This evidence of contagion is a negative situation. The problem is that current bailout funds won't cover the size of these larger markets if Spain and potentially Italy need a bailout.
What does Europe need to stem contagion?
We believe that several major tools are required to stem contagion, but due to the political and legal barriers, more market turmoil is likely before those tools are used. Here are the major tools currently under consideration:
- Europe-wide deposit insurance. In our opinion, this should be a priority. Among the principles of the formation of the European Union (EU) was the free movement of capital. Therefore, there is no law to prevent outflows from Greek banks to Germany or the United Kingdom. Another sign of contagion is the current slow-motion outflow of deposits from banks in Greece, Portugal and Spain, where depositors may be concerned about the safety of their funds. Further weakening of banks in economically pressured countries can reinforce an economic contraction. Therefore, a Europe-wide deposit insurance program could help instill confidence in banks and stem the outflow from weaker economies to stronger ones. However, it would likely require parliamentary approvals, so this probably isn't a short-term solution and could encounter political opposition. A deposit insurance program may be on the docket for the next EU summit in late June. Eventually, this program may require a full banking union with common supervisors and methods to get rid of insolvent banks.
- Recapitalizing European banks with EFSF/ESM bailout funds. Currently, the European Financial Stability Facility (EFSF), and the European Stability Mechanism (ESM) that will begin to replace it in July, can't be used to recapitalize banks. Countries receiving EFSF funds must submit plans to the International Monetary Fund (IMF) showing how they'll adjust their economic policies to ensure repayment of funds. However, IMF Managing Director Christine Lagarde has indicated her support for using the EFSF/ESM to lend directly to banks. The issue is that the ESM may not be sufficiently large to protect both Spain and Italy.
- Giving the EFSF/ESM bailout funds a banking license to increase firepower. We believe this could be beneficial because the EFSF/ESM alone is not likely large enough to give markets confidence. Allowing the EFSF/ESM to borrow from the ECB and leverage its capital like a bank could exponentially increase its firepower. The ECB currently resists this idea, but if the financial system begins to break down, the ECB could use the goal of stabilizing the financial system to resort to non-standard measures. While a longer-term solution would likely need euro bonds, we believe there would be less political and legal resistance to giving the bailout funds a banking license, enabling it to be put to use in a quicker time frame than euro bonds.
- Euro bonds. The concept of euro bonds means that eurozone countries jointly issue debt with the assumption that as a group, the bonds would be better received by investors (and thus carry lower interest rates than individual peripheral countries) because the group as a whole would be responsible for backing that debt. However, there are at least two major roadblocks to euro bonds. The backing, or guarantee, would likely be opposed by taxpayers and politicians of financially stronger countries. On the other side, since fiscal budgets would likely be reviewed at the eurozone level, weaker countries would probably be subjected to the scrutiny and demands of stronger countries, losing a portion of their sovereignty. The fiscal pact agreed to earlier this year is a small step in this direction, but lacked enforcement measures. Germany's proposal for a European redemption fund may be the first step toward euro bonds.
Could the ECB re-use prior tools?
The ECB used two other major tools earlier in the eurozone debt crisis: the three-year loans termed long-term refinancing operations (LTROs) and purchases of sovereign government debt on the open market. However, we doubt another LTRO or renewed bond purchases would be sufficient. Either the ECB or the bailout funds of the EFSF/ESM could be called upon to purchase bonds at some point, but we do not believe that bond purchases would be sufficient to stem the crisis because the problem of undercapitalized banks would remain. Additionally, we've already seen that the last LTRO only bought two months of reprieve.
Will the Federal Reserve of the United States act?
In the event of a disorderly Greek exit and financial system dysfunction, we believe the Federal Reserve could participate with other central banks in a broader coordinated action to stabilize the system.
What are the arguments for keeping Greece in the euro?
Some people have wondered why Germany, for example, should bother to continue supporting Greece instead of encouraging its exit from the eurozone. It's important to note that, while Germany bears the biggest burden for any bailout, it's also one of the biggest beneficiaries of the euro. Using data from the German Federal Statistical Office, we calculate that a majority of Germany's growth over the past decade has come from exports. Germany wants to avoid contagion that could result in the collapse of the euro, as a reversion to the Deutsche Mark would likely result in a higher valued currency for Germany, hurting the prospects of German exporters.
