By Wolfgang Münchau
No political organisation in the world is as skilled as the European Union when it comes to muddling though. Don’t knock it. For 27 member states to agree, the art of compromise is critical. Muddling through has served the EU well over the years.
The agreement reached by EU leaders in the early hours of Saturday was a politically smart muddle. Angela Merkel got exactly what she needed: a deal that limits Germany’s financial liability. The others could live with it. Some important technical details have yet to be worked out, but the deal is essentially done.
Unfortunately, you cannot muddle through a debt crisis.
There are, in essence, two ways to resolve a debt crisis: through a bail-out or through default. Or through some clever combination of the two if you know what you are doing. If you muddle through, you end up with the default option, literally.
So where will this agreement lead us? To answer the question, it is important to understand a couple of technical aspects of the financial rescue mechanisms agreed on Saturday. The current one – the European financial stability facility (EFSF) – will run out in 2013. It gives credits to countries in trouble, and may soon buy their bonds on the primary markets. These rank pari passu – on the same terms – with everybody else’s investments. That means, should the country default, everybody gets hit equally. If, say Greece, were to default today, Germany and France would have to make good on their credit guarantees to the EFSF. It would be a political disaster. German conservatives would cry “transfer union” and drag Ms Merkel to the German constitutional court. The creditor nations would therefore not allow a default until 2013.
In 2013, a new mechanism will replace the EFSF. It is called the European stability mechanism (ESM). The crucial difference between the two is that its credits will be senior to those of private investors. The idea is to make default possible, with only a moderate risk to the budget of the creditor nations. By 2013, the European banks should be in a better position than today to absorb big losses, or so one hopes. Voilà, end of crisis.
To come up with such an idea requires a good deal of ignorance of how financial markets work. Unfortunately, financial illiteracy is, and always has been, a hallmark of much of European economic policy.
What has been happening is that forward-looking investors see through this scheme, and correctly assess the risk of a future default, also for existing bonds. They know that once a country defaults, old and new bonds will be treated alike. They are also bearish on neighbouring country bonds. Spain is solvent, of course, but an implosion of Portugal plus a further likely decline in Spanish house prices pose risks. Spain may thus need temporary access to the ESM at some point, at which all Spanish bondholders would automatically become junior. Those investors will then no longer own a traditional government bond, but a mid-ranking tranche of a complex debt product – one that was downgraded by a large rating agency last week. So if you are a Spanish bondholder, and you hear the news from Brussels that the ESM is now agreed, and big enough to accommodate Spain, you have reason to be very afraid.
But your likely loss may not be necessarily someone else’s gain. This is the real irony of it all. Policymakers in Germany or France are just as unlikely to push for a managed default in 2013 as they are now. After the collapse of Lehman Brothers they rightly refused to take the risk of a systemic meltdown for which they would be blamed. But if they are scared of a default now, they will be in 2013. At that point, the politicians will say to themselves: let’s do what we do best, and muddle through again. They will make another loan with excessively high interest rates, and demand another austerity plan – one that stands as little chance of success as the present ones.
This game will continue until the debtor country’s economy collapses under its debt burden, at which point the inevitable default will be very messy. If you are lucky, you are no longer in office by then, and you can blame your successor for the mess.
So what to do instead? You could either accept the logic of a default, and arrange for it now, followed by a big programme for bank bail-outs, a recapitalisation of the European Central Bank, and credit support for the defaulting country. Or else, you accept the principle of a bail-out, not through cross-country transfers, but a single European bond that replaces all national debt. I personally would choose that option. A large and highly flexible rescue mechanism with pari passu status, the ability to underwrite debt or buy bonds in secondary markets, would have been a step in that direction.
Ms Merkel said at her press conference that her one concession – for the ESM to be able to buy bonds in primary markets – is not going to make much of a difference. She is right. The rescue mechanism as constructed now is an emergency facility only. On Saturday morning, the EU got itself an arrangement that lives in a purgatory between bail-out and default, as it muddles through a never-ending crisis.
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