Daily Archives: October 10, 2011

Less than three weeks before the next G20 meeting in France, the eyes of the world are firmly fixed on Europe. President Nicolas Sarkozy seems to share the desire of many of his predecessors for grand global meetings. Well, this one is going to be just as, if not more, important than many such meetings of the past. The power of the G20 meetings in the spring of 2009 in London, the success of the Plaza September 1985 gathering and the Louvre Accord 1987 will need to be matched, if not exceeded, if we are to get past the current eurozone crisis.

A number of key policymakers from outside of the eurozone, including Tim Geithner and George Osborne, have highlighted the November 3 meetings as critical in setting global financial markets on a better footing. On Sunday UK prime minister David Cameron urged European leaders to take a “big bazooka” approach to resolving the crisis, warning they have just a matter of weeks to avert economic disaster. Unsurprisingly, expectations have been raised. The credibility of the Europeans’ stance will be crucial, possibly in a way that it hasn’t been at any global leaders’ gathering yet.

Unfortunately, eurozone’s policymakers seem to be fond of the “muddle through” approach to policymaking. This has been a feature of European solutions to issues arising from the European Monetary Union since its creation in 1999, through dealing with challenges such as the adjustment of the Growth and Stability Pact and, of course, repeatedly since the Greek debt crisis exploded last spring. Yet it seems as though muddling through is no longer enough to keep financial markets at bay. If no credible “big bang” is unveiled next month to convince the markets, consequences are likely to be severe.

Firstly, given hardly anyone still believes Greece can avoid a major debt restructuring, it would be better to get it over and done with. The country appears to have neither the aptitude or flexibility to cope with the repayments it faces, and it clearly can’t grow its way out of such debts. By offering a decisive restructuring, agreed and recognised by key European and G20 policymakers, this would show eurozone leaders were finally facing up to reality.

Secondly, policymakers need to agree to a framework for the adequate recapitalisation of Europe’s banking system. If there is going to be a successful debt restructuring for Greece, with minimum adverse contagion effects, this will be vital. President Sarkozy and Chancellor Angela Merkel appear to have agreed in Berlin this weekend that they will have a comprehensive package by the end of the month. Taking guidance from the successful US stress tests of early 2009, it is time for them to take the lead, and put an end to the constant second guessing by the financial markets about the capital adequacy of Europe’s banks.

Thirdly, leaders must make clear that while Greece has a solvency challenge, the bigger economies of Italy and Spain only have problems with liquidity. In order to convince the markets of the distinction, both Italy and Spain need to demonstrate that their medium to long term fiscal paths are credible and improving. Adopting Germany’s constitutional budget stability model could be a major feature.

Lastly, and perhaps most importantly, all the key eurozone policymakers have to show that that they are on the same page. This is true with respect to Germany and France, as well as the European Union itself and the European Central Bank. While it is important that the ECB’s cherished independence be respected, events have demonstrated throughout the past troubled 18 months, that the bank has been forced to undertake a number of policies it had not planned to do. It needs to embrace a different spirit if agreements made by Europe’s leaders and the G20 are to be successful. Many other independent central banks have considerable flexibility without abandoning their prime goals. Just look at the Federal Reserve Board, the Reserve Bank of New Zealand, which pioneered inflation targetting and, most recently, the Swiss National Bank.

By using the phrase “unlimited” in describing their how far they would go to intervene to support a lower limit for the Swiss Franc’s value, the SNB has not had to spend much at all to achieve these goals (so far at least). By adopting the same bold approach to direct liquidity-provision for the European bond markets, or possibly through leverage for the expanded European financial stability facility, the ECB could turn the current situation around. Longer term, steps towards genuine fiscal union including the development of a true euro-denominated bond market seem sensible goals. But unless Europe’s policymakers stop trying to “muddle through”, all these goals will be pointless.

The writer is chairman of the asset management division of Goldman Sachs and former chief economist at the investment bank.

Response by Raoul Ruparel

Keeping the ECB independent is key to the euro’s survival

Jim O’Neill sets out some important and necessary steps for how to solve the eurozone crisis – including a restructuring of Greece’s debt, recapitalising Europe’s banks and greater leadership from the European Union leaders. However, the problem in the eurozone crisis was never primarily one of not knowing what to do, but how to get there within the constraints of a supranational currency, pegged to national democracies and fiscal policies. What’s clear, however, is that spraying more liquidity at the eurozone crisis is in itself not a magic panacea – and could even make the single currency less sustainable in the long term.

The notion that the European Central Bank should offer an “unlimited” backstop for eurozone nation states, as Mr O’Neill mentions, is a case in point. Clearly, the loser from the “muddling through” approach employed by EU leaders over the past year has been the ECB. It has seen its credibility drained and its independence compromised (for example through its U-turns on accepting junk bonds as collateral). In fact, an important component of finding a long-lasting solution to this crisis is that any financial backstop for the eurozone is established at the intergovernmental level, not through the ECB.

There are a number of reasons for this, many of which stem from the central bank’s experiences during this crisis. First, the cheap and plentiful liquidity that the ECB has provided to European banks created perverse incentives and moral hazard, possibly leading banks to chase profits through higher yields on peripheral sovereign debt, thereby increasing exposure to the crisis. In addition, this unlimited credit created a set of so-called ‘zombie banks’ reliant on ECB liquidity to survive, but without any conditionality to reform the bad practices and mismanagement that got them into this situation in the first place. The lack of an exit strategy from these policies shows why transferring this model to the sovereign debt markets would be dangerous and undesirable.

Furthermore, let us not forget that, unlike the Federal Reserve and other central banks, the ECB does not have a dual mandate – its primary aim is that of price stability. If markets do not believe it can achieve this, and if the line between politics and monetary policy become increasingly blurred, then market instability and fluctuations may become the norm for the eurozone. That the eurozone lacks a lender of last resort, is a structural flaw in its fabric which has been sorely exposed by the current crisis.However, papering over it with unlimited liquidity in the near term will not solve the problem. And perhaps most importantly, forcing the ECB into the role of lender of last resort could seriously jeopardise German support for the entire euro project, with the ultimate outcome equally unpredictable to that of the current market turmoil. The Germans still take ECB independence seriously, as witnessed by the dramatic resignation of Jürgen Stark over the ECB’s bond-buying programme. As attractive as it may sound at first glance, we should be wary of the temptation of sacrificing the ECB’s credibility at the altar of a short-term fix.

Finally, let’s not forget that, even following a solution to this crisis, a vast array of countries will be left with mismatched interest rates, an overvalued currency and a convoluted decision making process. The problems in the eurozone run much deeper than additional liquidity can solve. Yes, Greece needs to restructure, banks need to be recapitalised and if an inter-governmental, democratic way can be found to top up the European financial stability facility, with more focus on banks, this should also be explored. Alas, this may not be enough to save the euro.

The writer is an economist at Open Europe, an independent think tank on the European Union.

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