Europe’s Last Chance to Save Itselfby
Europe’s economic catastrophe is unfolding so slowly that it has come to seem like business as usual.
For some analysts, the optimistic scenario -- yes, optimistic -- now requires a Lehman-style financial collapse provoked by a Greek exit from the euro system. Nothing less, they reason, will get European Union governments to act. How’s that for a vote of confidence in politicians?
Whatever happens after the June 17 Greek election, an even greater calamity than a Greek euro-exit threatens Spain, a much bigger economy whose collapse would be far harder to manage. The danger is imminent. Spain’s borrowing costs have risen almost to the level that signals insolvency, and its banking system is crumbling. If the rot can’t be stopped there, Europe’s prospects are grim.
At the summit planned for the end of this month, Europe’s leaders need to aim higher than their default strategy of “do nothing, see what happens.” Two new proposals are being discussed: a “banking union” to shore up the EU’s beleaguered financial system and a “redemption pact” to guarantee the solvency of Europe’s debt-stressed governments. Although neither plan would completely fix the problems, both are worth pursuing.
The banking union idea calls for a single euro-area approach to financial regulation, a jointly backed deposit-guarantee plan and a collectively supported system for recapitalizing distressed banks. This makes sense because adopting the single currency has erased the borders separating national financial systems. Stress in one country is instantly transmitted to others. A completely integrated financial market requires a unified approach to regulation and support.
However, shoring up distressed financial systems requires public money -- and that’s contentious. Spain is seeking collective deposit insurance and bank recapitalizations mainly because it no longer has the money to act on its own. Germany balks at open-ended support for such initiatives, a posture that risks its well-being, not just its partners’. Yet a summit compromise looks possible. It would involve steps toward banking union plus limited collective backing through an enlarged European Stability Mechanism, which is now underfunded. This would be less than ideal, but better than nothing.
The redemption pact confronts the overarching question of government insolvency head-on. The idea is to roll national sovereign debts above 60 percent of gross domestic product into a jointly guaranteed fund. Thanks to risk-pooling, the refinancing cost would be lower than prevailing rates for distressed borrowers (and higher for the creditworthy). Governments would promise not to raise their remaining debts above the 60 percent ceiling. They would also make binding deposits into the fund such that it would dissolve after 20 to 25 years. One method of enforcing the pact would require countries to post collateral in the form of foreign-exchange reserves.
The good thing is that the plan is a stride toward issuing euro bonds, a move we have advocated for the last year and which German Chancellor Angela Merkel continues to rule out. She also wanted nothing to do with the redemption pact when it was first floated, perhaps suspecting it was euro bonds by stealth (which it is). She has softened that line and hopes are rising for another possible compromise.
Unfortunately, the main drawbacks of the redemption pact are the very features that commend it to Merkel: It’s designed to be temporary, but the euro area needs a lasting fiscal repair. It would work through compulsion and penalties, raising questions of democratic legitimacy, rather than by creating incentives for good fiscal conduct.
Under threat of tough penalties, the pact imposes severe austerity for decades on countries such as Italy. Even if that were desirable -- we think it’s too harsh -- it’s just not credible. The EU needs to break the habit of making promises nobody expects to be kept.
Still, the plan is a step in the right direction. If the summit can accept the principle of debt mutualization, however constrained and convoluted, financial markets will be reassured, and that’s the first order of business.
Meanwhile, the European Central Bank should be doing more. On Wednesday, it left its benchmark interest rate unchanged at 1 percent and continues to frown on quantitative easing of the sort conducted by the U.S. Federal Reserve, all despite signs that the euro area’s slowdown is worsening. The ECB can’t fill the policy vacuum, as its president, Mario Draghi, said last week, but that’s not the point. Further monetary stimulus is perfectly feasible and would help.
Europe has vacillated long enough. It needs to act before the full cost of its paralysis comes due, and the June 28-29 summit may be its last chance.
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