Published in Business Spectator (Melbourne), 9 December 2010
Life in Euroland is full of ironies but they don’t come much more bitter than Sunday’s announcement to award the prestigious Charlemagne Prize 2011 to Jean-Claude Trichet, the head of the European Central Bank (ECB). According to the prize committee, Monsieur Trichet will be honoured for his commitment “to the cohesion of monetary union, the stability of the euro and the maintenance of competitiveness in Europe”.
In Trichet’s mother tongue, this would pass as a veritable esprit de l’escalier – a good idea whose time has passed. If European central bankers and politicians had ever wanted to create a stable currency, they should have thought about it 20 years ago when they formulated the rules of monetary union. They could have reconsidered the idea when they admitted Italy and Greece into the eurozone. They could have averted the worst when they dealt with the first breaches of the Stability and Growth Pact by France and Germany in 2002 and 2003.
Having missed all those opportunities, it is now too late for a stable euro. The European Union’s rescue efforts are only making a bad situation worse. Instead of saving the euro, let alone European taxpayers, they are only attempting to save financial institutions. If this is worthy of any prize at all, it would be for creating the greatest moral hazard in financial history.
The bailouts for both Greece and Ireland were officially sold as exercises in pan-European solidarity. The cold reality was quite different. In both cases, the real concern was not to help these fraught economies back on their feet but to protect European financial institutions exposed to the PIIGS states of Portugal, Ireland, Italy, Greece and Spain.
According to the Bundesbank, German investors alone have a total exposure to PIIGS debt of €451 billion ($610 billion). The respective figures for French, British and Spanish banks are equally frightening. These large sums explain why politicians are keen to prevent a default in these economies at all costs, whether it helps the PIIGS economies or not.
Indeed, the rescue packages first given to Greece and then imposed on Ireland will make life harder for them. When the aid packages to Greece and Ireland run out, Athens will be left with a debt to GDP ratio of 160 percent. Meanwhile, Dublin’s interest payments will consume more than a third of Irish tax revenues. In other words, they will both be bankrupt.
If these outcomes are supposed to be the solution, then what again was the problem? First and foremost, it was a debt problem in both countries. There is no way this can be tackled by burdening Greece and Ireland with yet more debt, though this is precisely what the EU efforts amount to.
The reason for the inadequacy of the EU response to the sovereign debt crisis is simple. Europe is more afraid of creating another banking crisis than it is concerned with the stability of its currency or the long-term solvency of its countries.
Before every crisis summit so far, there have been calls to make investors bear at least some of the costs of the rescue efforts. In particular, the German government stressed the need for haircuts or other debt restructuring programs. This is unsurprising since it is a tough job for any politician to explain to a domestic audience why they should pay for faraway profligate countries.
However, such rhetoric about making the banks pay never survived the summits. Fearing future funding difficulties, the weaker countries have no interest in threatening their potential investors with a default risk. For the PIIGS, it is much more convenient to rely on other governments to bail them out or guarantee their debt.
The stronger countries, on the other hand, have not yet managed to design a practical mechanism to involve private financial investors. Despite all the talk of an insolvency law for sovereign countries, European politicians have shown a remarkable ignorance of how insolvency laws work.
In any corporate insolvency, it is the old investors that have to bear the brunt. It is they who must share the losses before any fresh capital can be raised to lead the company out of its difficulties.
What European politicians, led by Angela Merkel and Nicolas Sarkozy, have proposed is the very opposite of such an ordinary debt restructuring process. Instead of privileging new capital over old capital, they want to play it the other way around. In their plans, the debts of all existing bondholders will be protected; new insolvency rules are only supposed to apply to the new investors. This proposal is bizarre.
The political logic is understandable: protecting the existing bondholders would shield the European banking system from incalculable losses (and guarantee their easy profits from high interest payments on PIIGS debt). But there is no corresponding economic logic to this idea.
In order to protect existing bondholders from the risk of default, future bondholders will have to bear an even greater risk. The question then becomes why any investor would still be willing to play by these rules.
As Jakob von Weizsäcker, chief economist of the German federal state of Thuringia, recently pointed out in an essay, this mechanism risks cutting off the PIIGS governments from the capital markets. “By promising old creditors to escape unscathed, any new creditors would not be in for a haircut but for a clean shave. Fresh capital will not be available for such a gamble,” he wrote.
The European Union’s rescue efforts for the euro have so far suffered from one cardinal mistake: they were driven by the desire to save the bonds held by the banks, pension funds, and private investors. This has created enormous moral hazard, underwritten by Europe’s taxpayers. But it has not solved the euro crisis, which requires a haircut for all existing bondholders of over-indebted governments if it is meant to work. Unless, of course, the ECB continues and expands its policy of buying up bonds of struggling governments.
This brings us back to Jean-Claude Trichet and his Charlemagne Prize. Charlemagne not only entered the history books as the great unifier of Europe. He also established a stable, silver-backed currency whose weight units survived for more than a millennium in many countries.
Giving a prize in Charlemagne’s name to a person complicit in the rapid debasement of a paper currency is another bitter-sweet European irony.