Will Europe’s leaders finally deliver the goods when they meet in Brussels this evening? For a year and a half now, they have been trying to solve the financial crisis on their continent with one bailout after another, only to see markets take a turn for the worse. The latest metastasis began in the middle of September, when the debt crisis that began in early 2010 in tiny Greece spread to France, Europe’s No. 2 economy after Germany, following the downgrading of the biggest French banks by Moody’s, the rating agency, for having piled up too much bad debt from Greece and many other countries. In a frightening echo of the days leading to the 2008 financial collapse, Europe’s biggest banks suddenly faced a freeze in global money flows and stayed in operation only after the world’s leading central banks, including the U.S. Federal Reserve, the European Central Bank (ECB), and the Bank of Japan, jointly intervened with emergency cash lines.
As 27 presidents, prime ministers, and chancellors converge on the European capital, hopes are high for a comprehensive deal, but few are expecting the crisis to be solved once and for all. That’s because the Europeans need to solve four simultaneous crises at once: a government debt crisis on top of the 2008 banking crisis that Europe never resolved, on top of a competitiveness crisis that makes weak Mediterranean countries permanently dependent on loans, on top of a political crisis that makes decision making among the 27 EU member countries all but impossible.
Here’s what details of tonight’plan have emerged and what they’re likely to accomplish:
First, a full year and a half after Europe’s leaders first went into denial about Greece’s inability to pay back its $500 billion national debt and tried to “save” the country with ever bigger bailouts, there is now a plan to restructure Greece’s debt just like any other country’s in a debt crisis. There is talk of a 60 percent “haircut” on Greek government bonds. The problem is that so far it is still “voluntary,” meaning that many of Europe’s shaky banks will try to avoid the write-off and keep the bad debt on their books.
Second, Europe’s leaders finally admit that something must be done with the continent’s banks. Europe’s dirty secret is that its banks have long been even more of a mess than America’s—they were among the biggest investors in America’s toxic subprime assets, and then went big time into the now-toxic bonds of overindebted states; hence the 62 percent plunge in the Euro Stoxx Financials Index since March, compared with minus-21 percent for the Dow Jones financials. France, which probably has the shakiest banks of any major European economy, to this day has refused to force them to recapitalize and shrink. The plan, as leaked to the Financial Times today, involves a $140 billion bank bailout (though the IMF and others estimate recapitalization needs to be much higher). But it’s a weak plan, full of vague “shoulds” and “oughts” that will likely leave too many loopholes for the banks and their investors to evade forced recapitalization and the absolutely necessary debt-to-equity swaps. The way the bailouts are set up now, they could allow France and others to pass the cost of bank bailouts to Europe’s taxpayers, potentially making the debt crisis worse.
Third, in order to prevent contagion to other overindebted countries, such as Italy and Spain, outlines are emerging for a plan to issue “bond insurance.” Here’s how it works: a bailout fund, possibly leveraged to as high as 2 trillion euros, would cover the first 20 percent or so of any losses by investors on bonds issued by individual European countries. That plan, first put forward by German financial-sector lobbyists, could end up expensive for taxpayers. Bond insurance makes sense, but the cheaper—and more effective—alternative would be not to cover any first loss on any bond, but provide only a kind of catastrophic risk insurance for the worst defaults. That would put a floor on potential losses—and raise bond prices—at a far lower risk to Europe’s taxpayers, says Achim Dübel, a German bond-market expert who developed the plan.
Fourth, European leaders are trying to show they’re a little more serious about cutting deficits and lowering their debts. Germany and France are leaning on Italy, whose $2.5 trillion national debt is the world’s third highest after America’s and Japan’s, and whose government bonds are stable only because the ECB is massively buying them. After Greece, Italy is another poster child for what’s wrong with the European Union. The moment the ECB started intervening in the markets to support Italian bonds, Prime Minister Silvio Berlusconi backed off on a set of planned reforms that would have started to get Italy’s debt under control. It’s an open secret that Berlin would prefer Berlusconi out and a new government in power to push through a backlog of economic reforms that would allow Italy to regain the confidence of investors. Perhaps taking the hint, Berlusconi today started talking about early elections.
Italy illustrates perfectly the deeper crisis, which the current plans don’t solve. Many of Europe’s semi-socialist governments simply do not know how to roll back spending, and have been even less eager to pass the kinds of market-opening economic reforms that would raise growth and make it easier to pay back debt. France, which together with its wobbly banks is the elephant in the room of the euro crisis, has never passed a serious reform to its pensions, civil service, or employment laws in the last 60 years. Greece, despite the crisis, has barely even begun to privatize or start collecting back taxes. The problem is that once any comprehensive bailout deal is signed, power will shift back to the debtors, as Europe has no mechanism to force a Sarkozy or Berlusconi to reform. The paradox, therefore, is that without the pressure of the current crisis, the much deeper crisis will continue to fester.