Travelling in Europe before the IMF Annual Meetings in Washington D.C., there was an air of worsening crisis. A series of bad news fed the fear factor. Shortly after the Swiss National Bank intervened in the Swiss franc, a UBS rogue trader was charged with losing 2.3 billion euros in unauthorized trades. Then, S&P downgraded Italy. Market volatility was higher than ever.
I asked my friends in Europe on their perspective of the crisis. There are three possible scenarios. The first is the present structure and situation of basically helping Greece prevent a default, but at present the chances of this scenario being viable without something more drastic are diminishing. The second is a political and fiscal union in which there is a European tax mechanism to tax winners and transfer payments to help losers. The third option is the failure of the euro and therefore the European Union itself. Nouriel Roubini and other doomsters seem to suggest that the third option is the most likely.
There are as many views and “blame game” as there are observers. It is difficult to believe who is right. Staunch Europeans say that the leading surplus country, Germany, will eventually write the cheque to sort out the mess, because history suggests that the price of the failure of the European Union is simply too catastrophic to imagine. Two world wars were fought because of instability in Europe in the 20th century. No one wants a repeat of that. However, it is not easy for the Germany Chancellor Merkel to explain to German tax payers why they should bail out the others.
The structural weakness in the European system is that decision making is by consensus and therefore very slow. For example, the U.S. view of the crisis is that the Europeans were too slow to recapitalize their banks. Since European banks hold substantial amount of PIGS country debt, if any of them default, the banks would be substantially affected. This explains the sharp drop in European bank shares, made worse by global banks cutting back their inter-bank lending to European banks, so that the European Central Bank seems to the main bulwark providing liquidity to the banking system and at the same time buying more and more sovereign debt paper of the weaker countries. There are limits to what the ECB can do.
The European regulators are clamping down on short-selling, claiming that it is the speculative buying of CDS on sovereign debt that pushes up the market perception that the risks on sovereign debt of countries like Italy and Spain would default. Rating agencies of course rely also on the risk spreads as indicative of default risks, so the combination of fear and downgrades only make the situation worse.
As is the case in all crises, the financial markets are now over-shooting from excessive optimism to excessive pessimism. Before the crisis, the market made a fundamental error that the credit default risks of Greece and the weaker countries are roughly the same as the strongest country, Germany. This is of course a false assumption. Today, Greece is paying more than 16 percent per annum, Italy more than 5 percent and Germany roughly 2 percent for 10year debt. The higher the real interest rate, the more the economies are going to slow. The slower the economy, the more likely are the government deficits to grow, so there is a vicious circle pushing towards a sovereign debt crisis, compounded by the fact that banks are locked into the sovereign debt mess.
I was asked to comment on this using an Asian perspective. The lessons from the 1980s are that there are four stages of crisis resolution, since crisis is an event, but reform is a process. The stages are diagnosis, damage control, loss allocation and changing the incentives that created the crisis in the first place. Europe is now in the last two stages, which are politically the most difficult. Part of the problems lie in the accuracy of the initial diagnosis, whether the crisis is one of liquidity or solvency.
Since both U.S. and Europe are advanced countries, there was an initial assumption that solvency was never an issue, and therefore the problems could be solved through liquidity. This explains quantitative easing and lower interest rates as the stance of monetary policy. However, as real interest rates rise, you can remain liquid but insolvent, because real interest rates depress asset prices while liabilities become more expensive to repay in real terms.
In other words, no one should doubt the solvency of Europe as a group, but would the stronger members pay for the losses of the weaker ones? This is the incentive issue, like the father paying for the losses of one of his family. If he writes the first check, then he may have to write more checks, because other members will also relax and ask father to pay. This is exactly the dilemma of Germany. If they pay for Greece, they face moral hazard of paying more and more. If they don’t pay, the family may break up with even more costs.
One analyst used the vivid example of a group of mountain climbers on a cliff. The lowest climber (Greece) has already fallen off. The other climbers up the rope are hanging on tenuously. The decision of the lead and strongest climber is either to rescue everyone or to cut the rope to save himself. What is the right decision?
The lesson from the Asian crisis is relevant here. In the midst of the crisis, the Japanese proposed the Asian Monetary Fund, using surplus savings of the richer Asian countries to help the crisis economies. The Europeans and U.S. immediately objected and insisted that the IMF be used instead. At that time, I saw the choice of IMF as logical, because of two reasons. First, you cannot build a fire engine in the middle of a fire, because it may not be effective. You have to use an existing fire engine. Second, if you use a family engine, how can you enforce the discipline on family members, when there is emotion involved? Hence, the IMF may not be the lender of last resort, it is the enforcer of last resort.
As we are all aware, the Europeans created its own European Financial Stability Fund when the crisis occurred, but it faces the identical problem as the Asian Monetary Fund. How would the EFSF or the European Central Bank enforce discipline on the borrowing countries? The complex emotional, legal and political issues involved make enforcement unpopular and difficult. The IMF, however, was created and trained to be the “bad” cop, the unpopular enforcer. This makes the incentive structure more balanced.
Thus, my personal view is that the IMF should play a central role in the disciplinary part of the European debt crisis resolution story. It is independent and it is global. The next article will discuss how the funding part should be resolved.
By Andrew Sheng
Andrew Sheng is president of the Fung Global Institute. ― Ed.
(Asia News Network)