The latest meeting of the European Council on March 24-25 was supposed to settle the economic governance reform of the EU. It did indeed agree on a so-called “Comprehensive Package”, including the terms of reference of the future European Stability Mechanism (ESM) to solve sovereign debt crises as well as a so-called “Pact for the Euro Plus”. Two years back, hardly anyone would have expected such progress. But in particular the ESM may prove insufficient both for the prevention and resolution of debt crises.
Three weaknesses need to be dealt with. First of all, disagreement over how to increase the capital stock both of the current facility, the ESFS, and the future ESM, show that governments are increasingly reaching political limits as they have to provide credit and guarantees to fellow Euro-zone partners. For instance, the Finnish government refused to agree to the increase of capital of the ESFS because it feared that the EU-critical “True Finns” would gain even more votes in the upcoming Parliamentary elections.
Second, the ESM does not provide a convincing legal framework for sovereign defaults. Collective Action Clauses (CACs) will be included in all sovereign bonds issued after 2013. But a lot of time will have passed until a substantial share included CAC. More fundamentally, the ESM may in fact reduce the ability of member states to refinance themselves on the markets. Bonds may lose attractiveness if a country receives IMF and ESM-credits as both enjoy preferred creditor status.
Furthermore, the ESM will not be equipped to fend off so-called self-fulfilling financial crises. Credit will only be granted as the ultima ratio if the Euro zone’s financial stability is at stake, upon unanimous decision and involving tough conditionality. At first sight, this may seem reasonable in order to prevent moral hazard problems. But if the ESM will not be able to provide liquidity rapidly, and if the overall credit volume may in the end turn out to be too low, then the Euro zone will continue to lack means to fend off panic and speculation in the markets. Contagion effects similar to those in 2010 could develop, if market participants once again deem financial support as being too little and too late. This price of later rescue decisions could possibly rise – as it did in the case of Greece. By the way, in recognition of the need to prevent self-fulfilling financial crises, the IMF has recently invented new instruments to provide liquidity to governments at a very short notice.
Thirdly, the banking crisis which is intimately linked to the debt crisis is not solved. The EU is about to run a third round of stress tests and these may once again be far too mild to detect the true weaknesses. But unless the banking sector is recapitalised and restructured, dealing with a sovereign default will be very difficult as the costs to bear in the event of a hair-cut will be far too high. This self-inflicted inability to solve the root-problems leaves politics with two less attractive options: Either to set-up a new rescue package combined with an extension of the duration of given credits – which would essentially mean postponing crisis resolution as a solvency problem cannot be tackled with liquidity help. Or a disorderly default – which, for good reasons, the EU governments wanted to prevent in spring 2010.
In case of a next round of the sovereign debt crisis, these issues will push onto the EU’s agenda. Under high market pressure, radical solutions may once again have to be sought which political leaders would exclude from today’s perspective. One of them could be the introduction of Eurobonds for a certain share of debt. These would encourage financial stability in the monetary union if they can only be accessed under strict conditionality, including an adherence to the rules and limits for budgetary and economic policy coordination in the EU.