We’re going to need a bigger bazooka!
stephen clarke, 28 October 2011
On Thursday some greeted rises in world stock markets as a sign that the EU’s bail-out ‘bazooka’ had worked in scaring away speculators and reassuring the markets. Today’s news that Italy has had to sell 10 year bonds at a record high price indicates that simply inflating the bail-out fund is no panacea.
In the run up to the Euro-crisis summit on Wednesday people discussed the bail-out fund, €1 trillion, €1.5 trillion, even €2 trillion?! It was a case of how big the bazooka needed to be. Unfortunately not enough thought has been given to examining where exactly this money will come from. This is important as simply stumping up cash can just transfer the risk from one party to another.
Carmen M. Reinhart and Kenneth Rogoff, in their seminal book ‘This Time Is Different: Eight Centuries of Financial Folly’ highlight the link between bank crises and sovereign debt crises: when a bank gets into trouble and is bailed out by the sovereign, the debt and the risk is simply transferred to the sovereign. We saw this happen in the recent financial crisis and we could be coming full-circle with European sovereign defaults threatening the same European banks that were previously bailed out.
The upshot of this is that risk cannot be brushed under the carpet. This is worth bearing in mind with plans to increase or ‘leverage’ the financial firepower of the EFSF. If European states are going to agree to guarantee a greater number of bonds issued by threatened states then this will put the finances of such countries at risk. If the ECB is to take a greater role in supporting the finances of the club-med states then this will also negatively affect the credit ratings of the Eurozone countries that explicitly stand behind the ECB.
In either case, the sovereigns that would be expected to foot the bill, France, Germany, etc, are themselves under increased financial pressure. Growth has slowed in nearly all European countries, European states will, in all likelihood, have to help their banks increase their capital in expectation of a write-down on Greek debt, and the majority are pushing through austerity measures that reduce the scope for any financial largesse.
While the Eurozone may need a bigger bazooka, there is no safe way to fund it. One other option is closer fiscal union, which looks increasingly likely despite German aversion to it. The other option is to transfer risk outside the Eurozone. In recent days there have been reports of Klaus Regling, head of the European bailout fund meeting with Chinese officials in a bid to get China to support the EFSF more than it is currently doing so. To all intents and purposes this is the closest thing to a ‘free lunch’ Eurozone leaders are going to get, however the ramifications of China holding far greater quantities of European debt are not clear. Politically, China will certainly demand a quid pro quo for its support, as one analyst recently put it: ‘China wants to get what it wants if it is to play a role in this’. Economically, China itself is facing some worrying developments, including rising inflation and a tightening of credit. Furthermore, it should be clear to everyone that Chinese sovereign debt purchases in the last decade contributed to the financial imbalances that were so evident in the wake of the financial crisis; there could be significant dangers of resuming or even increasing this trend.
One of the lessons of the financial crisis was that financial wizardry could not mitigate all risk, and in muddying the waters it could make matters worse by severing links of accountability in the financial system. Eurozone leaders should reflect upon this lesson when they seek to rearm the European bazooka.