End of the bailout era
How big should Europe’s firewall be? Some analysts reckon the euro zone needs as much as two trillion euros, enough to bail out Italy, Spain, and some others if need be. By comparison, the size of the planned 500 billion euros of the European Stability Mechanism (ESM), the euro zone’s permanent bailout mechanism, looks paltry. Unless it includes the unused funds of the European Financial Stability Facility (EFSF), the temporary structure put in place in the wake of the Greek fiasco.
The current thinking is to lift the 500 billion euro cap in order to create a firewall big enough to convince the International Monetary Fund to cough up funds too. The most ambitious plan, devised by the European Commission, is to fold the EFSF’s unused guarantees into the ESM, which would boost the total size of the facility to 940 billion euros.
But increasing the firewall too much may not be desirable, or necessary. Once the money is there, there is a danger markets will push governments to use it. Countries with high borrowing costs may also become addicted to cheap bailouts. A fund big enough to bail out Italy and Spain could be created, but such large bailouts would be destabilising; governments in northern Europe will be highly reluctant to sign up, and their own credit would be impaired. Then there’s the risk that after Italy, France might one day follow.
Bailouts are necessary sometimes. Greece needs such deep social reconstruction that it will be on life support for years. Portugal may find itself in the same camp if its efforts to reform don’t pan out, and it may need to tap the bailout fund again. Ireland could need some extra money too. But it doesn’t look like other euro zone countries need the full treatment. Take Italy; last year its bond yields topped seven percent, prompting commentators to argue that a bailout was inevitable. But it wasn’t; a few months of high yields was enough to topple Silvio Berlusconi. Keeping countries exposed to market forces may be a better way of enforcing change than bailing them out.
Leaving markets to act unchecked could be dangerous. The Italian crisis last year was contained because the European Central Bank kept bond markets from spiralling out of control by buying government debt. It then protected Europe’s banks by making long-term funds available. Clearly, that requires the ECB to put member states’ capital at risk, just like the ESM will do. But the ECB route is better: market forces are still brought to bear, the ECB lends against collateral, and buys bonds at a discount, even turning a profit. When the crisis eases, it can quickly withdraw, as was done with Italy. Save for their psychological effect, the bailout funds don’t need to be increased at all.