The self-imposed restrictions to a solution at the EU summit

2011-10-25

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Officially we now are between two EU summits. One took place on October 23 with the aim to set the foundations for an agreement that will finally be reached at the next summit on October 26. In practice the meetings and negotiations have started from Friday and have been taking place ever since until they are concluded on Wednesday night.

European elites are called to find solutions on three main parameters with respect to the immediate issues that arise from the crisis plus a fourth that has to do mostly with institutional and governance issues:

1. Greek debt restructuring: the discussion on the so-called haircut and how big should that be and in what way should it be presented in order to avoid collateral damage such as the triggering of a ‘credit event’.
2. The recapitalization of the system’s quasi-bankrupt private banks first to make sure that they do not collapse to the mounting pressures and second to guarantee that they will survive the shock of a potentially big haircut on Greek debt.
3. The expansion of the firepower of the region’s bail out fund, the EFSF, to allow it to effectively prevent the irreversible spread of the crisis to Italy and Spain, while also be assigned to provide in one way or another capital to banks.
4. Adding to these they are considering a fourth issue, that of closer economic governance, possibly through modifications in EU Treaties that will allow for some sort of greater control over fiscal issues from Brussels.This however does not provide any solution to current problems, it rather takes advantage of the situation to integrate further an area of policy that has remained at a national level.

So they have three issues to deal with regarding the purely short-term approach vis a vis the crisis and a fourth issue which will most probably pave the way for further economic integration, better economic governance. This will, in theory at least, provide a more credible preemptive measure to profligate public spending.

These issues are debated within a given political and legal context that is in this case very rigid. A number of self-imposed restrictions need be respected in whatever solution:

1. The ECB must at any rate remain independent in order to avoid a violation of its institutional role. In practice this implies that it must not be involved in any plan that will provide funding on countries for fiscal purposes. This is both a legal and a political matter. Legal in the sense that the ECB is by law restricted from getting involved in the fiscal issues of member-states as that violates the no-bailout clause. It is also a political one, since a possible intervention would be a bad precedent providing incentives on states not to carry on with what are seen as necessary reforms and with stricter budget control. The intervention of the ECB in the markets to buy Italian and Spanish bonds has always met stiff resistance both internally and externally and is likely to stop.
2. There must not be any eurobonds without prior fiscal integration. Here the issue is purely political, even though one might seek to attach to it an argument of legality. The introduction of eurobonds can potentially create incentives for inaction, which would suggest that Italy and Spain do not have the pressure to implement reforms. Moreover Germany and the other surplus countries will never accept such provisions without a fiscal union in place that would guarantee no irresponsible spending occurs.
3. The haircut on private investors that hold Greek debt must be done in such a way that will not trigger a credit event that would imply the payback of CDS contracts. In practical terms the process be designed in a manner which private investors will “voluntarily” accept whatever losses so as not to consider the loss as a partial default. Here the issue is technical, yet its importance is cardinal, since any miscalculations could lead to adverse effects. Greek debt must be reduced but at the same time it must be presented in a way that is acceptable by market standards.
4. Any debt reduction in Greece must be done in a way that will deter others from following a similar path in search for debt “redemption”. In other words debt reduction will be accompanied by quite unpleasant measures and political conditions that will create the necessary deterring effect on others.
5. The expansion of the EFSF must be done in such a way that no more taxpayer money needs to be utilized so as to avoid any further political costs from the already unsatisfied national electorates of most countries. The growing anti-bailout sentiments force politicians to seek ways of using financial engineering to expand the EFSF.
6. The BRIC (Brazil, Russia, India, China) countries and other emerging markets, must not be allowed a bigger say in internal EU issues. Their help will be well-accepted but only if the conditions are favorable for Europeans.

Three topics to deal with the immediate effects of the crisis plus a fourth to better control fiscal policy. Discussions on these topics must not violate the above-mentioned six axioms. Can our leaders be creative enough to come up with a package that is both viable and compliant to the legal and political restrictions? Or will this rigidity and the lack of options give birth to yet another series of half-measures that will die at birth, just like the decisions of the July 21 summit? At Wednesday night answers to these and many other questions will be delivered and the world will know whether Europeans are able to stand up to the challenge of solving their problems.