Economic Policy Review ISSN 1313 - 0544

Salvation for All Europe

08.12.2011
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I am the door; If anyone enters through Me, he will be saved, and will go in and out and find pasture.

John (10:9)

 

In July, the 17 Member States of the Euro area signed an agreement for the new format of the European Financial Stability Fund (EFSF). The main elements of the "corrected" Fund are the increase of the guarantees that the Fund could emit for loans of troubled countries in the Euro area and the possibility of the Fund to intervene "in case of emergency" in the primary market for Government debt. In that way the Fund will be able  to buy directly government bonds at the time of their emission. That is to say that on one hand the Fund will be able to guarantee bonds of the Euro zone countries and on the other, will be able to buy them. It is not hard to see that in this case it gets a closed circle from which the market is completely turned off – both on the supply side (because of the guarantees) and on the demand side.

The moral hazard in this Fund will become even stronger in the middle of 2013, when it is planned for the temporary designed Rescue Fund to become a permanent mechanism, called European Stability Mechanism. Everyone who had learned some basics of economic theory knows that where there are guarantees, the credit risk is no longer the borrower’s responsibility, but on the guarantor.

Furthermore, the reliable buyer of government debt in the face of the Fund increases the moral hazard. In the absence of pressure from the markets to correct the fiscal disbalances and debt reduction, and the awareness that there is always a way to refinance on a relatively low cost, any of the countries in trouble will have no motivation to actually solve the problems. And as we all know, everything in the economy is a matter of incentives – with such incentives out there, we can expect the relevant activity/inactivity.

Apparently, the European leaders will not stop anyway. The rescue of the big political project for the Euro area will probably be extended to the major european banks. The discussions from the beginning of this week lead to it. On the other hand, after the crisis in the autumn of 2008 the banks in some European countries received capital injections from their governments, so to compensate the losses of the so called “toxic assets”, and apparently now the main goal is to achieve a major supranational rescue operation.

In fact, the banks in the EU (both in U.S. and in many developed and not so developed countries) for a  long time don’t behave like market players who take risks and therefore take the consequences of their decisions. The existence of guarantees for the rescue of the banks by governments (implicitly, unlike the explicit guarantees in the case with EFSF) change the behavior of the banks towards more risky, because the real risk is not applied by them. Couple of years ago the banks owed negative assets in their balance sheets, related to the so-called sub-prime credits and their derivatives. Now once again they have toxic assets – this time because of the governments to be stucked in debt with a rising risk of default.

The differences between the current situation and that of the high tide of the financial crisis are not so big – neither in terms of problem assets, nor in terms of anticipated decision, exactly a rescue by the governments.

What is omitted, however, is that while there are such apparent or implied garranties for the governments and banks, these banks and governments will take the risk policies and exposures, because they will always be able to rely on salvation in the moment they look for it. The great hypocrisy (or using the better sounding euphemism “double standard”) is that on the one hand, we are always ready to help banks if they get stuck, but on the other – we plan to impose them a tax on financial transactions. The idea for this tax was accurately explained with the risky behavior of the banks and their role causing the recent crisis. However, it is not so much argued about the reasons for this risky behavior – namely, unlimited guarantees, which can the banks rely on, in case of difficulty.

Ultimately, what we find is a magic circle. Guarantees lead to more bad debts and fiscal abuse by governments, which, on their side, will require more guarantees from the European Financial Stability Fund, European stabilization mechanism or as it is called nowadays the rescue scheme. In that way, the banks will continue to buy bonds of countries in trouble and worsen the quality of their assets until they know they can rely on a rescue. And this behavior will require even greater guarantees for banks – apparent or implied. A spiral like this, which causes increasing of the debts and guarantees, is certainly not sustainable. The higher we climb on this spiral, the more painful will be the landing.