Bad Economics and Bad Politics in the Eurozone
When Lehman Brothers collapsed, no one knew which bank would be next. Counterparties lost faith in all measures of the soundness of banks. Under such a scenario, the only course of action that made sense was to hold one’s money close to the chest. This individually rational response was collectively disastrous. The uncertainty around the size and distribution of potential losses led to systemic collapse.
Something similar has been unfolding in the Eurozone bank/sovereign crisis albeit in slow motion. The failure to draw a line under the crisis has meant that the continuing uncertainty around the size and distribution of losses in the Eurozone is haemorrhaging our economy. The size of this deadweight economic loss, with all its human cost, is increasing with every additional day of inaction. Political dithering and mixed messages have ensured that no one knows how, when or where these losses will materialize.
Under these circumstances, it is rational for investors to keep their distance. They are penalizing both sovereigns exposed to weak financial institutions and financial institutions exposed to troubled sovereigns. They assume the worst for both but this collective fear is far in excess of the worst possible realistic economic outcome. States and banks with healthier balance sheets have got caught in the crossfire.
Instead of reacting decisively to reduce uncertainty, our political leaders have done the exact opposite. Their continuing dithering has increased the absolute economic and human cost of the crisis. Mixed messages, a seeming lack of competence and a decision to focus on issues such as competitiveness that at best tangential to crisis resolution today have increased uncertainty with grave economic consequences. This is bad economics.
Euro-federalists have suggested everything from minimalist E-bonds to a complete fiscal union. At the other end, some sceptics have even called for kicking troubled countries out of the Euro zone. Political expediency and economic logic rules out any break-up of the Eurozone and political stalemate and public opinion stand in the way of a fully-fledged fiscal union.
Our political leaders have instead chosen to gamble taxpayer funds with abandon. They are taking on ever increasing amounts of liabilities on public balance sheets in the EU. This happened not just when countries rescued their banks the first time round and again when a deteriorating situation in Greece led to a ‘rescue package’ for Greece. This was less a bailout of the Greek sovereign but more an indirect bailout of banks in Germany and France exposed to Greek bonds.
Ireland, having foolishly issued guarantees for its financial sector, was forced by the ECB and the EU to honour these with the consequence that an otherwise sound Irish sovereign was dragged down by its haemorrhaging banking system. Bondholders have been made whole. Taxpayers are being made to pay.
The loans provided to Greece, the ECB’s purchase of Euro zone sovereign bonds, and the creation of the European Financial Stability Mechanism (EFSM), have all shifted the risk of losses from creditors to the taxpayers of troubled member states underwritten by the taxpayers of member states with more sound finances. An opaque ‘shadow fiscal union’ has been created but no one bothered asking the voters. The official discourse is that both creditors and taxpayers from countries such as Germany will be fully repaid in time. Since this is not possible, this public stance is irresponsible and probably dishonest.
With debt burdens bigger than their economies, and growth rates below or close to zero and skyrocketing borrowing costs, the only choice for Greece and Ireland will be to restructure outstanding debts by rescheduling or imposing significant haircuts on creditors. Creditor losses are likely to run into tens of billions (hundreds if Spain and Portugal also seek aid) of Euros.
When they hit taxpayers in Germany and France, it will be a serious body blow to the eroding trust that EU citizens have in their leaders. Even more important, it would also poison member states’ relations with each other, perhaps irreparably. Losses at the ECB will damage its credibility inflicting additional damage to the Euro project. This is bad politics.
Delaying this inevitable restructuring of Greek and Irish will simply increase the losses to EU taxpayers. Too much has already been given away to creditors and too much has already been taken away from taxpayers. Today’s summit is yet another missed opportunity to finally draw a line under this crisis and limit damage to the European project. Let the March summit signal the end of the era of bad economics and bad politics.
Sony Kapoor is Managing Director of Re-Define (www.re-define.org), an International Think Tank and this piece appeared in the EU Observer on the 4th of Feb as a Comment Piece