It is finally game on in Europe. The starter’s pistol fired long ago, yet only now does it seem that the EU and ECB are getting out of the gate. There is no more time to dwell on misdiagnoses, missed opportunities and policy slippage. Extend and pretend is no longer an option.
I am not by nature an alarmist. But the cancer is metastasizing at an ever-accelerating rate. Italy, Spain and even France are now genuinely at risk. Failure to stem the tide now could well undermine faith in the modern global capitalist system — a system already stretched by political polarization and income inequality — with potentially massive social implications. In short: It’s go time.
Concretely, Europe has to leapfrog the phase of thinking the unthinkable and start doing the unthinkable. It begins with those on the inside admitting that the EU, as currently conceived, failed. It is not a liquidity crisis. It is not a leadership crisis (this is the smarter-than-thou throw-away line of those with a superficial understanding). It is a failure of design.
Why now? Two important things accelerated the process. One, in June, when German Finance Minister Schäuble first started speaking openly about debt restructuring for Greece, it triggered a change in market psychology, despite the fact many in the markets were already expecting a restructuring. Market psychology is a fickle beast; it is not always linear, rational or right. But he who has the gold makes the rules, and many market participants decided that the prudent response would be to wait on the sidelines until debt restructuring(s) played out. This undermined the ongoing bank recapitalization process as well as the rollover of sovereign debts. In a world of multiple equilibria, confidence and psychology are king.
Two, growth. Since July, we have experienced a precipitous slowdown in economic activity across the globe, most acutely in the US and Europe. Careful observers knew this slowdown was coming even before the Japanese earthquake/nuclear incident, but this nonetheless left the two main global economic blocks brittle and exposed when the confidence shocks came from the US debt ceiling hostage situation, the consequent downgrade, and the Summer round of Greek financial programing rocked the system. This is centrally important because with growth nearly all debt sustainability equations clear; without it, almost none of them do — absent deep debt restructuring. And it is next to impossible to envisage equation-clearing growth in the near-to-medium term in Europe with its heavy debt burden and a fixed exchange rate vis-à-vis main trading partners.
If there is good news, it is that these messages may finally be starting to get through. The refreshingly candid speech by IMF Managing Director Christine Lagarde in Jackson Hole represented the first shot of sodium pentathol in the arms of attending European officials. The annual Ambrosetti forum in Cernobbio this weekend, against the backdrop of a seeminglyirretrievably off track Greek program, served to further drive home the true gravity of the situation to a broader group of largely European thought leaders.
Proactive Beats Reactive
The failing program in Greece should be the definitive signal to the EU that liquidity solutions won’t work (and the meager haircut envisaged in current Greek PSI restructuring is still really a liquidity solution). Attention is shifting from the fantasy of expansionary austerity toward the need for growth. The IMF, with the support of the US and China, needs to leverage the collapse of the Greek program into engaging the EU and ECB in a true, multi-country solvency solution. Greece, Portugal and probably Ireland are too late to save from a deep restructuring and exit from the single currency.
The plan, therefore, must be designed with a view to saving Spain, Italy and probably France so that they can be given enough time to give growth a legitimate shot. Only a solvency solution mindset can provide shelter for those three countries from serious economic contraction and an unsustainable probability of default. National politics and procedures will not accord the EU leaders the time to erect the fiscal union solution. Going down that path will only postpone a solvency solution. Eurobond emissions — even if politically feasible — would not work either until after the cancer has been excised. By then they may not be desirable.
Here are the three main elements any plan needs to embrace:
1. Recapitalize the banks so as to short-circuit the contagion propagation mechanism as much as possible. EU policymakers need to understand what seems to have so far escaped them: this is more about winning the psychological war of confidence than it is the actual recapitalization of the banking system. It is useless to insist that markets don’t understand. It is pointless to repeat that recapitalization needs are small. It is not credible to blame speculators. And it would be counterproductive to try to resuscitate the stress tests in any way. Markets have concluded that they are not convincing. Shock and awe — tired though this cliché has become — needs to be the overarching inspiration.
2. Second, deep haircuts and exit from the single currency for Greece and Portugal and likely Ireland. Only Ireland has a reasonable chance of generating sufficient growth within the context of the euro, but if Ireland is to be spared, the plan to protect it must not fail, lest it undermine the credibility of the broader operation. The technical issues surrounding this are daunting, but not impossible. Moreover, there is no viable alternative left.
3. Nothing will scare those betting against Europe more than unleashing the unlimited balance sheet. Only the ECB fits this bill. The ECB needs to turn the fire hose in support of the sovereigns on the firing line. They have already been pinning Spanish and Italian debt at around a 5% yield. They may soon need to support France. But rather than being stealthy about it, they need to commit to it up front. Worrying about undermining reform resolve in Italy and Spain, while understandable, is, at this point, a second order issue. There are other ways to scare the passenger without threatening to drive your own car over the cliff. The ECB should either state or heavily imply that until further notice they are willing to subjugate their single mandate to this objective. Those worried about inflation should take comfort from the experiences of Japan and the US. And, lastly, of course there must be continued liquidity support for the banking sector even after the recapitalization. This will be a hard, but necessary sell.
There are no good choices left. But if an agenda along these lines doesn’t materialize soon the risk of defection — and both end of the creditor continuum, Greece and Germany, are rapidly losing patience — the odds the EU will lose control over the process will jump parabolically. Orderly beats disorderly. Plan beats no plan. Proactive beats reactive. The time for the quantum leap in mindset is now.
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