LONDON – With the crisis of the eurozone’s periphery having mutated into a crisis of its core, the prescriptions for recovery must change. Fortunately, it is not too late, but an effective response must be immediate, overwhelming, and free of the ideological rivalries that have enfeebled the eurozone since the common currency was launched. The European Central Bank is the only institution that can generate such a response.
The eurozone now faces a classic currency crisis. Inevitably, this crisis – manifested, under a fixed exchange-rate system, through bond spreads – threatens to take down debtors indiscriminately, be they governments, banks, or households.
In attempting to save governments through fiscal austerity, banks are threatened with balance-sheet losses and a sudden collapse in confidence, while households suffer much higher unemployment. Attempts to shore up the banks through “stress tests” that lack credible recapitalization facilities and resolution mechanisms have undermined confidence in sovereign debt. In the end, it appears to be taxpayers who are hurt most by attempts to fight a debt crisis with more debt.
At the extremes, the eurozone’s debt problems can be solved through bailouts or default. By promising bailouts in return for fiscal austerity, governments have inevitably been pushed toward the prospect of socializing an unbearable amount of private debt. As the negative feedback loop between banks and sovereigns grows, confidence in a growing number of governments’ debt has steadily been eroded.
The lack of a fiscal-transfer mechanism within the eurozone, born of member states’ unwillingness to cede control of their own fiscal policies to a central authority, has always been the euro’s Achilles’ heel. Fixing the current governance structure and creating a fiscal-transfer mechanism are yesterday’s lost opportunities and tomorrow’s necessity.
That means, first and foremost, that the ECB, like other central banks since 2008, will need to look beyond the “hard money” ideology upon which it was founded. To be sure, the answer is not to print endless amounts of money or to relieve politicians of their responsibility to fix a broken system. But nor can the ECB sit by and allow the crisis to reach full force.
The strongest signal that a central bank can send during a financial crisis is to ease monetary policy aggressively. Standard monetary policy, together with bad structural policies, is to blame for the eurozone’s growth disparities. Lost competitiveness in the periphery was, in part, an equilibrating movement caused directly by the economic-adjustment process under a common monetary policy. Accordingly, interest rates should be used more actively to cushion the adjustment, given that bailouts are unaffordable and default is undesirable.
A de facto ECB guarantee to back all eurozone government debt will be more controversial. But there is no alternative. The newly established European Financial Stability Facility is an appropriate vehicle to fight peripheral fires, but it is far too small – and cannot be scaled up quickly enough – to fight a systemic blaze. Leveraging the EFSF’s resources should be considered, but any such move will be constrained by the need to preserve the vehicle’s AAA rating with sufficient sovereign guarantees.
Moreover, deployment of EFSF resources remains hobbled by political bickering (highlighted by the current fight over Greek loan collateral). Each political battle to secure more resources for a transitional crisis-fighting fund leads to further constraints on governments’ power to act in times of crisis. Rather than forging ahead with fiscal or political union, this process increasingly fosters division, both within and between eurozone countries.
Effective insurance is normally the least likely to be used. The ECB is the only eurozone institution that has the capacity, through its power of seigniorage and profit/loss sharing to all member central banks, to provide Eurobond-like support. It could “guarantee” all eurozone debt, either formally or with the force of will (effectively promising to purchase any and all government debt). Bringing down sovereign borrowing costs would partly, if not entirely, restore governments’ ability to fund bank recapitalization where needed.
In theory, it is immaterial whether the ECB eventually buys all euro sovereign debt through its Securities Markets Program or guarantees all debt pre-emptively. But the former would tend to reinforce the negative feedback loop between banks and sovereigns, while the latter would likely avoid socializing a rising volume of private debt as the feedback loop is attenuated.
Under such a system of ECB guarantees, there would still be an important role for traditional stabilization programs, like those now in place for Ireland, Portugal, and Greece – particularly while countries still run primary deficits. Sovereign defaults, which may yet be the end-result of one country’s failure to reform, could be better facilitated, in terms of loss sharing and mitigating contagion. And constitutional debt brakes would be no more or less likely to be successfully implemented in the wake of ECB guarantees.
There is only one thing worse than a debt overhang, and that is an avalanche. The ECB can do nothing about the overhang, and it has rightly resisted assuming responsibility for debt problems that are ultimately fiscal in nature. Nonetheless, with the crisis now becoming systemic, the ECB must take up the fiscal-transfer baton that eurozone leaders have so unceremoniously fumbled.
Of course, losses would be borne by eurozone taxpayers, with Germany potentially covering a disproportionate share. But the losses would be mitigated as banks avoid sharp deleveraging and asset fire sales. The eurozone would be safe, at least temporarily, and leaders could resume their glacial trudge toward fiscal and political union.