by Don Alexander, MBA
Associate, RSD Solutions Inc.
The Eurozone crisis moved into phase 2 when the contagion spread to Italy, Spain and European banks. ECB purchases of government debt have provided a temporary solution, but may have political problems and legal implications that make them unsustainable and may include the need for time-consuming changes in the underlying treaties.
Baldwin notes that phase 2 bank problems are entwined with government debt concerns. The line separating illiquidity and insolvency for nations and banks was crossed last month. The ECB provided a temporary solution, but the financing facility (EFSF) itself remains insufficient to cover government debt service and banking system assistance/recapitalization. The estimated facility could need funding well above $1 trillion. The only policy combination that policymakers may agree on, and implemented in a timely manner, involves political cover for ECB bond buying in exchange for credible national fiscal reforms. The ECB’s actions are unsustainable politically (acting for politicians) and illegal without changes in the underlying treaties.
The near-term need is for ECB to backstop the debt of solvent European countries that would help temporarily stabilize financial markets. There are two options: either the ECB continues to backstop European bonds with political coverage or leaders create a Eurobond scheme for government debt. These are short-term solutions, both requiring credible control of new debt issuance. This can be accomplished if national governments adopt credible fiscal policy (Germany) and/or it is shifted to a supranational level. The best policy option in terms of timing is ECB backstopping of government debt with political support and domestic fiscal reforms. But the implementation of fiscal union or Eurobond issuance would take too long.
Given the magnitude of the problem, the current EFSF will not work since it is capped at €440 billion. The risk is that policy paralysis and contagion may require a more radical solution if prompt action is not taken. The more likely scenario is for a restructuring of the eurozone and increasing chances of reduced membership until countries get their fiscal house in order.
For more on Welcome to Phase 2 of the Eurozone (EZ) Crisis (VOXEU, Richard Baldwin, Sept. 5th), follow the link: http://www.voxeu.org/index.php?q=node/6942
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