Daily Archives: July 22, 2011

Europe may have taken an historic step in its meeting on Thursday – it seems, for once, to have done more than “just kick the can down the road”.  First, its leaders recognised that it is not just Greece that faces a problem; it is a European problem, which requires a European solution.  The euro was, at birth, an unfinished project; it took away two key instruments of adjustment – interest and exchange rates – and put nothing in their place.  As President Nicolas Sarkozy has emphasised, this is a major step in correcting this deficiency, creating a European monetary fund.

Second, the leaders recognised that Greece’s problems require a focus on debt sustainability – lowering the debt burden and increasing gross domestic product, and Europe is doing something about both.  Not only are maturities being extended, but interest rates are being lowered; but even more important is the commitment to investments that will stimulate the economy, create jobs and increase tax revenues.  Growth cannot be restored unless lending, especially for small and medium-sized enterprises, increases.  The increased flexibility given to the European financial stability facility may help, but I suspect more needs to be done, for instance through creating a small business revolving fund.

The communiqué from the leaders recognised too the enormous strides that Greece has made and renews the commitment to technical assistance to help Athens implement the reforms that it has undertaken.

There were other important policy reforms – or at least moves in the right direction.  The clear statement  that public authorities should place less reliance on private rating agencies – the European Central Bank should not delegate responsibility to judging what is and is not acceptable as collateral – was long overdue, especially given the rating agencies’ terrible record in making judgments and the continued flaws in governance (often being paid by those that they are asked to rate).  If the ECB is concerned that a credit event will lead to turmoil in financial markets, it should take a more active stance to address the underlying problems:  eliminating the non-transparent over-the-counter derivatives, ensuring that banks are adequately capitalised and preventing banks from being excessively interconnected.

Making the private sector bear more responsibility for its lending is also long overdue.  The repeated bail-outs of banks around the world (and the bail-outs in Latin America, east Asia, Mexico, etc) have encouraged reckless lending.  The socialisation of losses accompanied with the privatisation of gains that occurred in the 2008 bail-outs in Europe and the US leads to a perversion of the market economy.   The private sector once again tried to blackmail governments – saying that the consequences of not bailing out the lenders would be disastrous – and Europe should be congratulated for not giving in, even if the ECB did what it could to give this argument support.  The details of the private sector involvement are not yet clear, but what is clear is that they should have a significant “haircut”.

With all these kudos, I have four cautionary comments.  The European Union has once again reiterated its resolve to a quick return to fiscal rectitude (at least for those countries not in crisis).  Europe’s recovery, however, is still frail and excessively quick cutbacks will slow growth, and even risks a double-dip recession.  Lower economic growth will be bad even from a narrow view of deficits and debt.  Moreover, Ireland and Spain both had budget surpluses and low debt-to-GDP ratios;  that should serve as a reminder that these restrictions are neither necessary to ensure future growth and prosperity.  Unfettered markets – and especially under-regulated banks – were central in causing the crisis; and too little has yet to be done.

Secondly, revenues from Greece’s privatisations may help address the country’s financial difficulties, but not if privatisation is pushed too rapidly, with a rigid timescale.  Fire sales worsen a country’s balance sheets – and the market responds to these rigid time frames with lower prices.  Greece should be committed to rapidly preparing its assets for sale, but the timing of the sales themselves should be sensitive to market conditions.

Thirdly, the greater flexibility given the EFSF is important, but some of the proposals being bandied around need to be treated with caution.  One entails moving to variable rate loans.  Ask America’s homeowners about the wisdom of that!  Better risk instruments – including the appropriate use of GDP bonds – could improve risk sharing and enhance the likelihood of a strong recovery.

Finally, the commitment to growth is essential.  Evidently, references to a “Marshall plan” contained in earlier drafts of the communiqué, were eliminated.  I hope that this does not signal a move away from a strong commitment, requiring potentially significant resources.

Europe has, at last, been forced to do a cold calculation of the costs and benefits of taking the next steps to create a successful euro, and not doing so.  Any rational calculation showed that the benefits of doing what it has done vastly outweighed the costs.  As I wrote earlier, the question was not one of economics but of politics.  The politics finally came together.  There is more to be done, but these were critical steps.

The writer is a recipient of the 2001 Nobel Memorial Prize in economics and University Professor at Columbia University

European leaders took a big and important step towards dealing properly with the eurozone debt crisis at their summit on Thursday. This required courageous compromises on the part of many, most importantly Germany and the European Central Bank. But further design enhancements and skilful execution will be required if yesterday’s decisions are to translate into the durable restoration of growth and financial stability to the region’s troubled peripheral economies.

Debt solvency, growth and contagion have been, and are, at the core of the problems of Europe’s periphery. They speak to both the causes of this painful homegrown crisis, and to the manner in which it has been spreading. It is therefore highly encouraging that European leaders are finally taking more aggressive steps to address all three aspects.

Firstly, on solvency, the programme countries (Greece, Ireland and Portugal) will now benefit from lower interest rates and a significant extension of loan maturities.

Secondly, greater focus is being placed on promoting growth in the periphery, though this is still too restrained relative to what is required.

Finally, contagion risk – especially for Italy, Spain and the Europe-wide financial system – is being lowered through a new, flexible and fast-disbursing credit facility available both to sovereigns and banks.

This all constitutes a major step for leaders that, for almost two years, were essentially in denial. Having persisted too long with a liquidity cure for a solvency problem, they are now taking a major step towards deploying better instruments for the challenge at hand.

But success is far from guaranteed. It depends in particular on two factors: further enhancements to Thursday’s agreement, and ensuring proper execution.

As it stands, the package still lacks sufficient upfront debt relief for the most troubled economies, Greece in particular. Putting this in place quickly is central to fiscal solvency and growth promotion. Given the starting point, there is simply no substitute for some form of immediate debt reduction whose benefits flow directly to highly troubled sovereign debtors.

In addition to dealing more decisively with the crushing debt overhang, such debt relief would also assist in ensuring the proper level of overall financing and, critically, fairer burden sharing between the private sector and taxpayers.

Then there is the execution risk. Four parties will have to deliver simultaneously, and in a focused fashion, to make this package effective.

Governments in core countries – Germany, Finland and the Netherlands in particular – must convince their sceptical citizens that this is a good use of their hard-earned tax euros.

The ECB must also come up with a skilful way to compensate for the balance sheet hit it will have to take at some point on account of its peripheral bond purchases and repo operations.

Private banks must waste no time in taking advantage of favourable market reactions to raise additional capital.

Finally, the peripheral economies must deliver an internal economic adjustment that is both substantial and acceptable in socio-political terms.

History will show that, on July 21 2011 European leaders met and, jointly, stepped up to the plate to respond better to an internal crisis. But history will only label this a success if Thursday’s courageous compromises are followed by proper enhancements and skilful execution.

There is still much to do if this historic summit is to mark the beginning of the end of Europe’s painful debt crisis.

The writer is the chief executive and co-chief investment officer of Pimco

Response by Sony Kapoor

Don’t mistake Europe’s tiny step for a giant leap forward

The steps taken by European leaders may look big but only because their actions thus far have fallen so short. The compromises look courageous only because the conflicts have been so shrill. What feels like a giant step to European leaders is, once you strip away the rhetoric, merely a small one.

The skillful execution Mr El-Erian refers to can only so much when the fundamental problem of the sustainability of Greek debt has only been addressed marginally. Yes, solvency and growth have been the main problems driving this crisis, but lip service aside EU leaders have done little to address them.

On solvency, yes offering a lower interest rate of 3.5% on EU loans to Greece, Ireland and Portugal would help particularly the latter two but since the three countries were already paying a of around 5% on existing debt any benefits would be incremental. The extension of maturities on public lending is also helpful but in tackling illiquidity, not insolvency.

The history of public lending to sovereigns is littered with multiple rounds of debt relief in the form of interest reductions and maturity extensions, particularly in Africa and Latin America that failed to restore solvency. As in these cases, what was needed for Greece was debt cancellation, not the debt relief that has been delivered.

The much-discussed private sector involvement is a damp squib and will, under an optimistic scenario, provide only Euro 20 – 25 billion of debt reduction out of a stock of Euro 350 billion. Markets and holders of peripheral country debt are celebrating as the burden is borne mostly by EU taxpayers and Greece, not them. But the calm will be shattered when realization dawns that the fundamental problems at the heart of the EU such as the solvency of Greece remain unaddressed.

I agree with the importance of growth, but fail to see how merely talking about growth or the phrase ‘Marshall Plan’ used in the leaders’ declaration will deliver it. The Marshall Plan provided aid while the EU is only providing loans. It stimulated investment, while Greece and other program countries face gut-wrenching austerity for the foreseeable future.

The expansion of the crisis toolkit available to the EFSF was indeed positive, but it was first discussed and then rejected in 2010. It still needs to be approved by parliaments and this carries execution risk but much of the rest of what the leaders said was once again too little, too late, as we have highlighted in our commentary on the conclusions.

The writer is managing director of Re-Define, an international think tank

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