European leaders held a summit this weekend intended to produce strong steps to halt the Euro Crisis. A follow-up summit will be held Wednesday at which the leaders plan to announce their decisions, after working out details and compromises in the intervening days.
In a fashion now typical of the crisis responses, the actions expected to be announced this week are likely to improve the situation, but will be far from sufficient to resolve the core problems. There are three pillars in the expected plan. The European Financial Stability Facility (EFSF) will be levered up in some manner to a size more appropriate to the magnitude of the crisis. European banks will be forced to add capital to increase their protection from sovereign defaults and other risks. Finally, debtholders will be persuaded, in some manner, to accept larger losses on their Greek government bonds.
It is good that the leaders are trying to comprehensively tackle these problems, but the responses are weakened considerably by political constraints and compromises. First, government leaders are unwilling to increase their national commitments to the EFSF beyond the previously agreed 440 billion euros, which is clearly inadequate to reassure markets, especially since much of that is already committed. Therefore, they are looking for ways to lever those funds to get closer to the 2 trillion euros or so of capacity that is really needed. It appears this will be done by providing guarantees or insurance on a portion of the value of bonds issued by troubled eurozone countries. This is better than doing nothing, but is unlikely to restore markets in those countries to anything like normal operations.
Knowing that the first 20% of potential losses on Portuguese or Italian bonds will be absorbed by someone else is not that reassuring when investors in Greek bonds are about to be hit with losses of 40-60%. The type of investors who would be lured by such guarantees are the ones who look for fat returns from somewhat riskier investments, which suggests that bringing them in will not appreciably reduce the required interest rates. Instead, government bond markets need the much larger capacity and liquidity provided by the kind of investors who look for safe, liquid investments. That will not happen without solving the underlying problems or providing guarantees backed by more creditworthy countries or multi-lateral bodies.
Second, a bank recapitalization that adds approximately 100 billion euros of capital is also a step forward, but, again, will not lay investor fears to rest. The IMF recently estimated that sovereign debt problems had eaten away at least 200 billion euros of economic capital from the European banks. Adding a figure half that large is unlikely to impress markets for long. The 90 largest banks, which are the ones targeted for the increases, have about 1 trillion euros of capital now, so this would add about 10%. Looked at another way, they have around 27 trillion euros in assets, so the new capital protects against a further decline of less than half a percentage point in the value of their assets.
The technical details of the recapitalization plan will matter as well. If designed badly, the plan could even hurt by encouraging European banks to cut back on lending and to sell existing assets, potentially creating fire sales such as contributed to the financial crisis in 2008. A serious credit crunch would likely plunge Europe into recession.
Third, strong-arming investors into “voluntarily” accepting losses of 40-60% on their Greek government bonds will certainly add to the risks of contagion if market concern about other troubled eurozone countries spike again at some point.
Some progress is better than nothing, and these steps may lay the groundwork for stronger actions in the future, but it would have been refreshing if the governments had finally been able to get substantially ahead of the markets for a change.
If Italy were to enter a phase of uncertainty, with shaky governments, with a new government, and be attacked on the financial markets, this would be a huge problem. Not just for Italy, of course, but for the rest of Europe. Italy is just too big to fail.