Bill Emmott - International Author & Adviser


Firewalls won´t help Europe avoid the iceberg
The Times - October 10th 2011

Forget the Black Death. Forget, too, the South Sea Bubble of 1720, the Baring crisis of 1890 and even the Great Depression of the 1930s. According to Sir Mervyn King, governor of the Bank of England, we may be in the worst financial crisis ever. Angela Merkel, Germany’s chancellor, probably agrees, since she has had to spend yet another Sunday in the delightful company of France’s President Nicolas Sarkozy, and has previously had to endure vulgar comments about, ahem, her physique, from Italy’s ever-subtle Silvio Berlusconi. It surely can’t get worse than that.

            Well, it could, though not such as to justify Sir Mervyn’s hyperbole. Central bankers are normally taciturn and under-stated. That he chose to be the opposite might mean that he knows of some forthcoming horrors that we don’t, but more probably he was stretching a point to justify his announcement of a new round of money-printing (aka “quantitative easing”, by buying a further £75 billion-worth of gilts), given that inflation remains well above the Bank’s mandated 2% target.

            The new policy looks right, even if the argument used for it risked being counter-productive. Britain’s economy has been stagnant for the past nine months, there is no prospect of tax cuts or other fiscal stimuli, and our main export markets—Europe—are indeed staring into an abyss. With oil prices 25% down from their peak in the spring, unemployment high and pay being frozen, the danger of deflation is now higher than that of inflation. Monetary stimulus is the only option in response, although in today’s depressed conditions it is no panacea, either.

            There are, as this columnist pointed out on August 22nd, bright spots in the world’s economic picture that will provide Britain and Europe with some support: Japan is rebounding from its post-tsunami slump, America is still crawling forwards, and the Asian emerging giants are growing lustily despite a modest slow-down from their inflationary double-digit growth rates. Yet that would all just be nice tunes from the Titanic’s orchestra if the euro were to hit an iceberg.

            So will it? Iceberg-avoidance was the purpose of yesterday’s meeting between Mrs Merkel and Mr Sarkozy. It will also be the purpose of a series of policy moves that will be made by euro-zone governments during the next few weeks, which will be about injecting new capital into banks, adding firepower to the euro’s rescue fund, and dealing with Greece’s evident inability to repay its sovereign debts.

            The difficulty will lie in judging whether these moves will be enough to prevent slow European growth turning into a new slump, which is what a 2008-style financial collapse would bring. The only sure prediction is that Messrs Merkel, Sarkozy and others will declare this month or next that all problems have been solved and that a new dawn is breaking. So here is how to judge whether to believe them.

            Essentially, Europe’s problem is that after the 2008 worldwide slump, private debts became turned into much larger public debts especially in the countries least able to afford them, the sclerotic, inflexible nations of southern Europe. The creditors for those government debts, which used to be defined as low-risk, are European banks and insurance companies, especially in Germany, France and Britain. As Greece has edged towards defaulting, so bond markets have begun to wonder who else might feel forced to ask for a discount, and both stock- and money markets have therefore started to wonder about the solvency of the banks that are holding this once-safe paper.

            The cure that for the past year euro-zone members have been attempting, with help from the International Monetary Fund, has been to give the troubled debtors bridging loans at cheaper, official rates. This has bought time but has done nothing to deal with the underlying disease.

Meanwhile European “bank stress tests” which assumed that government bonds would cause no stress at all simply sapped policy-makers’ credibility, which was further sapped by divisions and dysfunctionality in Mr Berlusconi’s government, which presides over the euro’s third-largest economy and owes more than 1.6 trillion euros (£1.4 trillion)—a default on even part of which would bring European banks tumbling down.

            To have a good chance of preventing other banks following Belgium’s Dexia into bankruptcy, euro-zone governments will need to work decisively and comprehensively on both sides of that nasty equation: making banks more able to withstand debt defaults; and making the size of that debt default predictable and containable. Then both of those actions need to be measured against the politics of the countries that will have to pay for them: will they be accepted, will they be sustained, will they pass muster with the German constitutional court?

            France and Germany have been arguing about whether banks’ capital should be shored up by private investors and national governments (as Germany favours) or collectively by the euro-zone’s rescue fund, the European Financial Stability Facility (as France has proposed). If Germany prevails, that will be a good sign, for an EFSF recapitalisation could be legally dodgy and anyway would use up capital that the fund is supposed to be keeping in reserve.

But if Germany does prevail, the national bank recapitalisations will need to be both large (preferably at least £300 billion) and co-ordinated, and will need to be backed by new stress tests that assume the sort of sovereign-debt write-offs that markets have been speculating upon, and then some. Only credible stress tests matched by really big capital injections will end the speculation and worry.

Such capital injections are not free lunches: they will add to the sovereign debt problem, at least in the short term. So the other test is about managing that sovereign debt. Everyone knows that Greece cannot afford its existing debt, despite its five austerity packages in the past 18 months. A good sign now would be European acceptance of that reality, through an announcement of an agreed halving of Greece’s debt.

Yet then comes the task that has been holding everything up: working out how to make that announcement in such a way that it does not immediately imply that Italy and others will soon follow. Vague talk of a “firewall” around Greece, as during July’s fumbled bail-out, will just make things worse. There needs to be a real and credible distinction between Greece and the rest. And that will be the hardest thing of all to achieve.





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