The road to cognition

September 27, 2011

By Mark Dow
The opinions expressed are his own.

European policymakers came to the IMF meetings in Washington in a defensive mode; some defiant, some with their tails between their legs. Once in Washington, it only got worse. Policymakers from around the world and investors of all stripes lined up to administer verbal beatings. Warnings of cascading default, global depression and bank runs echoed throughout the meeting rooms. Thankfully, by the weekend’s end, the message sank in, and Europe emerged with the beginnings of an agreed plan.

The news is not so much the nature of the plan. The broad lines of a likely structure had been anticipated by various analysts and market participants in the run up to the meetings. What was new was the recognition on the part of the EU leaders that several specific steps — steps heretofore publicly dismissed by the broad swath of European leaders — were now necessary. The three elements are:

  • A serious and confidence-building European bank recapitalization process
  • A far deeper restructuring of Greek debt
  • A larger, leveraged war chest with which to finance the bank recap and build a firewall to protect Italy, Spain and France

This represents a significant step forward. It is good for markets, good for Europe, and, indeed, good for the rest of the world. It addresses many of the urgent issues, and would also allow Europe to focus on the important, longer-term ones.

However, a lot a work remains to be done, and this plan, even if perfectly carried out, does not solve several critical issues. Here are the risks:

Implementation risk. National governments have to pass the European Financial Stability Facility implementing legislation, and the Frankenstein of a financial structure that is being contemplated needs to avoid constitutional challenges, downgrades, and other logistical roadblocks. If it can be credibly argued that the plan stays within the confines of the Treaty, it will go a long way toward assuaging punctilious German concerns.

Size. The eventual leveraged fund has to been seen by the market as having a de facto unlimited balance sheet. Markets like finite numbers and will be quick to start the countdown of remaining resources as soon as the new entity starts buying Italian and Spanish bonds. The numbers being floated (~EUR 2 trillion) look on the low side. I think a number north of EUR 3 trillion would more likely achieve the famous “bazooka effect”. The more you have, the less you need. I may be underestimating EU creativity, but to do this I think IMF NAB resources may be needed as a second loss tranche, along the lines of what I suggested last week and Raghuram Rajan mooted yesterday in the Financial Times.

Optimal-degree-of-crisis syndrome. This is another form of implementation risk. The modus operandi in Europe has been minimalist, instrumentalist, and reactive. They have responded once their pain thresholds were reached, only to relax efforts once the sense of crisis subsides. This has led people to underestimate the fundamental resolve of EU leaders. But, the structural coordination issues in Europe are very serious, and policymakers will have to work very hard to avoid falling again into this trap in the coming months.

Portugal (and maybe Ireland). Two things that stood out from the weekend in Washington were (1) how clear the consensus was around a deeper restructuring for Greece and (2) how far policymakers were from considering a solvency solution for Portugal (or Ireland). The reasons are political, not economic. The implication for Europe is if Portugal — a country most careful analysts believe is insolvent and highly uncompetitive — ends up on the protected side of the firewall, markets will be skeptical that this is a definitive solution. And, if any part of the solution is deemed to lack credibility, the credibility of the entire plan will be called into question. The same can be said for Ireland, even though its insolvency is more ambiguous and its competitive position is much better than that of Portugal or Greece.

Fundamental design flaw. The biggest issue is one of design. Europe does not meet — and never has met — any of the main criteria for an optimal currency area. So, even if the urgent financial issues of the EU were to be solved by this latest initiative, it will not — for both structural and cyclical reasons — bring about growth. The single currency, for all its virtues, represents handcuffs for the peripheral countries. With nothing but fiscal adjustment and structural reform (which in the initial years is contractionary) on the horizon as far as the eye can see, the feedback into the debt sustainability equation is likely to be persistently negative. In the long term this will be a very serious problem — perhaps an unsustainable one — for not just Greece and Portugal, but also for Italy, Spain, and possibly France.

For now, however, the Europeans are coalescing around a financial plan. After much denial, they seem to have taken on board the psychological dimension of the battle they are in. It is important that the world now steps up to provide its full support. It may not be a growth plan, and it contains short term risks and longer term design flaws, but given the fragile state of the global economic landscape, once again, plan beats no plan.


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