In the next few days, Greece’s Prime Minister, George Papandreou, will meet Chancellor Angela Merkel of Germany and President Nicolas Sarkozy of France in what will likely become the defining moment for a crisis that is shaking Europe. What they decide is also likely to shape the future of the euro area and transform its politics for decades.
The possible solution for Greece’s crisis being discussed—according to the press—envisions German and French banks involved and backed by their governments in the financing of the Greek public debt. This idea should not come as a surprise, since it follows the pattern unofficially established in the last 18 months across Europe to overcome the roughest winds of the financial and economic crisis. But for this reported scheme to be adopted, Berlin and Paris will likely have to trample on the Treaties of the European Union. The consequences of doing so may be substantial.
Starting in 2008 and through 2009, the eurozone responded to the first phase of its banking crisis with a policy of unusually easy money. The monetary stimulus was probably the most important element of the European strategy. The banking system was at risk, so the European Central Bank (ECB) made credit available at very low cost. The eurozone banks could tap low-cost financial resources at the central bank and invest them mostly in higher-yield sovereign bonds. This monetary support helped the banks’ balance sheets, which had been weakened by excessive investments in bad quality assets. In addition, easy money channeled through the banking system helped the European governments finance their fiscal deficits by increasing the demand for sovereign bonds. The statute of the ECB does not allow it to finance the European governments directly, so this triangular arrangement was kept unofficial. But the amount of European sovereign issuances financed last year through the banking system was probably equivalent to half of the total demand for government bonds.
The Greek crisis seems de facto to be replicating and enhancing this strategy. French and German banks hold a significant amount of Athens’s bonds. So they are heavily exposed to the risk of a Greek default. The Governments of France and Germany are thus offering to their public and private banks an extension of the State guarantee to the new investments in Greek bonds aimed at avoiding a default in that country. Under this arrangement the ECB, which was formerly signaling an exit from the policy of easy money, is likely to keep on providing liquidity at low cost for a while. Probably for as long as the uncertainty surrounding sovereign risk in many countries persists.
The strategy remains the same: easy money; granting endangered banks access to high investments yielding up to 400 to 500 basis points more than credit from the ECB; and public deficits stabilized by the banks themselves. In this case the strategy is reinforced and enhanced through the State guarantee. It is all rather simple.
Unfortunately, saving a government even in this way is almost certainly a violation of the Maastricht Treaty, and binding monetary policy to the governments’ fiscal demands is also a breach in the treaty. Moreover, extending the state guarantee to investments of some but not all European banks appears to be a violation of the rules of the European Union’s Single Market. All these steps may make up a reasonable strategy, probably the only one available now, but they also imply a revision of Europe as we know it. If the strategy works, Greece will be bailed out, the contagion will be avoided, German and French banks will cash in on high yields, and easy money will erode the public debts across Europe. But as a central banker explains, “If laws are not in place, facts rule and dictate the future.” What happens now will establish a precedent for the next decades.
The first part of the precedent is the Franco-German leadership molding the future of the euro area member countries in the absence of European institutions. The eurozone has no government (yet) and the European Commission plays a marginal role, basically limited to reinforcing the requests for fiscal discipline in Greece. The second part is the role of the banking systems as an (interested) transmission mechanism of policies. This situation is actually not new, but a return to the German model of the 20th century when German banks, under the umbrella of the German state, provided a business cushion for firms that needed to fund long-term investments, overcoming mainly cyclical downturns. The third part of the precedent is the pivotal role of the euro and of the ECB.
All three elements of the precedent foreshadow a different future for Europe. The eurozone will become politically more influential relative to the rest of the European Union. State regulation of the banking system will change its nature and this change will probably simplify the financial industry in Europe. The enhanced political influence that the ECB is responsibly, but unofficially, exercising will have to become explicit and subject to public scrutiny. National governments’ decisions must become compatible with the common interests of the euro area. If not, sooner or later public opinion will lose faith either in national democracy or in Europe. Accountability for cross-border economic policy should become the basis for a sense of mutual responsibility. That could give a new meaning to the ancient Greek words of politics and democracy, as these concepts become more free of the power of the monopoly of national powers.