Super Mario Brothers
The Super Mario Brothers need to work together to save Italy and the euro.
Even if Mario Monti can form a strong government in Italy, the euro zone is vulnerable to bank runs and a deflationary spiral. Stopping that is the role of Mario Draghi, the European Central Bank’s boss. The zone needs vigorous supply-side reform but looser monetary policy. With Silvo Berlusconi gone, the duo and Germany’s Angela Merkel should try to forge a new grand bargain based on this.
Last week witnessed both the Italians and the Greeks dragged to the brink, they looked into the abyss and disliked what they saw. The two countries have or are in the process of forming national unity governments led by technocrats. This is a step in the right direction. But dangers abound.
The biggest risk is of a visible bank run. There has already been massive deposit flight in Greece as savers fear that the country could get kicked out of the euro – a scenario which is still real despite Lucas Papademos’ appointment as prime minister. But so far there have been no queues outside branches as there were with the UK’s Northern Rock in 2007. If that were to happen, television pictures would be relayed across Europe in seconds potentially provoking copycat runs.
Even without visible deposit runs, euro zone banks are debilitated. Many have already suffered runs in the wholesale markets: U.S. money market funds have sharply cut supplies of short-term cash; and hardly any bank has been able to issue unsecured bonds since the summer. The banks are able to get money from the ECB but only for up to a year. Their funding problems now look set to suffocate industry via a renewed credit crunch.
Meanwhile, the banks’ difficulties are exacerbating governments’ funding problems. France’s BNP revealed this month that it had cut its holdings of Italian debt by over 40 percent in the previous four months. Other banks could follow suit, thinking it is better to take smallish losses now rather than get caught in a Greek-style debt restructuring later. This means that, even if Monti gets a mandate to push through structural reforms – which need to be more radical than those planned by Berlusconi – Rome could struggle to finance itself on decent terms. Ten-year bond yields, which ended last week at 6.5 percent after shooting up to 7.6 percent, need to come down to 5 percent for the country’s debt to be sustainable.
The euro zone may already be in a double-dip recession. A renewed credit crunch plus extra austerity demanded of governments – France was the latest to tighten its belt last week – could push it into a fairly deep one. The snag is that the more governments raise taxes, the faster economies shrink, which in turn makes it harder for them to balance their books and so piles further pain on the economies.
Many European nations lived beyond their means for years. They enjoyed excessively generous welfare states and didn’t allow the free market to operate properly. So big changes are needed. But the current policy mix isn’t working. A new treatment is required that puts more emphasis on the long-term reforms – such as pushing up pension ages, making it easier to hire and fire, reforming bloated civil services and privatisation – and less on short-term pain.
Such a new policy mix would require action not just by governments but by the ECB. The central bank is now the only realistic source of mega funding after many non-euro countries made clear at the G20 summit in Cannes this month that they thought the zone should solve its own problems. China, meanwhile, indicated that it would only help in return for unpalatable quid pro quos such as extra power at the International Monetary Fund.
Draghi and his colleagues at the orthodox central bank need to make three radical changes. Germany, the euro zone’s conservative main paymaster, would need to back the changes to give them political cover.
First, the ECB should offer banks longer-term cash to prevent an imminent credit crunch. Governments should simultaneously require their banks to hold more capital so that they have adequate cushions to withstand the hard times ahead. The 106 billion euros of capital injections agreed at last month’s euro summit should be doubled in line with what the IMF recommended. That might then reassure the ECB that it wasn’t lending to potentially insolvent banks.
Second, the central bank should be prepared to act as a lender of last resort to governments which are following responsible policies. The Lisbon Treaty prevents it from lending directly to states, but that shouldn’t stop it leveraging up the European Financial Stability Facility, the euro zone’s bailout fund. The EFSF would then have the firepower to help Italy and Spain if needed. So long as Berlusconi was presiding over a dysfunctional government, it was sensible to avoid bailing it out. But provided Monti can deliver, that would no longer be relevant.
Finally, the ECB should prepare to launch “quantitative easing”. At the moment, inflation in euro land is 3 percent. But it is soon likely to head below the 2 percent level that the ECB defines as price stability. Given that official interest rates are now 1.25 percent, there’s not much scope for further rate cuts. But the ECB could print money to buy government bonds and other assets, in the same way that the U.S. Federal Reserve and the Bank of England are doing.
The ECB does have a government bond buying operation already. But this is a long way from quantitative easing. First, it is small: 0.8 percent of GDP; the U.S. and UK programmes are 16 percent and 18 percent of GDP respectively. Second, the ECB mops up all the money it creates when it buys bonds whereas the Fed and the Bank of England inject extra cash into the economy. The main benefit of a similar operation would be to help restore the competitiveness of struggling economies by weakening the euro which, despite the crisis, is astonishingly strong at $1.38.
Such a grand bargain might sound rational. But is it possible to orchestrate a deal between 17 different countries and a fiercely independent central bank? Not yet. But just as pressure from the markets and Italy’s euro partners has pushed Rome into doing things it wouldn’t have contemplated even weeks ago, pressure from the markets and the rest of the world may soon push the euro zone to be more creative too. The Super Mario Brothers need to get cracking.