Konjunktur Shadow ECB Council reflects on danger for the euro and ways to make the currency union more stable

Is there only a choice between a breakup of the currency union and moving to a transfer union? Members of the Shadow ECB Council discuss the implications of the fiscal crisis of the peripheral countries in preparation of their monthly meeting. Latest entry by: Janet Henry

Gustav Horn: "Pressure on Ireland to use the ESFS was wrong"

The Euro is safe in the medium run and it could even be stronger than ever if the right things were being done. But there are also risks that need to be addressed. The basic strength of the Euro comes from a global perspective. But there are internal problems. From a global perspective in contrast to China, Japan and the US there is no external balance problem of the Euro area. So there is no need to adjust neither to limit surpluses nor to limit deficits. From an internal European perspective things do not look so bright. Within the Euro area imbalances have to be overcome and this is a symmetric task. Either we will have a de facto transfer union with the surplus countries permanently transferring money to deficit countries by European emergency schemes or governments will set up a framework that prevents countries from building up structural imbalances in the first place. This has to be applied to deficit as well as to surplus countries and should target the current account. That means public as well as private debt has to be monitored. If such a scheme is installed the Euro will be stable. If not, the turbulence will continue and the Euro area will chaotically converge to a transfer union. A break up is politically and economically not feasible, because nobody except speculators will benefit from that. Late speculators on a break up therefore will loose a lot of money.
The pressure on Ireland to use the ESFS was wrong. It should be at the discretion of a country if it wants to use the money or not. If it wants to do so it deliberately subjects to the conditions involved with that step. Otherwise it will always be argued that these conditions were enforced by "Brussels","Berlin" or "Paris". That will diminish its acceptance and their effect. In addition to that demands to use the ESFS triggered more speculative waves that worsened Irelands situation.
Gustav Horn is Scientific Director of IMK institute

Marco Annunziata: "There is no guarantee that an IMF/EU program will suffice to stabilize markets"

The dramatic resurgence in tensions on sovereign bond markets is a painful reminder that the Eurozone has some important unfinished business. Pushing Ireland towards the EFSF and the IMF was at this stage inevitable, but there is no guarantee that an IMF/EU program will suffice to stabilize markets. After all, investors already knew that eventually Ireland could be supported via the EFSF. To maximize the chances of success, EFSF lending to Ireland should be of longer maturity than the loans to Greece. For example, 10-year loans would avoid an early spike in repayments, and would give Ireland more time to restore growth and fiscal sustainability. Beyond this, EU policymakers need to come to a joint position on a possible debt restructuring framework. The solution which would be most conducive to market stability would be either (i) no debt restructuring ever, or (ii) debt restructuring possible only on new debt issued after a specific date—in line with the Seoul statement. The latter however implies that the EU will stand ready to finance Greece and any other country in need for a much longer period than just three years, namely for as long as these countries can rebuild market confidence and regain market access at reasonable yields. If that is the case, EU leaders should state so clearly to make the commitment credible. Alternatively, EU leaders could decide that private investors should face the risk of haircuts on existing debt. This would be a perfectly reasonable position, but they will then have to accept that market tensions and volatility will persist. As long as countries keep their fiscal consolidations on track, even the second scenario will not in my view pose an existential threat to the euro. It will, however, imply a significant constraint on the ECB, which will find it hard to exit either the asset purchases or the extraordinary liquidity provisions.
Marco Annunziata is Chief Economist of Unicredit

Jacques Cailloux: "The ECB should step up its bond purchases and a flexible credit line is needed to prevent contagion"

It is urgent for European policy makers to respond to the contagion risks that sovereigns face in the euro area. Since the start of the crisis, the response put in place while forceful at times has been mostly reactive rather than pre-emptive. The issues are well-known: they are a combination of liquidity and solvency problems which does make a pre emptive policy response very complicated albeit warranted. While European policy makers are still focusing on the fundamentals, market dynamics at times can be non linear leading a sovereign into a bad equilibrium very abruptly. It is therefore of the utmost importance that a contingency plan is laid out to prevent the pressure on sovereigns to continue building up. There are two options, both of which should be pursued: (i) the ECB should step up its bond purchase programme and include Spanish securities (ii) the EFSF/IMF support should be transformed into a “flexible credit line” a la IMF. Such a stand-by facility would likely contribute to stabilise market confidence. The combination of self fulfilling prophecies, pro cyclical rating actions and political instability is a toxic cocktail that requires immediate pre emptive action.
Jacques Cailloux is European Chief Economist of Royal Bank of Scotland

Elga Bartsch: "The next game changer is outright quantitative easing by the ECB"

We said from the outset that the European sovereign debt crisis is the first real test for the institutional underpinnings of the euro and that the sovereign debt crisis is not going to be resolved quickly. The current contagion we are seeing the periphery is worrisome. It’s not just government bonds, it is also the banking sector. In our view, the announcement of an assistance programme for Ireland is a step into the right direction, especially as the programme will likely address the root cause of the issue: the banking sector. It is also positive that the issue is no addressed in the EFSF rather than merely being stabilised by the ECB with the liquidity provided in the Securities Market Programme, in the unlimited refi operations and and also Emergency Liquidity Assistance. At the end of the day, we need a circuit-breaker though and that circuit breaker is bank capital. Bank capital is very different from bank funding/liquidity in that it can be leveraged. The question is though whether the Irish programme came soon enough and will be implemented quickly enough to contain the contagion in the periphery. Back in May, Europe created some powerful instruments to contain the sovereign debt crisis. But they have not be used very effectively thus far and the communication around it from the various European capitals has not been helpful. Hence, investors ask themselves what it is the next game changer for the euro area if the sovereign debt crisis spills into the core? In my mind, the next game changer is outright QE by the ECB. But I also believe that we are not there yet. For now, Finance Ministers and Regulators need to pull their weight.
Elga Bartsch is Chief European Economist of Morgan Stanley

Erik Nielsen: "The Euro-zone project is safe and sound and perfectly capable of responding to this crisis"

I am pretty confident that the package for Ireland will materialise and create stability there. The discussion where the money will go – government versus bank recapitalisation – is academic; there is a serious hole is in the latter, and its for the Irish government to decide how to handle the burden sharing between shareholders, creditors, depositors and taxpayers. While the withdrawal of the Greens in Ireland may lead to early elections, its unlikely to lead to a delay in the program that will underpin the rescue package. It then seems very likely that Portugal will be next. While the deficit is smaller and the their banks are healthier, the Portuguese government faces some significant and lumpy payments starting in April. The amount needed for Portugal will be only about half that of Ireland, however. I acknowledge that markets might then turn on Spain, but I maintain my view that Spain is in a fundamentally better shape than any of the three small peripheral countries, and that such possible market pressure would not be based on underlying fundamentals. And if it does, I also remain confident that the European political institutions will respond in kind. The Euro-zone project is safe and sound and perfectly capable of responding to this crisis, but the original set-up is still lacking a way of squaring the lack of fiscal transfers with the need to create a sustainable debt-workout. But debt restructuring will only be a potential future issue in Greece.
Erik Nielsen is Chief European Economist of Goldman Sachs

Thomas Mayer: "The euro is in danger because we are drifting away from the agreed legal foundations of EMU"

The euro is in danger because we are drifting away from the agreed legal foundations of EMU. If this drift is not stopped acceptance of the euro in the "centre countries" will be undermined and political forces pushing for a break-up of EMU will gain ground. To return to save ground we need to re-establish the principles that every country is responsible for its own finances and the ECB focuses on price stability for the euro area. To achieve the former, we need to prepare for a possible debt rescheduling for countries that fail to regain access to market funding when their adjustments programmes run out. To achieve the latter, the ECB has to wind down its government bond purchase programme and end the extension of cheap liquidity to potentially insolvent banks.
Thomas Mayer is Chief Economist of Deutsche bank

Marie Diron: "The ECB should show that it will take part in a crisis resolution plan"

The Eurozone will survive if anything because it is in the interest of all: governments of weak and small countries, financial markets and of course the ECB. The EFSF has been put in place to deal with crises but financial markets are doubting that it will prove effective and sufficient. Each crisis brings bond rates to yet new highs, primarily in peripheral countries but with pressure now also being felt in other countries such as Italy and Belgium. This situation is not sustainable. A detailed and credible assessment of the Eurozone economies is needed. Ireland's case reminds us that the stress tests were clearly insufficient which raises questions about banking sectors in other countries. From the ECB's point of view, this involves distinguishing its role as regards the setting of monetary policy for the Eurozone as a whole and its role in a crisis resolution plan which would involve intervening in specific markets to help diffuse tensions. The ECB should show that it is ready to take such actions and not close the door on any instrument.
Marie Diron is Senior Economist at Oxford Economics

Julian Callow. "All countries should have independent fiscal oversight bodies"

In my view the euro is not in serious danger. So many of the difficulties related to just four countries, comprising 12% of euro area GDP, Therefore, it should be possible for the remainder of the euro area to support the countries in difficulty. That said, governments must work quickly and decisively to ensure a much stronger and more stable framework for its operation. Given that we are still a long way from achieving the fully-fledged political and transfer union that is ultimately the best way of securing the euro's future, governments must find methods to ensure that their collective actions are consistent and coordinated.
There are three big economic issues that must be addressed in the euro area: fiscal policy, the financial sector and divergent levels of competitiveness.
1. All countries need to have independent fiscal oversight bodies which can deliver an ongoing independent audit of fiscal sustainability. Currently the European Commission, IMF, OECD and ECB all have extensive fiscal scrutiny of governments, yet sometimes their message is not heard sufficiently well. Therefore I recommend that some of these extensive economic resources be combined into a Euro Area Fiscal Oversight Commission, which would provide expert advice to the national bodies and produce its own independent assessments on a quarterly basis, and make recommendations to the EU Council (as well as reporting to the European Parliament). This would improve peer pressure and transparency. While I can appreciate the desire of Germany to enshrine collective action clauses (CACs) into new sovereign debt issues, I believe that the suggested implementation of the timing of this, from mid-2013, is much too early. First, we must be in a comfortable fiscal equilibrium, and I do not see this being fully apparent in early 2013. I suggest that the timing of the introduction of CACs be postponed until 2016, to give many countries sufficient time to put their fiscal houses in order.
2.Financial stability requires the creation of a euro area banking supervisor, which can set common standards and apply these consistently across euro area financial institutions. It needs to be founded upon basic principles of regulation, which are well understood by experienced officials, for example by focusing closely on loan to value and on bank liquidity ratios. A fully funded eurozone equivalent of the FDIC would help to reassure depositors, which is important to backstop financial stability - the Irish bailout was precipitated by deposit outflows from the banking sector.
3. Divergences in relative competitiveness are in my view the hardest to resolve, but a programme of labour market reforms can help to generate new jobs. For example, in Spain the new hybrid "fomento" contracts are proving popular and helping to stabilise the labour market.
In conclusion, decisive action by governments to reduce excessive budget deficits, accompanied by supply side reforms, and supported by the European Central Bank adopting an accommodative monetary policy that anticipates the disinflationary implications of this transition, should help to raise business confidence in the euro area and therefore to reduce the very high level of unemployment.
Julian Callow is Chief European Economist of Barclays Capital

Angel Ubide: "Fiscal solidarity is a necessary condition for an integrated financial system"

The euro is not in danger but the management of the current crisis is clearly suboptimal. The debate on debt restructuring is ill timed and misguided. The European authorities must understand that an integrated European financial system is not compatible with a debt restructuring concept. In addition, the current crisis management stance is incompatible with a theoretical discussion about how future crisis might be handled. It is impossible to foresee how future crisis will develop, and thus it is pointless to try and define all the different ways in which a future crisis will be managed. The key issue is, again, that an integrated European financial system can’t be managed without some sort of centralized fiscal support. The great benefit of the euro is that the whole is greater than the sum of the parts. This benefit would disappear if financial markets become segmented along national lines, as it would if the concept of debt restructuring were to take place. European fiscal solidarity is a necessary condition for the integrated financial system, and with it the euro, to continue to operate successfully. It is high time that the European leaders understand this.
Angel Ubide is Chief Economist of Tudor Investment Corp.

Andrew Bosomworth: "The euro’s longevity is threatened by growing internal imbalances"

The euro’s longevity is threatened by growing internal imbalances and a sub-optimal policy-mix that risk breaking it up in the long run. There are three greatly simplified end-game scenarios for the euro in the long run. Let’s call them Happily Ever After, Fiscal Union and Break-up. Each has their own problem. In Happily Ever After, the debt-laden countries grow out of their misery, an unlikely event given current growth models. Fiscal Union stands little chance of das Volk supporting it. In Break-up, no one wants to divorce after spending so much political capital integrating thus far. So what can be done in the meantime?
A core problem of Europe’s current financial woes is uncertainty, caused by the threat of insolvency. A financial system will remain unstable until losses implied by insolvency, either real or perceived, are crystallized, socialized or earned away via higher growth. Greece and Ireland’s bail-outs buy time to give growth a chance, but they do not address debt sustainability. To reduce uncertainty therefore, policy-makers must address how to deal with unsustainable debt burdens via crystallizing or socializing potential losses. The following steps can help navigate that path:
1. Dispel the notion only bonds issued after 2013 can incur haircuts. All debt carries some risk of default. The specter of a two-tiered market confuses, encourages moral hazard and destabilizes the system further.
2. Rank bank deposits senior to debt. Ranking deposits pari passu with senior debt creates financial burdens too large for governments to shoulder. Bonds yield more than deposits, so they should carry more risk. Ranking deposits senior to debt calibrates risk with return and reduces governments’ contingent liabilities;
3. Deal with Portugal. Portugal risks losing market access unless it decreases its budget and current account deficits faster and increases potential growth. If Portugal is going to tap the EFSF, the sooner the better.
4. Accelerate fiscal consolidation in Spain and Italy in order to mitigate contagion risk;
5. Raise capital in Spanish banks. The mark to market of Spanish banks’ real estate and construction loans is not transparent and narrowing interest rate margins are deleterious for profitability. Raising capital mitigates contagion risk;
6. Raise Germany’s absorption. The euro area cannot survive if Germany continues exporting capital at the rate it does. Policies to strengthen domestic demand will help restore internal equilibrium in the monetary union.
The ECB’s policy tools do not avail it to address these issues, which are mainly the prerogative of government. But it can help governments navigate the road ahead by providing unlimited liquidity to banks via maintenance of full allotment auctions; being prepared to use the Securities Market Program to defend Spain and Italy; being prepared to lower policy rates should fiscal tightening tip the balance of risks toward deflation.
Andrew Bosomworth is Senior Asset Manager at Pimco

José Alzola: "Further steps in fiscal policy centralization are required"

The widening growth divergences between the core (Germany) and the periphery – which are likely to persist for the coming years – have exposed the fault lines of the EMU project: the inconsistency between a single monetary policy and decentralized policies in other economic areas (chiefly, fiscal policy.) This inconsistency was well known at the time of the establishment of EMU, but was expected to be resolved subsequently. Now is the time to tackle it but unfortunately there is a lack of leadership in Europe to carry the project of further political integration through. The current attempts to improve European governance (semi-automatic sanctions in the excessive deficit procedure, a permanent EFSF and a crisis-resolution mechanism) represent improvements but may not go far enough to stabilize the euro unless growth picks up soon and helps the periphery to muddle through its current fiscal and competitiveness problems. Aside from those efforts, further steps in fiscal policy centralization – which need not be completed immediately but that could be implemented over the years -- would be also desirable. José Alzola
is Senior Economist at The Observatory Group

Manuel Balmaseda: "The viability of the zone will require a new institutional framework"

What is at stake right now is the viability of the Eurozone as a monetary union. We, Europeans, must agree whether we bet on this project or we do not. If we do, we should end all these "national" quibbles and move towards the larger goal . If we do not, the Euro is already dead. The current crisis has brought to the forefront the inadequacies of the current European institutional framework, both at the policy/supervisory level and at the ECB. The viability of the zone will require a new institutional framework in which integration is much more that a long-term project. And integration must embody not only fiscal and regulatory issues, but, as the recent financial crisis has shown, financial/banking integration is also of primary importance. If we are to save the Euro, in the short term, the primary focus should be that, putting all other issues aside for now. The battleground is/will be Spain (because of its size, its past "success", its predicament) but it is not a question right now of whether Spanish debt is sustainable or not, it is a question of whether all these countries can live under the corset and the umbrella of the Euro, with all the sacrifices and benefits it entails. The viability of the common currency should be compatible with bond restructuring (if necessary) and with "local" bank failures (if they were to happen). Obviously, for this to be the case the required mechanism must be put in place. For now, the commitment to the Euro and to the development of institutions required to avoid moral hazard issues in the future should be the compromise.
Manuel Balmaseda is Chief Economist of CEMEX

Janet Henry: "Why are policymakers allowing the contagion to intensify to this degree?"

I don’t think the euro is in danger, in that I believe it has the means to ride out this crisis, but I am unclear as to why politicians and policymakers are allowing the contagion to intensify to this degree.Ireland and, potentially, Portugal receiving financial assistance is no great surprise but, with the current fears now raising the risk of bank deposit withdrawals in Spain, the fears are in danger of becoming self-fulfilling. The long-term solution is a new institutional framework which encompasses more fiscal integration but also a mechanism for dealing with banking sector issues on a European-wide basis. But near term it is hard to see what is going to bring a quick conclusion to the current contagion. In the absence of coordinated convincing verbal intervention from European politicians, the ECB will have to resort to purchases of Spanish debt and, ultimately, even outright QE. The problem is the latter will only exacerbate the political tensions.
Janet Henry is European Chief Economist of HSBC


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