Greek exit risks, fiscal integration-or-bust, the need for a deposit guarantee fund, beefing up the European Stability Mechanism and that Spanish debt-for-equity bank plan. Lorenzo Bini Smaghi, former ECB executive board member between 2005 and 2011, speaks to Euromoney about how monetary policy can’t - and shouldn’t - do all the heavy lifting to resolve the crisis.
Is there a material risk of the eurozone project collapsing given the crisis in Greece?
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There has been a lot of talk about exit. If you look at the polls in Greece, no one wants to exit. The Greeks want to have their cake and eat it, but in the end they will have to make the adjustments to do what is needed to stay in. In practical terms especially, it is very difficult for countries to leave the eurozone – especially if people ultimately want to stay in. In the end, you might need some coercion to get the country out, and this might not be easily done in a democracy.
What are some of the likely consequences in the event of Greece ditching the euro?
The exit from Greece would be very difficult and it will be scary in terms of market consequences but it could also provide an incentive for reform among the other euro members, with a view to increase political integration. What we are experiencing in Europe can be put into a broader global historical framework – just look at the history of the US.
Most economists reckon the official sector needs to write down the value of its holdings of Greek sovereign bonds before the country’s debt metrics become sustainable – and political stability can be restored. Why in recent years have you refused to consider this option?
I don’t think we can think of official sector haircuts, as it will mean fiscal transfers from the rest of the union to Greece. This will be a gift to Greece. If we do, what are the lessons? What will happen with Ireland, Portugal? We would be creating incentives for over-indebtedness. We should not forget that there has to be political accountability. Greece doubled the wages of its public sector in less than 10 years, for example. The eurozone won’t be a stable union if you can borrow freely and then go back and ask for debt forgiveness.
Over the weekend, Spanish government officials released details of a plan to recapitalize Bankia with Spanish government bonds, which could then be used as collateral to borrow funds at the ECB. What are you thoughts on this?
It has been done in the case of Ireland but this was done under very strict conditions in the context of a very strong IMF/EU/ECB package. This plan cannot be implemented unilaterally by the Spanish government. It needs to be done according to precise limits as agreed by the ECB on a restructuring plan for Bankia.
The ECB can lend only to sound banks and so it needs to be reassured it is sound and solvent; to do that it can’t rely on the word of the Spanish supervisor alone.
Let’s talk about the fiscal and monetary policy tools available to resolve the crisis. Is a pan-eurozone deposit guarantee mechanism feasible and desirable?
It’s technically feasible but the question is whether it is politically feasible and whether countries would be up for that since the funding would need to be shared. To some extent, the scheme requires a fiscal burden-sharing arrangement.
This measure will become more politically feasible if the crisis becomes more acute. Often in our democracies, people need to see the worst of scenarios before they make tough decisions, just like the US Congress changing its mind on Tarp [Troubled Asset Relief Programme].
What might seem unpalatable today might be seen as less unpalatable tomorrow, especially if Germany sees that this is in its interest. But we have not seen contagion spreading to bank customers which would yet fuel bank runs across Europe. At the same time, we have seen after the Lehman Brothers’ failure that market contagion can spread in ways that were not anticipated beforehand.
It would be preferable to implement a deposit guarantee fund ex-ante but, as often happens in Europe, things happen ex-post.
Market consensus is that allowing banks to access the European Stability Mechanism (ESM) directly – or allowing the ESM access to the ECB’s repo window – would be the most effective measure to prop up the Spanish banking system. Are you in favour and under what conditions?
The ESM can be used to recapitalize the banks, but this has to happen via the countries applying for ESM funds. The ESM should remain directly accessible by the sovereign, which is the counterparty of the fund, against some clear conditions.
If ESM was allowed to recapitalize the banks directly, it would need to have leverage over these banks. There should be a transfer of responsibility whereby banks would be under the supervision of the ESM. This could then be seen as the beginning of a crisis-resolution fund, a special fund, which would recapitalize the banks and also induce them to restructure their balance sheet and manage bad assets.
This might be a stealth move towards the creation of a eurozone-wide bank supervisory structure, which we need to have anyway, since in a single-currency bloc you can’t have 17 independent banking supervisors.
What about allowing the ESM to access the European Central Bank (ECB) repo window? Is this an inventive way of boosting collateral?
Right now, it’s not feasible. There would be a risk this would be interpreted as a circumvention of the prohibition of monetary financing. This policy measure would be powerful in terms of increasing the purchases of sovereign bonds, but the liabilities that the ESM has on its balance sheet would also rise.
If the ESM is given a licence to do what other banks can do in the market, that would be very powerful. The point is that the ESM needs more capital to leverage – and questions thereby arise as to whether this is politically feasible.
The ESM would need sufficient capital so it can leverage and operate like a commercial bank. As a result, it would need to function like a bank with an adequate core tier 1 capital ratio, etcetera.
So what monetary policy tools are you in favour of? Bond purchases? LTRO 3?
One has to consider the most efficient measure. The three-year LTRO [long-term refinancing operation] programme has been the most efficient. To be effective, the ECB bond purchase has to be perceived by the markets as being without limits, which would mean that the ECB is not concerned with taking the risk directly on its balance sheet.
If it [LTRO 3] is needed, the ECB will do it again. I don’t think any central bank should pre-announce its intentions. A central bank should engineer constructive ambiguity in the market on the understanding certain measures would be implemented if needed.
Fears have grown that a Greek exit from the eurozone would exact a heavy toll on the ECB’s balance sheet, which is already struggling with Target2 liabilities, and the prospective reduction in the value of collateral it holds for its financing operations. As a result, many analysts say ECB fears over its balance sheet strength will moderate its ambition provide further monetary support to the banking system. What are your thoughts?
The ECB’s reserves have doubled in recent years – the reserves of the eurosystem stand at around €300 billion, and it has its own risk management with respect to LTRO. What’s more, a counterparty would have to fail and the collateral it has posted has to be valued at a price lower than the haircut – two big events – before losses are felt on the ECB balance sheet.
The risk on the ECB’s balance sheet would be the last of my worries in the event of a Greek exit from the eurozone, as there would be so many other more pressing problems on the real economy, for example.
Is there legitimacy to the argument that national central banks in the eurozone should be allowed to expand the ELA programme, a liquidity facility in which national central banks set the collateral requirements and are directly liable for?
More ELA programmes could take away the pressure to restructure the balance sheets of the banking system.
Why does the ELA programme lack transparency? The value of the programme, who is accessing it and the value of the collateral is anyone’s guess.
There is a limit to transparency. The central bank is taking the risks on its balance sheet and this should be measured and made transparent to its shareholders. But a public display of the central bank’s assets on a continuous basis might not be useful, especially at times of crisis.
Given negative sovereign-bank feedback loops, a policy impasse, an existential crisis in the eurozone and a weak banking system that is inhibiting the transmission of monetary policy to the real economy, some analysts would say you are being far too timid in your monetary policy prescriptions. What would you say to your detractors?
There are two objectives: one is to calm the markets and restore stability; the other is to put pressure on fiscal authorities to do their part. It is not only the responsibility of monetary policy to resolve the crisis, which is largely due to concerns about budget stability.
Any action has to be taken ultimately with the aim of building a stronger system over time, not a weaker one. If some measures provide relief over the short term but lead to loss of confidence among certain quarters in the euro area, they would have to be reversed over time, undermining credibility. You need to take action in a framework that also fosters political authorities to take their own responsibilities.