s leaders are contemplating
some inappropriate steps.
Specifically, they are talking about recapitalising the
banking system, rather than guaranteeing it. And they want to do it on a
country-by-country basis, rather than on the basis of the eurozone as a whole.
There is a good reason for this: Germany does not want to
pay for recapitalising French banks. But, while Chancellor Angela Merkel is
justified in insisting on this, it is driving her in the wrong direction.
Let me stake out more precisely the narrow path that would
allow Europe to pass through this minefield. The banking system needs to be
guaranteed first, and recapitalised later. Governments cannot afford to
recapitalise the banks now; it would leave them with insufficient funds to deal
with the sovereign-debt problem.
It will cost much less to recapitalise the banks after the
crisis has abated and both government bonds and bank shares have returned to
more normal levels.
Governments can, however, provide a credible guarantee,
given their power to tax. A new, legally binding agreement - not a change to
the Lisbon Treaty (which would encounter too many hurdles), but a new agreement - will be needed for the eurozone to mobilise that power, and such an accord
will take time to negotiate and ratify. But, in the meantime, governments can
call upon the European Central Bank, which the eurozone member states already
fully guarantee on a pro rata basis.
In exchange for a guarantee, the eurozone’s major banks
would have to agree to abide by the ECB’s instructions.
This is a radical step, but a necessary one under the
circumstances. Acting at the behest of the member states, the ECB has
sufficient powers of persuasion: it could close its discount window to the
banks, and the governments could seize institutions that refuse to cooperate.
The ECB would then instruct the banks to maintain their
credit lines and loan portfolios while strictly monitoring the risks they take
for their own account. This would remove one of the two main driving forces of
the current market turmoil.
The ECB could deal with the other driving force, the lack of
financing for sovereign debt, by lowering its discount rate, encouraging
distressed governments to issue treasury bills, and encouraging the banks to
subscribe (an idea I owe to Tommaso Padoa-Schioppa).
The T-bills could be sold to the ECB at any time, making
them tantamount to cash; but, as long as they yield more than deposits with the
ECB, the banks would find it advantageous to hold them. Governments could meet
their financing needs within agreed limits at very low cost during this
emergency period, and the ECB would not violate Article 123 of the Lisbon
Treaty.
These measures would be sufficient to calm markets and bring
the acute phase of the crisis to an end.
Recapitalisation of the banks should wait until then; only
the holes created by restructuring the Greek debt would have to be filled
immediately.
In conformity with Germany’s demand, the additional capital
would come first from the market and then from individual governments - and
from the European Financial Stability Facility only as a last resort, thereby
preserving the EFSF’s firepower.
A new agreement for the eurozone, negotiated in a calmer
atmosphere, should not only codify the practices established during the
emergency, but also lay the groundwork for an economic-growth strategy.
During the emergency period, fiscal retrenchment and austerity are unavoidable; but, in the longer term, the debt burden will become unsustainable without growth - and so will the European Union itself.
- Reuters
* This piece comes from Project Syndicate. The opinions
expressed are his own.
