We can leave it to the Portuguese voters to pass political judgment on José Sócrates and his government for their protracted and stubborn resistance to tapping the European Union’s emergency fund, the European Financial Stability Facility. Sócrates had been playing for time, in the hope of staggering past the general election that was scheduled for June, leaving the next government with the unhappy legacy. His failure will prompt wry satisfaction in the European Commission, the European Central Bank (ECB) and in many national capitals whose pleadings over several months for Lisbon to seek a loan had been repeatedly rebuffed.
So Sócrates’s gamble on timing has been lost. It is possible, but still unlikely, that Portugal’s resort to EU aid – with additional support from the International Monetary Fund (IMF) – coupled with ECB interest-rate rises will be a domino that will knock over others, beginning with Spain. One nightmare scenario has the markets driving Spain into the emergency ward followed by such other highly indebted countries as Belgium and Italy. A disorderly queue of member states being lined up for EU support within a couple of years might be more than the Union could handle.
In part, the sovereign-debt crisis is Europe’s aftershock from the near-collapse of the global financial system in 2008-09. That brush with disaster has prompted the most thorough changes in the supervision and regulation of financial services on both sides of the Atlantic for many decades. But the reform process in Europe is not yet complete. The Union is still short of some essential defences against the seismic systemic tremors that would follow debt default and/or restructuring by Greece, Ireland or Portugal. The Union’s own gamble with time is to keep the countries on its perphery afloat at least until the EU is better able to cope with the shocks of debt default and restructuring in any or all of these countries. But is time on the Union’s side?
In March, Olli Rehn, the European commissioner for economic and monetary affairs, talked of a “quiet revolution” that was transforming the Union’s authority not only to deal with political and economic mismanagement of deficits and debt by member states, but also to raise safety and stability levels in financial markets. Key aspects of this revolution that are little remarked upon outside the banking and financial services sectors are the creation of the European Systemic Risk Board and of cross-border regulatory authorities for banking, insurance and occupational pensions and financial markets.
Tougher surveillance and regulation will not avert the turmoil that could follow if Greece, Ireland and Portugal crumpled under the political and economic burdens forced on them as conditions for EU/IMF support. A lone debt default and restructuring exercise by one of these countries would not be a threat to the Union’s financial system. But would governments in Portugal and Ireland be able to resist popular pressure for a relaxation of austerity policies if Athens were unable to hold the line against domestic resistance? The fall of one domino would leave the Union with little choice but to manage an orderly debt restructuring for all three.
Order is certainly preferable to a series of rolling crises eventually threatening the safety of some of Europe’s leading banks. Triple debt restructuring is a worst-case scenario that should have featured in the stress tests of 90 European banks that regulators are supposed to have completed over the next couple of months. It seems we still have to learn the lesson of the past three years about the perils of underestimating threats to financial stability. Not all of their exposure would be in jeopardy, but French and German banks are owed more than €500 billion by the governments and private sector in the three peripheral countries. British banks on their own have exposure to Ireland that is close to half that amount.
One of the Union’s defences, not yet deployed, is legislation to prevent taxpayers from having to save ‘too big to fail’ banks. It seems likely that European banks will have to provide ‘living wills’ that would enable regulators to shelter retail banking while allowing investment banks to go to the wall. Does the draft banking resolution legislation need to be fast-tracked?
The answer depends on the readiness of three very different societies to tolerate a worsening of the already very bleak times through which they are living. History suggests a justified pessimism about whether the political will can be sustained. Six IMF austerity programmes since 1980 have been followed by defaults within two years (Turkey, Venezuela, Dominican Republic, Uruguay, Indonesia and Argentina).
The consequences of EU/IMF programmes are huge cuts in gross domestic product and slender prospects of delivering the economic growth that will enable debtor countries to pay off their debts. The EU/IMF packages for Greece and Ireland have been too generous to creditors (the one for Portugal will be no different) partly because of the fragility of many EU cross-border banks. Common sense and economic prudence require debt restructuring that inflicts some losses on bondholders, accompanied by a rapid recapitalisation of systemically important banks. We are living on borrowed time.
John Wyles is an independent consultant based in Brussels.