Congratulations to German Chancellor, Angela Merkel, for winning the vote in the Bundestag on the EUR440 billion EFSF. But, it’s not big enough. To save the Euro a “shock and awe” policy needs to be implemented to remove any doubts about the future of the Euro Zone.
The Euro-Zone debt crisis is a rerun of the interbank liquidity crisis that hit banks from August 2007 and escalated throughout 2008, leading to the demise of Bear Stearns and Lehman Brothers. Instead of the markets worrying about which banks can repay their loans, it is now which countries.
Figure 1: Shows the dispersion and the average counterparty risk across US banks as priced by 5-year CDS premia between Jan 2007 and Dec 2010. Banks included are JP Morgan, Bank of America, Wells Fargo, Morgan Stanley, Goldman Sachs, Lehman Brothers, Bear Stearns.
Although, short-term liquidity injections were enacted almost as soon as the crisis began, these did not address underlying problems that eventually caused calamity. Central bankers were too worried about the moral hazard of supporting the banking system but given, its importance to the wider economy, these concerns should have been noted but dealt with after a bailout in the form of regulation. Eventually, when the crisis hit horrific heights in September 2008, this is what policymakers did. But, earlier action could have reduced the severity of the financial crisis and the effects on the wider economy.
Figure 1 shows how average US bank credit risk grew after August 2007 but also, how the dispersion of credit risk jumped as the market broke down in September 2008. (The dispersion of risk is measured by the average of JP Morgan, Bank of America, Wells Fargo (the safer banks) and the average of Morgan Stanley, Goldman Sachs, Lehman Brothers, Bear Stearns (riskier banks)).
“Shock and awe” policies were implemented by governments in the last quarter of 2008 and in 2009, which proved to the markets that governments would do whatever was necessary to bring normality back to the markets. This included bank bailouts, coordinated interest rate cuts, toxic asset insurance in the form of TARP and quantitative easing. Governments backstopped the entire financial system to ensure normality returned as measured in interbank markets by the Libor/OIS spread.
Figure 2: Dispersion of Euro Zone sovereign debt risk, as measured by the Greek/German 10-year bond spread, and the average Euro-Zone 10-year bond yield spread versus Germany.
Figure 2 shows a similar pattern in Euro-Zone sovereign debt risks as in the bank risk in Figure 1. As the crisis has escalated, both the average Euro-Zone sovereign debt risk and the dispersion of sovereign credit risk have grown. The market for Greek, Irish and Portuguese debt has broken down but Euro-Zone policymakers have not convinced the markets that they will fully insure these debts.
Only “shock and awe” policies will do this to convince the markets that they are serious about keeping the monetary union together. This could be the implementation of a much larger EFSF, plus a commitment to introducing a common Euro-Zone fiscal body and euro-Zone bonds.
Furthermore, concerns surrounding the moral hazard of introducing such bailout packages could also be addressed by writing conditions for the redistribution of wealth across the Euro-Zone, together with a publicly known set of consequences for countries that fail to adhere to the rules and regulations. If a procedure is in place to deal with countries that break the rules then it can be dealt with in an organised and calm manner, without the uncertainty and fears of worst-case scenarios seen in the markets today.
Politicians are grappling with the costs of the bailout package but shock and awe policies are likely to cost less than the sticky plaster style policies implemented until now. Euro-Zone leaders have only been willing to pass packages that do just enough as opposed to policies that are so big that the markets can find little fault with them. The point here is that the bigger the bailout, the less it will cost the tax payer because if the markets know there is no chance of a Euro-Zone country defaulting, then they will be more willing to buy its bonds. For instance, the primary debt market for Ireland, Greece and Portugal is currently closed but if the financial security of these countries was insured by an overwhelmingly large support package then the markets would be much more willingly to buy bonds from these countries, thereby reducing the need to tap the EFSF.
Politicians in the Euro-Zone must realise this, otherwise, social and economic problems will deepen.