Hugo Dixon

Beware the “F” word. The European Central Bank and, to a lesser extent, the zone’s political leaders have bought the time needed to resolve the euro crisis. But there are signs of fatigue. A renewed sense of danger may be needed to spur politicians to address underlying problems. It would be far better if they got ahead of the curve.

The big time-buying exercise was the ECB’s injection of 1 trillion euros of super-cheap three-year money into the region’s banks. A smaller breathing space was won last week when governments agreed to expand the ceiling on the region’s bailout funds from 500 to 700 billion euros.

These moves have taken the heat out of the crisis – both by easing fears that banks could go bust and by making it easier for troubled governments, especially Italy’s and Spain’s, to fund themselves. Data from the ECB last week shows how much of the easy money has been recycled from banks into government bonds. In February, Italian lenders increased their purchases of euro zone government bonds by a record 23 billion euros. Spanish banks, meanwhile, increased their purchases by 15.7 billion euros following a record 23 billion euro spending spree in January.

The risk is that, as the short-term funding pressure comes off, governments’ determination to push through unpopular reforms will flag. If that happens, the time that has been bought will be wasted – and, when crisis rears its ugly head again, the authorities won’t have the tools to fight it.

Early signs of such fatigue are emerging. One is the tendency of politicians – most recently, Italian Prime Minister Mario Monti – to say that the worst of the crisis is over. They may wish to take credit for their crisis-fighting skills or relax. But it is too early to declare victory.

Italy is a case in point. Monti should have pushed through crucial reforms to the labour market earlier, while his popularity was high and the electorate was afraid that Italy would be engulfed by the crisis. He did not. And although he has now come up with a good package, his honeymoon period as the unassailable technocratic prime minister is nearing its end. His popularity fell to 44 percent from 62 percent in early March, according to a poll published last week by ISPO. Two-thirds of Italians oppose his labour reforms.

It’s a similar story in Spain. Mariano Rajoy, the incoming prime minister, should have cracked on earlier with a budget to bring the government’s finances into balance. To be fair, his administration did publish plans last Friday to curb its deficit – though it won’t be possible to judge how credible these are until Madrid explains how the health and education spending of Spain’s free-wheeling regional governments is to be reined in. Meanwhile, Rajoy’s honeymoon is also over. Last week, he failed to win the regional election in Andalucia and faced his first general strike.

Both Monti and Rajoy are still in strong positions. Although Italy’s political parties could theoretically kick Monti out, they are even less popular than him. Meanwhile, the Spanish prime minister has a sound majority in parliament. But as each month passes, it will get harder to push through reforms. Both men must hold their nerve and implement their full programmes while they can, without compromise.

Further afield, the appetite for austerity is also flagging – sometimes in unexpected places. The Dutch government, one of the high priests of fiscal rectitude, is finding it difficult to cut its own deficit. The ruling coalition may even collapse under the strain.

There is also increasing unhappiness about the fiscal discipline treaty Germany rammed through in December. Francois Hollande, the French socialist who is the front-runner to be France’s next president, wants to add a growth component to it. So do Germany’s social democrats, whose support is needed to ratify the treaty even though they are in opposition.

A fudge will probably be found that adds a protocol to the treaty which emphasises the importance of growth as well as discipline. Indeed, that would be no bad thing: too much austerity can be self-defeating as severe budget squeezes can crush an economy and make it even harder to raise taxes and cut deficits.

However, governments can’t ease up on short-term austerity and do nothing. What is needed is a vigorous programme of long-term structural reforms such as freeing up labour markets and introducing more competition into services industries. This could ultimately boost GDP by about 15 percent in large euro countries such as France, Italy and Spain, according to the Organisation for Economic Cooperation and Development. Even Germany, whose services markets are sclerotic, could benefit by about 13 percent of GDP.

Such a programme would make the euro zone’s economies fit enough to stand on their own feet when the anaesthetic of cheap money fades. But do governments have the will to make these changes given that the cheap money is lulling them and their people into believing the worst of the crisis is over?

A prod from the markets may be what is required. There are indications that this is beginning to happen. Spanish 10-year bond yields briefly reached 5.5 percent last week. The art, though, will be in the calibration. If markets move too little the politicians will be complacent. If there is too much, the euro zone will slip back into full-blown crisis.

Bailout may not be a four-letter word. But many of the rescue operations mounted to save banks and governments in the past few years have been four-letter acronyms. Think of the TARP and TALF programmes that were used to bail out the U.S. banking system after Lehman Brothers went bust. Or the European Central Bank’s LTRO, the longer-term refinancing operation. This has involved lending European banks 1 trillion euros for three years at an extraordinarily low interest rate of 1 percent.

The markets and the banks have jumped for joy in response to all this liquidity being sprayed around. So have Italy and Spain, whose borrowing costs have dropped because their banks have been able to take cheap cash from the ECB and recycle it into their governments’ bonds — making a profit on the round trip. But as has been the case with other four-letter bailouts, the LTRO has come in for criticism — most of it a variation on the theme that the way to treat debt junkies isn’t to give them another heroin injection.

One problem is that European governments could now feel less pressure to reform their labour laws and do the other painful things that are needed to get their economies fit. Another is that banks may delay actions that are required to let them stand on their own two feet: such as rebuilding their capital buffers and raising their own longer-term funds on the markets.

As if this were not bad enough, undeserving banks will be able to make bumper profits on the back of the ECB’s cheap money and, potentially, route them into fat compensation packages — although two British banks, Barclays and HSBC, have said they won’t allow bonuses to be inflated in this way. Meanwhile, the ECB could incur losses if the commercial banks that have borrowed all this money can’t pay it back and the collateral they have pledged turns out to be insufficiently valuable. Oh, and don’t forget that this is just a three-year operation. There could be another crisis when the banks need to find 1 trillion euros to repay the ECB in 2015.

The charge sheet is a long one. But the LTRO was a necessary evil. Just think back to early December when panic was stalking the euro zone. Without some form of bailout, there would have been a severe credit crunch that would have dragged the economy into a deep recession rather than the mild one it now seems likely to suffer. Large countries such as Italy and Spain could also have easily been shut out of the markets, potentially leading to a break-up of the single currency.

The ECB faced a too-big-to-fail problem. If it didn’t bail out the system, it would be faced with catastrophe; if it did, it would reward foolish behaviour. One can argue with the details. Did the money, for example, really need to be so cheap? But the central bank made a rational choice. The priority now is to limit the bad side-effects.

Mario Draghi, the ECB president, has made a start by telling European Union leaders at their summit last week that the three-year cash injection would not be repeated, according to Reuters. He said it had merely bought the euro zone time and it was essential that structural reforms were pushed through.

Hopefully, such lectures will be sufficient to do the job. But countries rarely reform unless their backs are to the wall. Take Italy. Mario Monti has made a remarkable start pushing through pension changes and liberalising services since taking over from Silvio Berlusconi. But there is much left to do: freeing up the labour market, privatising assets, revamping public spending and fighting tax evasion. How easy will he find it to push all that through now that Italy’s 10-year borrowing costs are below 5 percent?

Similar points can be made about Spain, where Mariano Rajoy’s reform programme has only just begun. Meanwhile, France, which has so far largely escaped the crisis, will not be under pressure to address its deep-seated labour market and pension problems. Francois Hollande, the socialist who will probably be the country’s next president, certainly has no ideological desire to do so.

But won’t the new European fiscal treaty deal with the issue? Sadly not. The demand for fiscal austerity was, indeed, the quid pro quo for the ECB’s bailout. But it was the wrong sort of conditionality. Balancing budgets is not the same as structural reform. The only thing pushing Europe’s governments down the latter route is exhortation and the warning that there won’t be any more bailouts.

With the banks, more tools are available to mitigate the damage from the LTRO. After all, governments, the ECB and regulators can tell lenders what to do. The most important changes – requiring them to build stronger capital bases and rely less on short-term funding — are already under way. The key thing will be to resist lobbying to delay and dilute these rules.

But there is also a case for revisiting the industry’s lax tax regime, especially if compensation remains high. Politicians have given most of their attention to taxing financial transactions, the so-called Tobin tax. But a better alternative could be to introduce what is known as a financial activities tax or FAT tax. Most countries do not apply VAT to banking. FAT, which would tax profits and compensation, would do a similar job. A three-letter tax could be part of the answer to a four-letter bailout.

It is fashionable for pundits outside Germany to lambast its government, the Bundesbank and the European Central Bank for being inflexible or stupid or both. Can’t they see that all that’s needed is for the ECB to fire its bazooka by printing unlimited money, and the euro crisis would be over?

After spending a couple of days in Frankfurt and Berlin last week, my impression is that these three institutions are neither stupid nor totally inflexible. That said, Germany is still determined to try its current plan for solving the euro crisis, though it has little chance of working. And by the time the trio get round to implementing a Plan B, the euro zone could be in deep recession or even have exploded.

The current plan has three elements. First, the governments of troubled countries such as Italy and Spain need to implement structural reforms and austerity. Second, the zone’s fire extinguisher, the European Financial Stability Facility, needs to be got in good working order in case the fires in Rome and Madrid become uncontrollable. Finally, governments need to agree a treaty committing them to long-term budgetary discipline.

A month ago, this plan might just have worked. But investor confidence has now deteriorated so sharply that even promising new prime ministers in Italy and Spain haven’t been able to stop their bond yields rising. Meanwhile, Belgium has become the latest country to get dragged close to the danger zone, with the yields on its 10-year bonds approaching 6 percent. Even Germany suffered a failed bond auction last week. The fire extinguisher also looks faulty: plans to leverage up the EFSF so that it is big enough to bail out Rome and Madrid have run into trouble.

Even the proposed treaty, which Germany’s Angela Merkel has been trumpeting with much ballyhoo, is unlikely to do much to restore confidence. While investors will like the idea that governments won’t rack up excessive debts in the future, they might not be so happy about the austerity needed to get every country’s debts below the promised level of 60 percent of GDP.

What’s more, there’s no guarantee that the current treaty can be changed given that it needs unanimous approval not just by the 17 euro zone countries but also by the 10 other members of the European Union, such as the UK. In some cases, there may also be referendums, whose results tend to be unpredictable. This explains why Germany and France are now casting around for alternative ways of getting the same result — say by having new treaties signed by a smaller group of countries.

Given all this, pressing ahead with Plan A might suggest that the decision makers in Frankfurt and Berlin are indeed stupid. That would be true if they were sure it would work. But they don’t seem to be. Indeed, the German finance minister called for extra resources for the International Monetary Fund on Friday in seeming recognition that the EFSF on its own won’t be enough to bail out big euro zone countries. Nevertheless, the policymakers in Frankfurt and Berlin still think that everything in Plan A is still necessary or at least desirable, even if it proves insufficient to solve the crisis. It is, for example, really important to keep the pressure on the new Italian and Spanish governments so that they deliver on their potential.

What’s more, coming up with a Plan B is problematic given that the ECB is forbidden from directly funding governments. This doesn’t mean that there’s no way saving the euro if Plan A fails. There are, after all, various gimmicks that could be used to get round the prohibition on directly funding governments. One is for the ECB to lend to the EFSF, making its fire extinguisher fully functional. Another is for the central bank to lend to the IMF and let it then lend to Italy and Spain.

The problem is that either manoeuvre would be extremely controversial as well as possibly open to legal challenge. That’s not to say the ECB would never contemplate unusual measures if that was the only way of preventing the euro breaking apart. But it would seem that, even then, it would only do so if it had political cover.

Such cover is gradually coming. Following the scares of the past week, both Finland and the Netherlands — which, along with Germany, have been the strongest advocates of austerity — started to crack. The Finnish finance minister said that if there were no other alternatives, an increased role for the ECB had to be considered. Similarly, her Dutch counterpart said he’d prefer the EFSF to be strengthened but, if that didn’t work, other measures would have to be considered: “In a crisis, one should never exclude anything beforehand”.

Meanwhile, the ECB seems likely to offer some short-term palliatives. First, it is continuing with its programme of buying sovereign bonds in the secondary market as a way of preventing Italian and Spanish yields going through the roof — a programme that Berlin has studiously avoided criticising. Second, the central bank looks likely to offer longer-term money to banks as well as accepting more types of collateral in return for it — measures that should counteract to some extent a looming credit crunch.  Finally, it may cut interest rates again in December to reduce the deflationary potential of the coming recession.

Fingers crossed, such short-term palliatives will prevent an explosion until Germany implements Plan A and figures out that it isn’t working. But even in the best case, such an approach probably won’t be enough to prevent a nasty recession. Meanwhile, there’s the ever-present risk that a panic could trigger a chain reaction which even a Plan B would be unable to contain.

When confidence in a regime’s permanence is shaken, it can collapse rapidly. The fear or hope of change alters people’s behavior in ways which make that change more likely. This applies to both political regimes such as Hosni Mubarak’s Egypt and economic regimes such as the euro.

Fear that the single currency may break up now risks becoming a self-fulfilling prophecy. Banks and investors are beginning to act as if the single currency might fall apart. Politicians and the European Central Bank need to restore belief that the single currency is here to stay. Otherwise, it could unravel pretty fast.

Until a few weeks ago, the idea that the euro wouldn’t survive the current debt crisis was a fringe view. Since the euro summit on Oct. 26-27, it has become a mainstream scenario. So much so that last week risk premiums on the bonds of even triple-A rated countries such as France and Austria rose to record levels, while Spain became the latest country to be sucked into the danger zone.

The summit itself made two technical decisions which have had damaging, unintended consequences. First, banks underwent a stress test that marked their sovereign bond exposures to market whereas previously regulators maintained the fiction that these positions were risk-free. This meant that lenders suddenly had to start holding capital to back their sovereign debt investments. Not surprisingly, they have become more reluctant to buy bonds. This, in turn, has made it harder for governments to fund themselves.

Second, the summit decided to strong-arm the banks into agreeing to a “voluntary” debt restructuring for Greece. Because the deal is supposedly voluntary, credit default swaps (CDS) – a type of insurance policy that pays out if an entity goes bust – won’t be triggered. This arm-twisting has convinced lenders that CDSs are a useless way of hedging the risk of investing in euro zone government bonds. Without a hedge, many prefer not to hold the bonds at all – again making it harder for states to fund themselves.

After the summit, things went from bad to worse with Greece’s disastrous plan to call a referendum on its latest bailout plan. That idea was withdrawn – but not before Germany and France suggested that Athens might need to be kicked out of the euro unless it came to heel. The snag is that it would be very hard to isolate the Greeks. If one country could leave the single currency, why not two, three or all 17?

As investors thought about the possibility of a euro break-up, they started factoring in currency risk. Under such a scenario, the new Greek drachma would plummet in value; the new Italian lira and Spanish peseta would also take a tumble; even the new French franc would depreciate versus a vibrant new Deutsche Mark. That gave the market another reason to sell pretty much every non-German government bond – again making it harder for those states to fund themselves.

As if this wasn’t bad enough, banks are also suffering from a liquidity squeeze. It’s not just investors who are getting jittery about putting their money in banks; lenders are reluctant to lend to each other because they are not totally sure that their peers will survive.

Banks outside the euro zone are also cutting their lines of credit to those inside the zone. The big four UK banks cut interbank loans by around a quarter in the three months to end September, according to data compiled by the Financial Times. Meanwhile, the United States is about to embark on a new stress tests of its lenders. This will include contingency planning against further disruptions in Europe. It wouldn’t be surprising if this provoked American banks to cut their exposure to their euro counterparts, further exacerbating their funding problems.

These vicious spirals have drowned out the good news on the political front. Italy, Greece and now Spain have new prime ministers, all of whom seem intent on cutting debts and making their economies fitter. But they will struggle to reduce their borrowing costs unless investors can be convinced that the euro is here to stay.

The one thing that probably would restore confidence is if the ECB found some way of supporting governments that were pursuing sensible policies. But the central bank itself and Germany, the euro zone’s main paymaster, have so far resisted this. In part, this is because they think governments won’t have a strong incentive to reform if they are bailed out too easily.

The logic of making countries sweat so that they address problems they have shirked for years, and sometimes decades, is a good one. But the ECB and Germany should remember that carrots are useful incentives, as well as sticks – and, if they don’t provide the carrot soon, the euro may not survive.

The euro zone is like Hotel California, UBS wrote in a report published in September. “You can check out any time you like but you can never leave,” it said, quoting the Eagles song. A British businessman, Simon Wolfson, has now offered a 250,000 pound prize to the person who can come up with the most convincing explanation of how an orderly exit from the single currency is possible.

The problem is the word “orderly.” There are lots of scenarios where a country such as Greece could quit the euro in a disorderly fashion, destroying its own economy and that of its neighbous as well as possibly plunging the world into a recession. But how is it possible to do this without triggering financial Armageddon?

The first difficulty stems from the fact that an exit couldn’t happen overnight. There is no legal procedure for a country to quit. Joining was supposed to be an irrevocable commitment.

Treaties can, of course, be renegotiated or broken. But this couldn’t happen rapidly -– or, more to the point, secretly. There are 17 members of the euro zone; and another 10 European Union members such as the United Kingdom, which don’t use the single currency. If Greece wanted to reintroduce the drachma, it would have to secure the unanimous agreement of these other nations. It is also inconceivable that it could take such a momentous decision without discussing it in parliament. Predict weeks, if not months, of heated wrangling.

Such debate would frighten the horses. Many depositors have already removed their savings from Greek banks. An open discussion about Athens leaving the euro would trigger a stampede. The whole point of bringing back the drachma would be to devalue it in the hope of making Greek industry competitive. Analysts think the initial fall might be 50 percent. If so, anybody patriotic enough to keep their money in a Greek bank would lose half their savings.

Transitional mayhem
Athens could then do three things: allow its banks to collapse; appeal to its euro partners for help; or impose controls on how much money people could take out of its banks.

Allowing banks to collapse in a disorderly fashion would be mad. It would be a sure-fire way to cause economic chaos and social disorder. The recent street protests would seem like a tea party.

Getting help from the euro zone would be ideal. But why would its euro partners want to bail out Greece’s banks, if the country was on the point of quitting the euro? The European Central Bank has already stopped making new loans directly to some Greek banks because they have run out of high-quality collateral. Instead, it has authorised the Greek central bank to provide liquidity, with Athens theoretically on the hook for any losses. But if Greece was about to quit the euro, the ECB would be worried that it would never get paid back. It would hardly want to authorize yet more lending as this could just increase the size of its future losses.

So Athens’ only choice would be to control how much people could take out of their accounts. It would be like wartime –- with savings rationed instead of butter and bread. This wouldn’t be as bad as allowing banks to collapse. But it would still plunge the country deeper into misery.

Brave new economy
The hope, of course, would be that Greece would eventually rebound on the back of a super-competitive drachma. Northern Europeans would flock to its beaches to enjoy half-price retsina and feta. Maybe. But there would be two other questions: how would the government finance itself; and how would inflation be contained?

Athens has too much debt. The latest forecast from the Troika (made up of the International Monetary Fund, the ECB and the European Commission) is that debt will reach 183 percent of GDP by the end of next year. That debt load will loom even bigger if Greece quit the euro. In drachma terms, assuming again a 50 percent devaluation, debt would rocket to 366 percent of GDP. The government has to default even if it stays in the euro; but the extent of the haircut would be bigger if it quits.

Greece also has a primary budget deficit: it is earning less than it spends even before interest payments. A unilateral default would make it a pariah state. Nobody would lend it money to finance its ongoing deficits. That would provoke an even more severe recession in the short run. The government would also be tempted to print lots of new drachmas to fill the hole in its coffers, fueling inflation and debasing the currency.

To avoid such a nightmare scenario, Greece would need to secure an orderly default if it quit the euro. The best hope of achieving that would be to cut a new agreement with the IMF. Most but not all of its debts would be cancelled. But it would have to agree to tight fiscal and monetary policies to make sure it didn’t run up new debts or descend into hyperinflation. In return, it would get some hard currency to manage the transition. But even with such a balm, the journey would be painful.

Vicious contagion
Unfortunately, the problems with a Greek exit from the euro would not stop with Greece. Contagion would be far more virulent than anything witnessed so far.

Seeing what was happening to Greek depositors, savers in Ireland, Portugal, Spain and Italy — and possibly even France and other countries — would run a mile. They would take their euros and deposit them in German, Dutch or Finnish banks. To stop a large chunk of Europe’s banking system collapsing, the ECB would have to authorise unlimited supplies of liquidity for an indefinite period of time.

The key decision would be whether to let any other countries go the way of Greece. Portugal would be seen as next in line because of its need to improve competitiveness. But Lisbon would probably not want to quit. Given that there’s no time to waste in the midst of a bank run, the least bad option would be to rally around all the remaining euro countries and insist they were permanent members of the club.

It might, though, be sensible to take the opportunity of a Greek exit from the euro to arrange simultaneously an orderly default of Portugal and perhaps Ireland while keeping them in the single currency. If their debt levels were cut to more sustainable levels, they would be in a better shape to withstand the whirlwind unleashed by Athens’ departure.

Wherever the line was drawn, it would have to be defended to the hilt. This wouldn’t just be about protecting depositors. Bond investors would believe more departures from the single currency were on their way. Portugal and Ireland don’t matter for the time being because they are supported by euro zone and IMF bailout programmes which don’t require them to tap the market for new money. But Italy and Spain, which are already suffering jitters, would be shut out of the market.

The convulsions from a bankruptcy of Italy, whose debt is nearly 2 trillion euros, would be so seismic that it shouldn’t be attempted unless there really is no alternative. But rescues by other governments wouldn’t be possible either. The region’s bailout fund, the European Financial Stability Facility, isn’t remotely big enough.

Financial jiggery-pokery — such as turning the EFSF into an insurance company to leverage its firepower — might just work in the current circumstances. But it wouldn’t have credibility if Greece was quitting the euro and there were bank runs across the continent. The best way to hold the line would be for the ECB to provide unlimited supplies of liquidity to struggling nations by massively expanding its purchases of Italian, Spanish and other sovereign bonds in the secondary market.

The good thing about the ECB is that there is theoretically no ceiling on how many euros it can print. The problem is that massive liquidity injections to both banks and governments could remove the incentive for lenders and countries to manage their affairs wisely. Once the storm had passed, it would be best to separate the illiquid institutions or governments from the insolvent ones and find a way of restructuring the debts of the latter in an orderly fashion.

But faced with the choice between an imploding euro zone or underwriting delinquency, the ECB would be best advised at least initially to plump for the latter even if that would involve eating its words. Still, there’s no disguising that it would be an unpleasant outcome.

An orderly exit from the euro is a virtual oxymoron. There are ways to minimize the damage –- principally by rationing access to savings during the transition, orchestrating an orderly default of the country that quits and unleashing the ECB as a lender of last resort to those that remain. Even with such a program, the economic damage would be huge. Without it, staying in Hotel California would seem like a holiday. The euro zone would become a towering inferno with everybody scrambling for the exits.

PHOTO: A banner featuring a Euro coin is seen on the European Commission headquarters building ahead of a European Union heads of state summit in Brussels October 26, 2011. REUTERS/Yves Herman