AMERICAN FUTURE

The Peterson Institute for International Economics recently published an 11-page policy brief provocatively titled “Europe on the Brink.” The summary of the brief follows.

• Attempts to resolve the problems in Europe are failing, and the crisis is spreading from Greece, Ireland, and Portugal to larger nations.

• Europe’s financial system relies on moral hazard, i.e., a “no defaults” policy, to attract the funding needed to roll overlarge amounts of short–term bank and sovereign debt. Now that politicians in creditor nations are calling for private sector burden sharing, investors are demanding higher interest rates to hold these debts. But higher rates may tip banks and nations toward bankruptcy.

• Europe’s banks and financial system are highly integrated across countries. Rising expectations of default in some countries could lead to large-scale capital flight into “safe” countries. This shift will raise concerns regarding solvency and liquidity of many financial institutions.

• The payments system of the euro area is serving as an opaque bailout mechanism that is currently preventing the euro area from falling apart at this time. If the number of nations in trouble spreads beyond Greece, Ireland, and Portugal, this bailout system will be stressed because of the potential size of accumulated funding.

• The European Central Bank (ECB) could soon see a vocal debate between inflationist and hawkish (anti–inflation) members. Inflationists will call for large–scale interventions, including bond buybacks and emergency loans, while the hawks will attempt to close loopholes in the payments system that effectively permit each troubled nation to create money needed to finance capital flight and budget deficits.

• At this stage in the debate, we see little chance that Europe can avoid ending the “moral hazard” regime, in which case it needs to plan for widespread sovereign and bank debt restructurings.

We see three plausible scenarios in the coming months:

1. The euro area manages to regain credibility regarding its willingness to “do whatever it takes” to resolve the current crisis while avoiding defaults and inflation. This ironically requires far more rapid and larger austerity than currently planned in the periphery.

2. The euro area choses decisively to end the moral hazard regime. While this will not be orderly, the problems can be reduced through comprehensive and rapid actions to restructure sovereign and bank debt in highly indebted nations, while recapitalizing banks elsewhere.

3. The euro area remains in limbo, unable to choose a clear path. This would lead to a large disorderly series of financial sector and sovereign defaults, while an “inflationary majority” is likely to eventually assert control of the ECB and manage a massive liquidity expansion.

The euro crisis is not under control. Deep structural flaws have become apparent—particularly the extent to which moral hazard has underpinned credit flows within the euro area. Ending this moral hazard will not be easy, particularly as European decision–making structures are struggling to find a
comprehensive approach.

UPDATE. The Financial Times Alphaville blog quotes the Royal Bank of Scotland on what’s wrong with the new Greek bailout:

. . . after almost 3 months of negotiations and effort, the Greek debt load will be at best reduced by 10 to 20 percentage points of GDP to what will still be seen as an unsustainably high level. Overall, this will have been an expensive political decision. In the end, Greece will likely continue facing a rolling crisis around IMF quarterly reviews. Doubts about the trajectory of the economy and the ability to raise privatisation receipts anywhere near the targets will persist.

The statement clearly gives the impression that euro area policy makers are increasingly ‘getting the message’, with 3 new tools being created: a precautionary programme, a lending facility for non programme countries to recapitalise banks and a bond buying programme in the secondary market. However, the level of detail provided is low, making it hard at this stage to really tell how the new tools will work in practice and how efficient they will end up being. In particular, there is insufficient information available to tell how preventive those tools will end up being deployed and this is related to the lack of clarity surrounding the so called “appropriate conditionality” that will be imposed on member countries accessing these new help mechanisms.

In our view a key limitation of the announcement is that it did not address the size of the EFSF [European Financial Stability Fund]. We have recently argued that a prerequisite to increase the flexibility of the EFSF was to increase very significantly its size with a view of ultimately having a lending capacity of around Eur2trn. Indeed, under the amended EFSF which will aim at having a lending capacity of Eur440bn, and given current and likely commitments, the EFSF will be left with a little more than Eur300bn of lending and or buying capacity – a too small amount to restore investor’s confidence that the euro area has once and for all dealt with its sovereign crisis. The crisis will in our view linger with markets likely to test the EFSF firepower.

The Alphaville post closes by noting that the recent downtrends in the yields on Italian and Spanish government debt have reversed:

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Not unexpectedly, opinions on the outcome of the emergency summit concluded last Thursday evening continue to be mixed.

Tony Barber, in the Financial Times, pens perhaps the most positive take I’ve run across:

Eurozone leaders . . . have pulled off quite a feat. For the first time since May 2010, they delivered a positive surprise by striking a deal that went further than many financial market participants had anticipated.

[...] Europe moves forward incrementally – sometimes a stumble, sometimes a step, sometimes a stride. It cannot be otherwise in a union of democracies that have pooled some sovereignty but have retained the features of nation-states. The complicated structures of European decision-making do not help. In trying to ward off the mortal threat to European monetary union, the eurozone’s leaders still look a little off balance but, on Thursday, they gave every impression of heading towards fiscal union.

Lest he be accused of wearing rose-colored glasses, Barber lays out his concerns:

Of course, this will not end Europe’s sovereign debt and banking crises. It may only be a matter of months before Europe’s financial firefighters reach for their hoses again.

[...] certain gaps in economic governance cry out for attention. Most of all, the eurozone needs credible enforcement mechanisms to ensure governments do not break agreed fiscal rules . . . the crisis is compelling eurozone leaders to assemble the building blocks of a common fiscal policy and economic government. They will surely have to go further . . . the path to a closer economic union contains a potential pitfall – public opinion. Politicians in Germany and rich countries such as Austria, Finland and the Netherlands have never asked voters if they want a union that channels part of their wealth to other countries. According to a poll for ZDF public television, only 47 per cent of Germans want Greece to stay in the eurozone; just as many want Greece to get out.Similar tensions extend across the 27-nation EU. The rise of far-right and anti-euro parties is a reminder that the EU stirs disenchantment among millions, who see it as an elitist project incapable of tackling issues such as youth unemployment and illegal immigration. Pan-European institutions bore voters: turnout has fallen in every election for the European parliament since the first in 1979. Sooner rather than later, politicians must address the problem of legitimacy. The paradox is that the debt crisis is driving Europe’s leaders towards closer integration while simultaneously sapping the public’s faith in that same goal. [My emphasis]

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Wolfgang Munchau, on the other hand, is skeptical. In the Financial Times he says that

. . . the effectiveness of an agreement should not be gauged by the immediate market reaction, let alone by how the agreement compares with expectations. For it to be a positive contribution to the eurozone debt crisis, it should meet three tests. Will it put Greece on a path towards sustainable debt reduction? Will the new rules for the European financial stability facility make contagion less likely? And is the participation of private investors realistic and fair? My answer to those three questions would be, respectively: no, no, and yes.

[...] Thursday’s agreement succeeded in staving off an imminent collapse of the eurozone. That is undoubtedly its greatest achievement. But we should not fool ourselves. It will only succeed if it is followed by other agreements that fix its gaps . . . When the Europeans return from their holidays, they will still have the euro – and they will still have the crisis.

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In his column in London’s Telegraph, Ambrose Evans-Pritchard says that Chancellor Merkel faces a revolt over the debt deal:

Jens Weidmann, the Bundesbank’s chief, said the accord exposes Germany and other creditor states to “sizeable risks” and greatly alters the EU’s constitutional landscape: “The euro area has taken a big step toward a collectivisation of risks. This weakens the foundations of a monetary union where each is responsible for its own budget. In the future, it is going to be even harder to uphold incentives for solid fiscal policies.”

Frank Schäffler, finance chair for the Free Democrats (FDP) in the ruling coalition, said the summit deal threatened “the castration of Germany’s parliament” by shifting budget power to Europe. Schäffler said there is already talk of a “third rescue package” for Greece. [My emphasis]

From the Wall Street Journal (no links):

. . . details of the plan made plain that it would do little to immediately reduce Greece’s huge stock of government debt—leading to fears that Greece could again flare up as the country struggles to meet its heavy burden. And economists are skeptical that Europe is prepared to head off trouble in other countries. Ireland and Portugal, the other bailout recipients, were given more time to repay rescue loans at a lower interest rate, but saw no other relief. The wider euro-zone bailout fund, given more authority to intervene pre-emptively before a country reaches the verge of bankruptcy, didn’t get any more money to do so.

The FT’s Gavyn Davies is somewhat optimistic:

The European summit on Thursday has resulted in a belated, but still impressive, step towards a resolution of the sovereign debt crisis. The measures were clearly more significant than the markets expected, but at the same time they have fallen short of a once-and-for-all resolution of Europe’s debt problem. Several key compromises have been made, notably between the German government and the European Central  Bank, and these have removed some previously immovable obstacles to progress. The institutional plumbing is therefore now in place to resolve the crisis completely. But this still leaves one crucial question: how much money will be sent down the pipes? On that, the summit offered no new guidance.

[...] The eurozone is now formally committed to filling the Greek financing gap for as long as its government adheres to its budget consolidation programme. Following the “voluntary” default on private debt, almost all of the Greek government’s remaining debts have been taken into official hands.

In the case of Ireland and Portugal, the situation is less clear cut. The eurozone is committed to continue providing financial support until they regain market access, provided they adhere to their budget programmes. These countries “solemnly reaffirm their inflexible determination to honour fully their own individual sovereign signatures”, so they are still responsible for standing behind all of the debt they have issued to the private sector up to now. The Greek situation is, rather unconvincingly, described by the heads of government as “exceptional and unique”.

So how can problems still arise for the three most troubled economies? In the case of Greece, it could happen because the government fails to stick to the budget tightening which has been agreed. The eurozone would then either have to provide more money, or the Greek government would default on its official debt and possibly leave the euro. That clearly remains a possibility.

For Ireland and Portugal, there is plenty of debt left in private hands, and markets have seen what happens when a sovereign nation reaches the limit of its financing ability – ie sovereign default. But for as long as these two countries remain inside the programme, they will be able to refinance their debt as it falls due, at low interest rates from the European Financial Stability Facility. This means that the markets cannot make the solvency position of these countries any worse by raising bond yields. Like Greece, these two countries might still be ultimately insolvent, but only if the pain of their budget tightening proves too much to bear inside the euro.

This greatly reduces the scope for financial crises stemming from the three most troubled economies, at least for as long as the EFSF has sufficient money to refinance Irish and Portuguese debts. Since it probably does have that money, that represents a major change in the situation. And we should note in passing that if the EFSF issues bonds to absorb all of this debt, it amounts to a very large issuance of Eurobonds to bail out the troubled economies, which is exactly what Angela Merkel, German chancellor, said she would not do.

What about Spain and Italy? We have known for some time that, as things stand, the EFSF emphatically does not have enough money to deal with these countries. However, the Summit does allow the EFSF to act in advance of these countries needing to enter a financial programme, and to provide more capital if the banking sectors of these countries should need it. As the economist Willem Buiter has said, this means that the EFSF now has a superior gun, but the same amount of ammunition as before.

Until the amount of ammunition is increased, the existential threats to the eurozone stemming from Spain and Italy have not been removed. Sooner or later, the eurozone will have to increase the resources available to the EFSF very substantially, or the markets will once again call its bluff. [My emphasis]

An editorial in the Washington Post focuses on the issue of economic governance:

Europe is still groping for a permanent political fix, however. This agreement might, as its authors intend, represent the first phase of a gradual move toward effective economic governance by a more centralized European authority — the very thing economists have long identified as the crucial missing ingredient in Europe’s single-currency project.

But “economic governance” is one of those phrases that obscures as much as it explains. To put it another way, the euro’s long-term survival depends on these conditions: For the indefinite future, Northern Europeans must be willing to bankroll Southern Europeans, and Southern Europeans must be willing to live under harsh austerity programs dictated by Northern Europeans. And voters in both regions must accept having even less say in the matter than they do already. [My emphasis] The people of Europe may indeed make that choice. But we’re not sure that they have done so yet — or that their leaders have even honestly presented it to them.

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The Wall Street Journal (no link) expects that the debt accord will be less costly for European banks than was anticipated:

Top European banks will face relatively modest losses under the new Greek bailout plan agreed to Thursday, according to a Wall Street Journal analysis of bank stress-test disclosures . . . The expected losses, nearly two-thirds of which are concentrated among Greek banks, are far smaller than many analysts and investors had feared . . . The smaller scale of losses is partly because the expected hits to the bonds’ face values—ranging from losses of 10% to 21%, depending on how they are calculated—are mild compared with the so-called haircuts of 50% or more reflected in trading prices of Greek bonds that analysts had built into their projections.

However, the Journal isn’t totally sanguine:

Still, analysts said it would be premature for banks or investors to breathe a sigh of relief. They warned that Thursday’s bailout deal might simply be the first in a string of sovereign restructurings that could saddle holders of European government debt with increasingly hefty losses. [My emphasis] “The reason that they’re smaller [is] you’re not given guarantees that you won’t face future haircuts,” said Andrea Filtri, a banking analyst in London with Mediobanca Securities. “This is a start. It’s not a definitive resolution.”

[...]The losses on bonds that will be exchanged under the bailout are likely to start showing up when banks report their midyear financial results in coming weeks, analysts say.

In Greece, the six banks subjected to the EU’s recent stress tests are collectively holding a total of about €43 billion of Greek government debt that matures in the next 10 years, according to the Journal’s analysis. That could translate into losses of more than €9 billion.

Outside Greece, French and German banks are among the biggest holders of Greek sovereign debt and therefore appear likely to absorb the greatest losses under Thursday’s bailout agreement, according to the Journal’s analysis and independent analysts. French banks could face a total of up to €1.4 billion in losses, while German lenders could see €843 million.

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An article in the New York Times takes a look at the many remaining uncertainties:

Many questions are left unanswered, including whether the credit ratings agencies will consider the deal a default or an action that should affect ratings across the Continent. And in the derivatives market — where traders have been swapping instruments that allow them to bet against Greek and other sovereign debt — it is unclear whether the industry association that makes rulings on those contracts will declare that the parties that bet against Greece should be paid, or not.Also clouding the market is the question of whether Europe’s plan for Greece is more of a bailout or a default — selective default, the term being used to describe the plan, is a term few investors have ever heard before. The ratings agencies declined to discuss their thoughts on the deal after it was announced, but they have said in the past that measures similar to the ones announced, including extensions of the length of the debt, would qualify as a default. And Greece’s situation is an anomaly for derivatives traders, who are more used to settling up after defaults of corporations, rather than those of countries.

[...] It is unclear how long it will take for the agencies to react. Moody Investor Services pointed out in a statement that it was “not a party to ongoing discussions on the Greek debt rollover,” and that it was observing developments and rating implications “in due course.” A spokesperson for Fitch Ratings said there were no changes to Greece’s ratings at that point. Standard & Poor’s declined to comment.

[...] Apart from the ratings agencies, another default ruling will likely come over the next few days from the International Swaps and Derivatives Association. After a well-known market participant requests that the industry association determine whether a default has occurred, a committee of 10 banks and five large asset managers will convene by telephone to opine on the matter. Their decision matters because it will drive large profits and losses for investors, depending on whether they bet for or against Greece, and some analysts have expressed fears that there may be a company that has a concentrated position that it may have trouble paying off.

[...] Closer to home for most Americans are money market funds, which hold billions in European banks’ debt, though analysts said the funds should remain safe under the plan. This summer, some estimates said 50 percent of the $1.6 trillion in prime money market fund assets were in the debt of European banks. [My emphasis]

The Times’ Floyd Norris opines:

It appears that the deal will mean solvent European nations will have to write some very large checks. Lenders will suffer losses, and some banks may need more bailouts, which Europe will pay for through a collective fund that will be authorized to borrow money backed by European states individually and collectively. That fund, called the European Financial Stability Facility, will also take over lending to Greece, at rates close to what the facility is forced to pay when it borrows money. Other parts of the communiqué issued by the European leaders after their summit meeting in Brussels promise there will be more central control over national budgets and tax policies.

Call it the federalization of Europe.

[...] In effect, the new decisions recognize that a strategy that might have been called “prosperity through austerity” was a hopeless failure [My emphasis] . . . Over the 12 months ending in March, the Greek economy shrank by 5.5 percent, while unemployment, at 12.2 percent when the country was first bailed out, rose to 15 percent.

Finally, in the Times, Jack Ewing has some disturbing words about European banking regulations:

Despite the threat to the banking system caused by Greece and huge markdowns on Greek bonds in the market, European banking regulations maintain the fiction that Greek debt is risk-free. The same holds true for bonds from Ireland, Portugal or any other European Union country. [My emphasis]

The regulations, left intact by new European Commission bank rules issued Wednesday, provide a strong financial incentive for banks to buy government debt. Because the risk of losses is officially zero, banks do not need to set aside additional reserves when they buy government debt.

[...] Governments have benefited from the regulations, which helped to create a market for their bonds and keep interest rates low. But now that Greece’s problems are shaking the euro area, the policy is being questioned. Banks’ extensive holdings of sovereign debt are a central issue in the crisis, creating a dangerous link between government fiscal problems and bank stability. The exposure of financial institutions to government bonds adds another layer of complexity as European leaders struggle to find a way to reduce Greece’s debt load without bringing down the euro.

[...] The new banking rules issued by the European Commission will sharply increase the amount of reserve capital that banks must keep on hand, in line with guidelines agreed to by the Group of 20 nations. But European government bonds will continue to be considered risk-free and immune to capital requirements, at least until 2015.

[...] International banking guidelines also put a zero-risk label on government bonds bought by banks in that country. As a result, most banks have huge holdings of their own government’s debt. The five largest Italian banks, for example, own 164 billion euros in Italian government debt, making them acutely sensitive to the fiscal fortunes of their homeland.

New rules taking effect in the course of the decade will force banks to set aside at least minimal sums to cover the risk of government bonds. The so-called Basel III banking rules approved by the G-20 last year would require banks to hold capital reserves equal to at least 3 percent of all their holdings, regardless of the perceived risk. That rule, intended to prevent banks from taking on too much leverage or gaming banking regulations, would also apply to government bonds. But the rule, known as a leverage ratio, would not take effect until 2018 and could still change.

Writing in the FT, Joseph Stiglitz (the Nobel Prize-winning economist) has an upbeat reaction to yesterday’s agreement:

Europe may have taken an historic step in its meeting on Thursday – it seems, for once, to have done more than “just kick the can down the road”.  First, its leaders recognised that it is not just Greece that faces a problem; it is a European problem, which requires a European solution . . . Second, the leaders recognised that Greece’s problems require a focus on debt sustainability – lowering the debt burden and increasing gross domestic product, and Europe is doing something about both.  Not only are maturities being extended, but interest rates are being lowered; but even more important is the commitment to investments that will stimulate the economy, create jobs and increase tax revenues.

There were other important policy reforms – or at least moves in the right direction.  The clear statement  that public authorities should place less reliance on private rating agencies – the European Central Bank should not delegate responsibility to judging what is and is not acceptable as collateral . . .

Making the private sector bear more responsibility for its lending is also long overdue.  The repeated bail-outs of banks around the world (and the bail-outs in Latin America, east Asia, Mexico, etc) have encouraged reckless lending.  The socialisation of losses accompanied with the privatisation of gains that occurred in the 2008 bail-outs in Europe and the US leads to a perversion of the market economy.   The private sector once again tried to blackmail governments – saying that the consequences of not bailing out the lenders would be disastrous – and Europe should be congratulated for not giving in, even if the ECB did what it could to give this argument support.  The details of the private sector involvement are not yet clear, but what is clear is that they should have a significant “haircut”.

But he has for cautionary comments:

The European Union has once again reiterated its resolve to a quick return to fiscal rectitude (at least for those countries not in crisis).  Europe’s recovery, however, is still frail and excessively quick cutbacks will slow growth, and even risks a double-dip recession.  [My emphasis] Lower economic growth will be bad even from a narrow view of deficits and debt.  Moreover, Ireland and Spain both had budget surpluses and low debt-to-GDP ratios;  that should serve as a reminder that these restrictions are neither necessary to ensure future growth and prosperity.  Unfettered markets – and especially under-regulated banks – were central in causing the crisis; and too little has yet to be done.

Secondly, revenues from Greece’s privatisations may help address the country’s financial difficulties, but not if privatisation is pushed too rapidly, with a rigid timescale.  Fire sales worsen a country’s balance sheets – and the market responds to these rigid time frames with lower prices.  Greece should be committed to rapidly preparing its assets for sale, but the timing of the sales themselves should be sensitive to market conditions.

Thirdly, the greater flexibility given the EFSF is important, but some of the proposals being bandied around need to be treated with caution.  One entails moving to variable rate loans.  Ask America’s homeowners about the wisdom of that!  Better risk instruments – including the appropriate use of GDP bonds – could improve risk sharing and enhance the likelihood of a strong recovery.

Finally, the commitment to growth is essential.  Evidently, references to a “Marshall plan” contained in earlier drafts of the communiqué, were eliminated.  I hope that this does not signal a move away from a strong commitment, requiring potentially significant resources.

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Also in the FT, Mohamed El-Erian (the chief executive and co-chief investment officer of Pimco) reacts positively, but with caveats:

European leaders took a big and important step towards dealing properly with the eurozone debt crisis at their summit on Thursday . . . But further design enhancements and skilful execution will be required if yesterday’s decisions are to translate into the durable restoration of growth and financial stability to the region’s troubled peripheral economies.

Debt solvency, growth and contagion have been, and are, at the core of the problems of Europe’s periphery. They speak to both the causes of this painful homegrown crisis, and to the manner in which it has been spreading. It is therefore highly encouraging that European leaders are finally taking more aggressive steps to address all three aspects. Firstly, on solvency, the programme countries (Greece, Ireland and Portugal) will now benefit from lower interest rates and a significant extension of loan maturities. Secondly, greater focus is being placed on promoting growth in the periphery, though this is still too restrained relative to what is required. Finally, contagion risk – especially for Italy, Spain and the Europe-wide financial system – is being lowered through a new, flexible and fast-disbursing credit facility available both to sovereigns and banks. This all constitutes a major step for leaders that, for almost two years, were essentially in denial. Having persisted too long with a liquidity cure for a solvency problem, they are now taking a major step towards deploying better instruments for the challenge at hand.

But success is far from guaranteed. It depends in particular on two factors: further enhancements to Thursday’s agreement, and ensuring proper execution.

As it stands, the package still lacks sufficient upfront debt relief for the most troubled economies, Greece in particular. Putting this in place quickly is central to fiscal solvency and growth promotion. Given the starting point, there is simply no substitute for some form of immediate debt reduction whose benefits flow directly to highly troubled sovereign debtors. In addition to dealing more decisively with the crushing debt overhang, such debt relief would also assist in ensuring the proper level of overall financing and, critically, fairer burden sharing between the private sector and taxpayers.

Then there is the execution risk. Four parties will have to deliver simultaneously, and in a focused fashion, to make this package effective. Governments in core countries – Germany, Finland and the Netherlands in particular – must convince their sceptical citizens that this is a good use of their hard-earned tax euros. The ECB must also come up with a skilful way to compensate for the balance sheet hit it will have to take at some point on account of its peripheral bond purchases and repo operations. Private banks must waste no time in taking advantage of favourable market reactions to raise additional capital. Finally, the peripheral economies must deliver an internal economic adjustment that is both substantial and acceptable in socio-political terms.

History will show that, on July 21 2011 European leaders met and, jointly, stepped up to the plate to respond better to an internal crisis. But history will only label this a success if Thursday’s courageous compromises are followed by proper enhancements and skilful execution. There is still much to do if this historic summit is to mark the beginning of the end of Europe’s painful debt crisis.

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Der Spiegel’s headline is “Sarkozy Gets his European Monetary Fund.”

The moves do indeed mean that the EFSF [European Financial Stability Fund] increasingly resembles the Washington-based IMF. It will now be allowed to grant pre-emptive lines of credit to countries under pressure on the financial markets. It will also be allowed to assist in the recapitalization of stricken banks. Even Merkel, who had long been opposed to the idea of a European Monetary Fund, allowed that “one could draw such a comparison” to the IMF.

[...] The plan presented in Brussels on Thursday evening is a classic French-German compromise. Sarkozy relented on the question of private involvement — prior to his Wednesday meeting with Merkel in Berlin, he had been strictly opposed. Merkel, for her part, relented in her opposition to broadening the powers of the EFSF. Her coalition partners in Berlin, the business-friendly Free Democrats (FDP), had been strongly against such a move.

 

The final statement from the eurozone summit is available here.

SECTION I. FROM THE FINACIAL TIMES

The FT’s initial reaction is a mixture of relief and skepticism. This is what the Lex column has to say:

The euro survives, until the next summit.The summiteers appear to realise that a solution to the sovereign debt crisis has been staring them in the face all along: the European financial stability facility. This body’s scope and financial firepower are to be greatly expanded. As a start, the cost of its lending to Greece, Ireland and Portugal will be cut to 3.5 per cent, and maturities doubled to 15 years. That concrete act should have immediate benefits for those three countries – and lasting effects on the eurozone’s fiscal cohesion.

All of this is positive. Yet the market reaction still looks a little extreme. The FTSE-Eurofirst 300 eurozone banks index has risen by 14 per cent in three days. Yields on Greek two-year bonds were 6.3 percentage points tighter at the close on Thursday than at the open. The Italian 10-year yield has fallen to below 5.4 per cent, from 6 per cent (still uncomfortably above the 5 per cent level). But then, the communiqué is an invitation to buy Italian and Spanish bonds. Talk about moral hazard.

The sticking point, as ever, is private sector involvement, which remains distractingly complex. The “financial sector” (all of it?) has shown its “willingness to support Greece on a voluntary basis” through “a menu of options”, to the tune of a net €37bn. “Credit enhancement will be provided.” That sounds almost like a bribe. But, as governments are now committed to keeping the euro alive, it would be perilous for investors to bet against them.

In another article, the FT avers that the ratings agencies will consider Greece to be in default:

Strategists expect all three main rating agencies to determine that Greece has defaulted, because bondholders will suffer losses whatever plan policymakers decide to adopt involving private creditors. The options are debt exchanges, rollovers or buy-backs.

Although all three rating agencies were not commenting on Thursday, strategists say Standard & Poor’s is likely to put Greece on selective default [see Section III of this post to find out what a "selective default" means], while Fitch will follow a similar route and put the country on restricted default, which is the same thing.

Strategists assume Moody’s will announce that Athens is in default, even though the agency does not have a specific default rating.

The terms “selective” and “restrictive” default mean Greece as an issuer will default, but only some of its bonds will be downgraded. Bonds that are not affected by whatever private creditor plan is used will not be defaulted.

[...] Many strategists say a default may not have a big effect on the market as Greece would only default on a temporary basis. Both Standard & Poor’s and Fitch are likely to upgrade the country’s rating back to triple C, a low junk-grade status, once the debt exchange, rollover or buy-back has been initiated to reflect a forward-looking view of Athens, with its reduced debt burden.

In a further article, the FT says that “[o]n average investors would take a 21 per cent hit in the net present value of their current bond holdings.

SECTION II. FROM THE ECONOMIST

In its initial take, the Economist asks whether its “Russian, or Belgian Roulette?”

Much of the attention in recent months has focused on the “involvement” of private creditors—nobody wants to talk of debt “restructuring”—and whether it would be construed as a selective default by credit-rating agencies.

But the most certain and immediate restructuring is not of the loans by the private sector, but of those by official lenders from the euro area. The interest on the euro-zone’s portion of the future Greek bailout is being reduced from about 5.5% to about 3.5%. Greece, then, is being allowed to borrow money as cheaply as an AAA-rate country. [My emphasis] Moreover, the maturity on current and future loans would be extended from 7.5 years to a minimum of 15, perhaps even 30 years. Were such terms applied to private lenders, credit-rating agencies would have no doubt about calling it, at the very least, a selective default.

All this is meant to “decisively improve the debt sustainability and refinancing profile of Greece”. Number-crunchers say the effect will be noticeable, but not dramatic. At the end of its rescue programme in 2014, Greek debt will still be worryingly high, they say. What the IMF is most excited about is the commitment “to continue to provide support to countries under programmes until they have regained market access, provided they successfully implement those programmes”. In other words, the EU appears to have given Greece, Ireland and Portugal – and any other country that may need to be bailed out – an indefinite commitment of financial support. [my emphasis]

This promise may well be tested when the current Greek programme ends in 2014. Will euro area countries really be willing to provide fresh funds if Greece is still unable to borrow in the bond markets?

No one knows or can know how long it will take Greece to regain access to the private market. If the Economist’s interpretation is correct, the EU is on record as being willing to provide bailouts of possibly infinite duration to the eurozone’s financially-challenged members. Would voters in the financially-strong members — especially in Germany — stand for it? Governments could fall over such an issue.

SECTION III. FROM THE EUROPEAN EDITION OF THE WALL STREET JOURNAL (no links)

How a “selective default” works:

Q: Thursday’s deal by euro-zone leaders means Greece is likely to be declared in “selective default” by credit-rating firms. What does this mean?

A: It’s a technical assessment that means investors in some Greek bonds will be worse off as a result of the deal. It implies holders of other bonds are still being repaid in full and on time.

Q:How significant is it?

A: Most selective default ratings last only a short time. Euro-zone leaders are hoping the deal, which reduces Greece’s debt burden and provides more official loans, will convince credit raters that chances of full repayment on remaining debt are improved.

Q: But euro-zone leaders spent months fighting selective default, worrying investors might fear other countries could go down the same default path. Isn’t that still a concern?

A: That depends on financial markets. Euro-zone leaders have done what they can to paint Greece as a special case—indeed, its debt is by far the highest as a proportion of annual economic output of any euro-zone country—and to emphasize that other governments will pay their debts in full and on time. They have also provided the euro-zone bailout funds with new tools aimed at preventing others from sliding into debt difficulties.

Q: The European Central Bank has been arguing it won’t accept defaulted bonds as collateral for its loans. That would have threatened Greek banks, which it has propped up with tens of billions of euros of loans.

A: ECB President Jean-Claude Trichet got euro-zone governments to agree they would indemnify the ECB for losses of up to €35 billion ($50 billion) if collateral proved inadequate. It looks as if Greek bonds will, as a result, still be acceptable at the ECB.

On the economic slowdown in the eurozone:

The euro-zone economy is now flat-lining at best, judging by the advance euro-zone Markit Purchasing Managers Index for July. It came in way below the consensus forecast at 50.8, the lowest level since August 2009 and close to the 50 mark that divides expansion from contraction. Both manufacturing and services activity slowed. Germany and France are expanding at the slowest pace in two years and the rest of the euro zone is contracting already, Markit says.

Earlier expectations of a second-half pickup are now doubtful. The spread of the sovereign crisis to Spain and Italy means it now affects countries making up 35% of euro-zone gross domestic product, versus the 5%-6% accounted for by Greece, Ireland and Portugal. Higher bank funding costs in these countries will force the pace of deleveraging. Ratings agencies are already concerned about growth in Spain and Italy.

UPDATE: The Economist weighs in:

It’s too early to say, but for the moment the bigger picture remains bleak. The rumoured policy changes still need to be agreed at today’s summit. The European public will ultimately weigh in on whatever decision is reached, and it seems like German voters, at least, continue to grow more sceptical of the currency union. And then there is the broader question: will the plan actually help? Even if Greece’s obligations are meaningfully reduced, it faces a wrenching period of fiscal adjustment and a shrinking economy. The more ambitious the plan, the greater the need for a bigger fiscal commitment, which will test national governments.

Euro-zone leaders will hope that their agreement moves Spain and Italy back outside of the crisis perimeter. But an auction of long-term Spanish debt today doesn’t bode well; Spain sold €1.8 billion in 10-year debt at an average yield of nearly 6%. If yields creep much higher than that, Spain’s debts will become unmanageable without euro-zone assistance. Meanwhile, evidence of a euro-zone economic slowdown grows. Given the austerity environment within the euro zone, foreign demand will be crucial in supporting its economy. But as we’ve seen today, good news on the debt crisis leads to a sharply rising euro (thanks in no small part to the ECB’s rush to increase interest rates). A dearer euro will hurt euro-zone exports at just the moment export growth is most needed.

The euro zone appears to have achieved a welcome calming of distressed markets. But there will be more trouble ahead.

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The Financial Times reports that EU leaders are edging towards a Greek deal:

European leaders were on Thursday evening edging towards a Greek bail-out plan that would get private holders of Greek bonds to shoulder part of the rescue’s burden – a political victory for the German chancellor, but one that will almost certainly lead to the first default on eurozone bonds since the creation of the single currency.

Eurozone heads of government quickly reached agreement in principle to lower interest rates on rescue loans to all three countries in bail-out programmes – Greece, Ireland and Portugal – to about 3.5 per cent, or 100-200 basis points lower than they are currently paying, officials said. They also agreed to extend the loans’ repayment schedules from 7 years to at least 15 years.

In addition, they gave the bloc’s €440bn bail-out fund, the European Financial Stability Facility, new powers to help countries that are not currently in bail-outs, including precautionary lines of credit and the ability to recapitalise any struggling bank in the eurozone.

But the central issue – as it has been for weeks – was how to get private Greek bondholders to become part of the package, which is expected to lead to a temporary default on some Greek bonds.

Jean-Claude Trichet, president of the European Central Bank, has fiercely resisted allowing a selective default, but officials say he gradually relented as long as it was made clear such bondholder programmes would be limited to Greece and no other countries struggling with debt loads would be asked to do the same.

In a draft of the summit’s conclusions, the leaders declared: “[We] would like to make it clear that Greece is in a uniquely grave situation. This is the reason why it requires an exceptional solution.”

Judged by the performance of the U.S. market (the DJIA is currently up 150 points), investors — at least for the moment — are pleased with what they’re hearing

The concluding parapraph of Wolfgang Munchau’s take on today’s on-going emergency summit reads as follows:

The outlines of the agreement, as they have been presented so far, still fall short of the main goals – to have an EFSF [European Financial Stability Facility] capable of dealing with Italy and Spain – and to have a Greek package that reasserts debt sustainability one way or the other. Like all decisions in the European Council, this is a compromise for sure. But there are limits to compromises when you are dealing with a contagious debt crisis. You either do enough, or you do not. They are still lacking a strategy to deal with the wider crisis. [My emphasis]

Here’s what else he has to say:

It looks like there will be deal on a eurozone package for Greece. The full details are still missing, but it appears that the eurozone is forcing Greece into a selective default. As part of such a package, short-term Greek debt will be more or less forcibly converted into long-term debt. The wretched bank tax is mercifully off the table. And the European financial stability facility will most likely be allowed to purchase Greek debt at a discount. Let us not mince words here. This would be a default, the first by an industrialised country in almost 100 years. [My emphasis] I am not quite sure how it is possible for the European Central Bank to agree to this, or to all of this . . .

So would this be a good deal? Those who are in the thick of it are running the danger that they got so obsessed with the formidable technical complexities that they lose sight of the bigger picture. The problem of the eurozone is not Greece, or some other small country on its periphery. The existential danger is the rise in market interest rates of Italy and Spain, two large countries in the eurozone’s core. To state the goal of today’s meeting in simple terms would be to say: the survival of the eurozone depends on whether its leaders will be able to take decisions that would allow Italy and Spain, and everybody else as well, to remain inside the eurozone on a sustainable basis. Greece is now just a side-show.

If that is the goal, I would judge today’s outcome in terms two priorities. The first, and most important, is the size and flexibility of the European financial stability facility, the rescue umbrella. At present, the overall size of the EFSF is €450bn. With a second Greek credit about to be agreed and second programmes for Ireland and Portugal very likely, the ceiling will not be big enough to bring in Spain, let alone Italy. To do that that the ceiling would have to be doubled, or trebled. Without this increase, it is inconceivable that the eurozone can get through this crisis intact. One could think of other constructions, such as having no fixed limits at all or sliding limits. The structure of the EFSF would have to be changed if it was going to be made this big. It would have to be properly capitalised. Italy’s 18 per cent share in the EFSF would otherwise not be credible.

This will not be agreed today and this alone is why the summit will fall short of what is required. As it stands, the eurozone has a mechanism that can deal with Greece, Ireland and Portugal, but no other country.

Size and flexibility go together. At present the EFSF can only lend money to governments. In turn, the applicant countries are subject to a full European Union/International Monetary Fund supervised austerity programme. You are either in or out. It is important that the EFSF can act pre-emptively, even in respect of countries that are not part of an official programme. The EFSF should also be able to purchase bonds on primary and secondary markets, help refinance banks or give emergency credits during a crisis. It cannot do any of these things now. The bigger and the more flexible the EFSF becomes, the greater the chance that Italy and Spain can get through the crisis.

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From the New York Times:

According to drafts of a statement being discussed by the 17 euro zone heads of government, banks have agreed to take part in several programs to reduce Greece’s debt, including plans that would mean exchanging existing bonds for new bonds with lower interest rates and longer maturities.

According to the draft declaration, euro zone leaders gathered in Brussels are set to agree on a series of measures to lighten the burden on Greece, Ireland and Portugal — all of which have been forced to seek international aid. Such an agreement would mark a significant shift of direction and a recognition that the mountain of debt hanging over those countries threatens to stifle any prospect of recovery for their economies.

More significantly, the euro zone leaders were also being asked to give wide-ranging new powers to the region’s bailout fund, the European Financial Stability Facility, by allowing it to buy government bonds on the secondary market and to help recapitalize banks where necessary. That would effectively turn the E.F.S.F. into a prototype European monetary fund. [My emphasis]

Under the proposals in the draft document, the E.F.S.F. would even be able to help shore up countries that had not requested a bailout.

If the proposals are adopted it would mark a big turnaround for Germany, which rejected such ideas only months ago. It would also signal a new willingness to come to terms with the scale of the euro zone’s debt crisis by taking a big step toward common economic structures .

Diplomats said that going forward with the proposals would require a change in the E.F.S.F. rules which would require ratification by national parliaments. [My emphasis]

My questions: (1) Would all national parliaments have to approve; (2) How likely is it that all national parliaments would approve; (3) How long would it take; and (4) What happens in the interim?

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Excerpts from an interview with Jean-Claude Trichet, President of the European Central Bank (ECB), published in the Financial Times Deutschland (FTD) on July 18:

FTD: To cope with the crisis the European Central Bank used non-standard measures. The Securities Markets Programme, special treatment for government bonds of Greece, Ireland and Portugal, the liquidity provision for banks. How far does the ECB go with its special rules?
Trichet: We can not accept to put in questions our role as the anchor of stability and confidence in the euro area and in Europe. If a country defaults, we can no longer accept as normal eligible collateral defaulted bonds issued by the government of that country. Because, in the eyes of the Governing Council, this would impair our ability to be an anchor of confidence and stability.
FTD: What does the ECB say to the fact that, in the context of the second package for Greece, governments have nonetheless been talking about solutions such as a debt rollover or a partial debt buyback, which could lead to default?
Trichet: The responsibility for this lies with the governments. The governments have been warned, in no uncertain terms and using all possible means. I have said so publicly. I have explained in detail to the Heads of State and Government and to the finance ministers, on several occasions, that, if a country defaults, we will no longer be able to accept its defaulted government bonds as normal eligible collateral. The governments would then have to step in themselves to put things right. That would then be their duty.
FTD: What does that mean in concrete terms?
Trichet: In the event of a decision by the governments leading to a selective default or a default, which, again, we are warning against loud and clear, the governments would have to take care that the Eurosystem is presented collateral that it could accept.

How the ECB’s position squares with the “selective default” now evidently under consideration at the emergency summit remains to be seen.

Two economists, in a post at VOX, argue that future eurozone crises can be prevented by learning how policymakers in the U.S. achieve fiscal prudence without loss of sovereignty. Notwithstanding the fact that most of us would dispute the assertion that the U.S. is fiscally prudent, the words of  Thomas Cooley and Ramon Marimon are worthy of consideration.

For the eurozone to stay together and prosper, they say it needs to accomplish two things:

• Address the short-term problem of the excessive indebtedness of the periphery countries in a way that does not cause excessive contagion and paralysis for the banking sector.
• Solve the mechanism-design problem to insure a degree of fiscal discipline in the long run.

As to the first of these requirements, any viable plan will probably involve two elements:

• A debt exchange of maturing issues for longer-term bonds possibly with lower interest rates that make debt servicing feasible.
• Some kind of guarantee of new debt.

The thornier problem is the second one. Eurozone members agreed to give up a degree of sovereignty when they abandoned national currencies for the euro. But that was easier than giving up fiscal sovereignty. To give it up would be impossible within the framework of the euro. [Emphasis added]

How then do to insure fiscal credibility? This is where the example of the U.S. comes into play:

The US states have many sovereign powers that give them a great deal of financial discretion. They have the power to establish their own tax systems and spending powers. Many states are legally required to balance their budgets . . . In addition states cannot file for bankruptcy under the US Bankruptcy Code. So how do the states guard against default and preserve their access to capital markets? In spite of their well-advertised budgetary problems the US states do have access to capital markets and at generally favourable rates. The reason is institutional. Most states give debt service a constitutional priority over other expenditures.

This means that the “sovereign” debt has to be paid out of revenues before other obligations . . . This mechanism does not prevent fiscal problems from arising . . . But fiscal problems become sovereign political problems, not threats to the stability of the US. It should be noted that their debt levels are quite small relative to sovereign nations.

With this as their backdrop, Cooley’s and Marimon’s solution to the structural deficiencies of the eurozone that have given rise to the current crisis is simply stated:

If Greece and other periphery countries were required to give general obligation debt priority, their internal problems would be no less severe. But their fiscal problems would not be a threat to the banking system and to other sovereign states . . . The institutional change of giving sovereign debt priority would solve the fiscal time consistency problem without Eurozone members having to surrender their authority over taxing and spending. It would make unsustainable fiscal policies a sovereign political problem since it would be the responsibility of the “national leaders” to come up with a proper “austerity and growth programme”, instead of one being imposed on them, which can easily be criticised as a loss of sovereignty.

Is this proposal feasible? The two economists are far from certain, saying that “[i]f it isn’t, it needs to be.”

I see at least two problems with the proposal:

• It is highly unlikely that any supranational institution could impose this requirement on sovereign nations. The requirement would have to be self-imposed.
• Assuming the self-imposition of the requirement, there would be a coordination problem. It is unreasonable to expect that the requirement would be simultaneously implemented, or even that all nations would decide to implement it. The laggards and/or dissenters would be severely punished in the financial markets. Perhaps the resulting situation would be an improvement on the current one. But it wouldn’t solve the fundamental problem of a single monetary policy overlaying multiple fiscal policies. For that problem to be resolved, Europe would have to become a republic, a United States of Europe. I’m not holding my breath.

Time is running out for salvaging Greece and, beyond it, Europe’s shared currency, the euro. Thursday’s emergency summit meeting looms as a Lehman Brothers moment.

If Europe’s leaders fail to extricate Greece from its current unsustainable debt-servicing obligations — by lowering interest rates and lengthening maturities at a minimum — the market reaction, for all of Europe, may be unforgiving, and uncontainable as investors conclude that no European sovereign debt is safe from possible default.

[...] The first, and perhaps immediate, consequence of a failed summit meeting could be a disorderly and destructive Greek default. The shock waves could spread to Ireland and Portugal as lenders conclude that if Greece can default despite European Union bailout programs, so could those countries.

Spain and Italy could also be drawn in. They are large, solvent economies threatened by liquidity crunches if their interest costs keep rising. But credit markets, seeing Europe paralyzed, have started to back away from these two as well. The European Union can afford a sustainable bailout of all three smaller economies. It would be far more costly to have to rescue the two larger ones.

What matters is that the relief Europe chooses results in a lower debt-servicing burden with longer payback periods and greater chance for growth for Greece and the other heavily indebted economies. Europe as a whole can raise money at much lower interest rates, and those funds can be used to restructure and refinance Greek debt.

No such solution is possible unless Chancellor Merkel steps back from her unrealistic insistence that Greece’s bank creditors first bear some of the cost of any debt restructuring. German taxpayers, and all of Europe, must be told that everyone will pay a disastrously high price if Greece is allowed to go under. Europe’s leaders need to make hard choices. And they need to make them now.

To set the stage for the summit, the Financial Times has published an analysis that addresses both items on the agenda. The Greek predicament can be summarized as follows: (1) very large debt repayments are scheduled for 2012, 2013, and 2014; (2) at the same time that the mandated repayments will be increasing, the contributions from the current bail-out package will be decreasing; and (3) against a backdrop of growing repayments and declining external assistance, the Greek banking system is falling prey to deposit withdrawals.

An many have said, Greece’s debt burden is so large that it may never get paid. Adds the FT:

Officials cannot acknowledge this, however, for fear of spooking bondholders into believing default is at hand. Similarly, private investors face political pressure to bear the burden of a new bail-out – but among the largest investors in Greek bonds are Greek banks, which would take huge losses (and need more international aid) if their holdings were cut in value.

Institutional conflict complicates matters, as “[a]lmost every participant in the debate – Athens, the European Central Bank, the IMF, the European Commission and national capitals – holds different and sometimes mutually exclusive interests.”

The Frankfurt-based ECB, for instance, is responsible for making sure Europe’s banking sector remains solvent. But the sector (as well as the ECB itself) holds vast quantities of peripheral bonds – meaning any undermining of their value could hit their capitalisation levels, limiting their ability to survive a Lehman-like collapse. The German government, on the other hand, under pressure from the Bundestag, wants some of those banks to accept less than they were originally promised for their bond investments.

[...] There is intense pressure on the Germans and the Dutch to drop their insistence that bondholders pay a price, a stance that has held up an agreement and led to most of the market panic. But Berlin and the Hague argue that without bondholder participation a new deal will not be credible, since it will not lower Greece’s overall debt burden.

Here’s the list of banks with the most exposure to Greek sovereign debt:

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Nobel Prize-winning economist Joseph Stiglitz says that the eurozone’s problems are political, not economic. The economic issue is “simple and clear.”

Greece’s debt has to be brought to a sustainable level. That can only be done by lowering the interest rate that Greece pays, lowering its indebtedness, and/or increasing gross domestic product.

The reason why the efforts of the past 18 months haven’t worked is that they have raised, not lowered, Greek interest rates.

Official lending (from the International Monetary Fund and the European Union) has seniority over the private sector. The riskiness of new private sector lending is thereby increased, with obvious implications for interest rates. Meanwhile, as official lending replaces private sector lending, the risks associated with past lending is shifted to the public.

Citing evidence from Ireland, Greece, Spain, Latvia and a “host of other experiments,” Stiglitz rejects the notion that austerity programs work. Instead, such programs induce economic downturns that reduce tax revenues. The improvement in the fiscal position of countries implementing austerity programs is therefore “inevitably disappointing.”

If Europe were to issue eurobonds — bonds that would be supported by the collective commitment of all eurozone governments, the debt problem would become manageable. Such bonds would have lower interest rates than the sovereign bonds of the troubled countries. The resulting decline in interest payments would make it easier for Greece and the others to escape from the financial wilderness.

What has prevented eurobonds from being issued? Economic nationalism (shades of the 1930s, anyone?). In Stiglitz’s words:

Those who, putting aside any sense of European solidarity, worry about creating a “transfer union” should be comforted: at such low interest rates the likelihood of a need for real subsidies is limited. But even if there were some subsidy, Europe could afford it. With a $16,000bn dollar economy, even if Europe had to bear costs commensurate with the size of Greece’s debt, these are minuscule compared to what will be lost if Europe does not come to the assistance of the countries facing trouble.

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Mario Monti (president of Bocconi University and former European commissioner) and Sylvie Goulard (a member of the European Parliament) continue the eurobond discussion in their FT article.

Commissioner Olli Rehn said last month in the European Parliament that, as part of an economic governance package, the Commission will be ready to propose the setting up of a system of common issuance of euro-denominated government bonds before the end of the year. This would be aimed at strengthening fiscal discipline and increasing stability in the euro area through market mechanisms, ensuring that those member states that enjoy the highest credit standards would not suffer from higher interest rates . . . The proposal is for the use of eurobonds as an instrument of debt management, not as a financing instrument for new expenditures.

[...] There is growing consensus that it would be difficult to find a lasting solution to the eurozone crisis without the use of eurobonds. This week’s eurozone summit could give at least a clear political signal that it is worth considering the eurobond proposal. A European vision, based on the creation of a European instrument, backed by a precise timetable, could be a good way to restore trust and stability.