POLITICS WILL BEDEVIL RESOLVING THE EURO CRISIS / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

Politics will bedevil resolving the euro crisis

By Wolfgang Münchau

Published: April 3 2011 20:55


Last week’s widening in sovereign bond spreads and the results of stress tests on Irish banks have reminded us that the eurozone has made hardly any progress in actual crisis resolution – in spite of its pretentious grand bargain. Over the next few weeks, I will try to map out various scenarios of how the crisis might evolve. It is probably the toughest challenge the European Union has confronted in its history. The eventual outcome will depend on a complex interaction of politics, finance and economics.


In this column, I focus on the politics of crisis resolution, beyond the well-known fact that there is opposition in countries such as Germany and Finland to large-scale bail-out regimes. This opposition is serious, but such countries also face political constraints that pull them in the opposite direction. One of those is a keen interest in avoiding a messy default. As a result, they are torn between two conflicting positions: avoiding default and avoiding bail-out.


It is intuitively clear why they do not like bail-outs. But why are they so afraid of default? I can offer three reasons. The first is asymmetric risk aversion. If you take a decision to wipe out a bondholder, you personally get blamed if something goes wrong. Europe’s policymakers do not want to end up like Hank Paulson, who as US Treasury secretary brought the planet close to cardiac arrest.


The second argument is cross-border contagion. There is a threshold of multiple sovereign defaults beyond which the financial system cannot cope. European banks and insurance companies have large intra-eurozone exposures. A default might require an immediate and potentially crippling recapitalisation of the eurozone financial sector.


Finally, a restructuring before 2013 would trigger a cross-border financial transfer under the rules of the current mechanism, something political leaders are desperate to avoid. It would be the worst of all worlds: default and bail-out in a single unattractive package. They have not yet prepared their electorates for the sound of money being sucked out of the country.


You may argue that all those fears are unsubstantiated, and you may well be right. The point, however, is not whether the financial system can withstand the shock of a debt restructuring, but whether the political system is ready to accept the tail-risk of a large accident. It is my hypothesis that it is not.


Furthermore, I believe this assessment will not change after 2013. Angela Merkel will probably take no risks in an election year. Even beyond, I can see no readiness by a future generation of leaders to take on risks that their predecessors did not. Since some countries are not doing much to restructure their own banks, the system will be as fragile in two years as it is today. The European Central Bank will still have huge exposures to sovereign risk and will issue the same dire warnings about default.


Lorenzo Bini Smaghi is perhaps the most vocal default opponent on the ECB’s executive board. He was recently asked whether establishing the European Stability Mechanism – with its senior creditor status – would increase the likelihood of a default. He said no. Governments still have an incentive not to go down that road. I do not agree with him on the substance of the argument but he is right in his assessment of what governments are likely to do. They will probably not allow it.

That would imply that Greece, Ireland and eventually Portugal will remain under the safety umbrella for a long time. Existing loan programmes will be replaced by new ones. The time for repayments will be lengthened; interest rates will be cut; the day of reckoning postponed. Eventually, the ESM, with the help of the ECB, will have accumulated the entire debt of these countries and there will be no private creditors left to be bailed in. If, or rather when, the system implodes, the ESM’s shareholders will pay the entire bill. Or they, too, will default.


This is a stark choice: between complete bail-out and complete default, between the break-up of the eurozone and a single European bond with a fiscal union. German and Finnish opposition has deprived the ESM of all those useful tools, such as bond purchases in the secondary market, that would allow it to pursue intermediate options – for instance, aiding in a partial default through swaps.


A stark choice may focus minds. But it is a dangerous game. Anti-euro movements of various degrees of seriousness have crept up in all of the triple A rated countries. Marine Le Pen, leader of the National Front, tops French opinion polls. “Eurozone-sceptics” are on the rise everywhere. While I do not expect any to come to power, they are influencing the debate. I am reminded of UK eurosceptics during the 1990s.


We should be under no illusion about the political wiggle room for crisis resolution. As we proceed, the nature of the crisis will change, and that in turn will impact on the politics of crisis resolution. This is the subject of the next column, in which I will be looking at debt sustainability. In particular, I will argue why the currently fashionable optimism about Spain is mistaken.


Copyright The Financial Times Limited 2011.