The European crisis and the G20 Summit

Author: Jacob Kierkegaard, PIIE

The G20 Summit in Cannes probably made its most important contribution to global financial stability and economic growth before it even commenced.

The summit, held 3–4 November, became a deadline for European leaders to deal decisively with the economic and financial crises in the euro zone.

Europe is experiencing at least four deep, structural, overlapping and mutually reinforcing crises: a crisis of institutional design; a fiscal crisis; a crisis of competitiveness and a banking crisis. None of the four crises can be solved in isolation, and there does not currently seem to be any single comprehensive solution that will end the crisis promptly.

At the Cannes summit, euro zone leaders agreed on a new set of measures to try and tackle these problems. Though inadequate in scope to bring the crisis to an end and calm financial-market volatility, these measures will help prevent further economic deterioration in Europe. Consequently, the risk of catastrophic spillovers from Europe to the rest of the G20 was reduced.

Ahead of the G20 Summit, euro zone leaders agreed on three principal strategies to contain the crisis: reduction of Greece’s debt; a bank recapitalisation target and new options to leverage the European Financial Stability Facility (EFSF).

First, the planned debt reduction takes the form of a voluntary bond swap with private holders of Greek government debt, resulting in a 50 per cent reduction in the nominal value of their debt. While urgently needed, this will not independently restore Greek fiscal solvency, and additional financial support for the country will be needed. As future support will undoubtedly involve the IMF, G20 members will also have the opportunity to discuss potential approaches to restoring Greece’s fiscal solvency. This voluntary debt swap is unlikely to trigger sovereign default swaps, and it removes a potential short-term source of dislocation in the financial markets. But the lack of payout after a 50 per cent reduction in debt may ultimately lead to the demise of sovereign credit default swaps — at least for industrialised nations — which may lead to increased financial-market volatility.

Second, euro zone leaders agreed to raise capital requirements in banks to 9 per cent Tier 1 equity, and adjust for the effects of market prices of sovereign debt. Although superficially helpful, the imposition of a capital ratio target runs the risk that banks will shrink their lending to businesses (due to denominator effects), rather than raising new capital. Regulators must be vigilant to avoid aggravating a building credit crunch.

Third, two options were agreed on to boost the financial firepower of the EFSF. Both are almost certain to fail. Option one, providing credit enhancement to new state-issued debt, is meaningless; the significant overlap between the insurer and the insured in the euro zone means any stability the measure achieves will be minimal. Option two foresees attracting investments from private and public financial institutions and investors. But few, if any, such investors exist — and possess the willingness and ability to make a material difference for European financial stability.

Fortunately, this does not matter, as both options are a smokescreen to provide cover for the European Central Bank (ECB) to remain directly involved in stabilisation measures. This is critical, as ultimately it is only the ECB, as a central bank with the ability to create new money, that commands the financial resources to stabilise Europe. By creating a distraction in the form of a ‘leveraged EFSF’, the ECB can continue intervening directly in the European debt markets to avoid a catastrophic rise of Italian and Spanish interest. Ironically, by supporting this ruse, G20 leaders will reduce the need to offer money themselves by helping the ECB keep the spread between, on the one hand, Italian and Spanish interest rates, and on the other hand German interest rates.

Usually, international gatherings like the G20 Summit in London in April 2009 deal with large crises by restoring confidence through the credible commitment of large sums of government money. Europe cannot do this. As was evident ahead of Cannes, Europe and the ECB rely on the economic pressure exerted by financial markets to push reform-reluctant leaders into ‘doing the right thing’.

Indeed, were the ECB to publicly declare its intention to act as a ‘lender of last resort’ for Europe, or the G20 to cobble together €2 trillion for the EFSF, the financial market pressure on such leaders to implement reforms would abate. Paradoxically, with Europe’s fundamental economic problems requiring years of tough reforms, Europe can only ultimately solve its economic crisis by prolonging it.

This logic will easily trump anything in the G20 Communiqué calling for enhanced global financial stability and strong balanced global growth. Instead, we can expect high levels of uncertainty and volatility.

Jacob Kirkegaard is a Research Fellow at the Peterson Institute for International Economics, and a Senior Associate at the Rhodium Group.