At the December 16th EU Council, European leaders missed yet another chance to contain the spread of the current debt crisis, which continues to threaten the sustainability of the historical achievements witnessed in European integration since the end of World War II. The leaders failed to acknowledge the systemic nature of the crisis and to act accordingly by implementing a “shock-and-awe” response through a credible financial safety net that could be extended simultaneously on a precautionary basis and in a flexible way to euro area countries that might be hit next.
Instead, they focused on the state of European affairs after the crisis, leaving the current framework to fight this increasingly systemic problem unaltered. Certainly, focus on the long-run viability of the euro is badly needed, and Mario Monti elegantly summarized the most relevant issues in this respect in a recent article.
However, it is very concerning that the EU Council fell short of upgrading the current crisis framework amidst the increasing economic turmoil hitting Portugal, Spain and even Italy, after Greece and Ireland. Proposals to strengthen the framework, which is centered on the European Financial Stability Facility (EFSF), included increasing its financial size as well as its flexibility in allocating funds.
To be fair, the refusal to increase the financial capability of the EFSF would have made little difference, as financial markets have shown few signs of confidence since the establishment of the EFSF this summer. The EFSF, in fact, summarizes financial markets’ deepest concerns rather than dispelling them. Here are the major ones:
Governance. The EFSF reflects a purely intergovernmental approach to the management of the euro area crisis with lending decisions having to be approved unanimously by all the euro area countries. More broadly, the intergovernmental approach also shapes the composition of the current European defense lines consisting of up to EUR 750 billion: EUR 440 billion (or 59 percent) through the EFSF’s intergovernmental mechanism; EUR 250 billion (or 33 percent) through the supranational IMF funding component; and only EUR 60 billion (or 8 percent) through the “federalist” mechanism entrusted to the EU Commission. One of the key reasons for the current crisis is precisely the fact that markets have very deep reservations about the credibility of a monetary union run on the basis of an intergovernmental approach rather than a federalist one.
Financial Capability. The EFSF funds its lending programs by issuing bonds guaranteed by its euro area shareholders. This has two implications: 1.) the interest rates charged to the borrowing country tend to be higher, thus further compromising the fiscal sustainability of the troubled European borrower; 2.) subscriptions to the EFSF’s bond issuances cannot be taken for granted in the case of a systemic crisis, where contagion to otherwise healthy national financial markets is a serious possibility. Another area where there has been lack of clarity is the AAA rating of the EFSF bonds. The top rating only applies to potential issuances covered by the guarantees of AAA euro area countries. As a result, the true extent of the AAA rating only applies to some half of the overall EFSF’s EUR 440 billion. In other words, the EFSF can issue AAA bonds to rescue Ireland but not Spain or Italy.
What’s Next? The rigorists continue to emphasize a national approach to the crisis by underscoring individual country responsibilities in the current context against the need for a better and stronger systemic response to this crisis. But the rigor may have ill-adverse effects. In fact, if the rigorists get their way, the European Central Bank (ECB) may well fill the institutional and financial vacuum it has been filling up to now, thus jeopardizing its very narrow mandate to focus on long-run price stability.
For instance, if market conditions were to prevent a successful subscription to an EFSF bond issuance, then pressure would mount for the ECB to act as a lender of last resort by underwriting unwanted bond issuances and/or supporting public debt bonds of distressed European countries.
The ECB has already shown itself to be more pragmatic and proactive than ever before in filling the current vacuum. But this interim role of crisis manager of last resort that the EU Council has implicitly entrusted to the ECB is the greatest challenge for the sustainability of the euro.