When you have a fire raging out of control it seems counterintuitive to try to contain it by setting yet more fire, but fire-fighters know that removing the availability of fuel around its edges will inhibit further growth of the central inferno. Economists seem to believe that a similar strategy will work to slow the rampant growth of debt in weakening economies, if recent rescue measures in the eurozone crisis are any indication. Is this a deliberate policy born of deep understanding and proven efficacy, or just a knee-jerk reaction to keep politician’s careers safe from the flames of economic disaster? As the eurozone crisis began to unfold, the focus of expectation for a quick bailout was firmly on the ECB. With its primary mandate to maintain price stability, e.g. keep inflation low within the eurozone, the ECB has the authority to issue euro banknotes and control liquidity in the economy. It does this by auctioning short-term contracts for cash to eligible banks – those that are able to meet strict collateral requirements.

Nowhere to turn
It soon became apparent, however, that weaknesses in the sovereign debt used as collateral in several member countries meant that their banks could no longer meet the requirements. The ECB stepped in with a controversial plan to take weak assets from member banks onto its own balance sheet, a move that was seen by many as inflationary. Pressure from some eurozone leaders for the ECB to continue supporting the euro by taking on more weak assets and off-setting them with calls on member states for increased capitalisation is contributing to a growing dispute over the bank’s role.

France, whose banks are heavily exposed to sovereign debt problems in the so-called PIGS zone, favours more involvement from the ECB. French Finance Minister Francois Baroin argued at a conference in November 2011, “The best response to avoid contagion in countries like Spain and Italy is, from the French viewpoint, an intervention [or] the possibility of intervention or announcement of intervention by a lender of last resort, which would be the European Central Bank.”

Not so, says Germany, which does not want to force its own relatively unexposed banks to take on more risk exposure through an increased capitalisation of the ECB. “The European currency union is based, and this was a precondition for the creation of the union, on a central bank that has sole responsibility for monetary policy,” German Chancellor Angela Merkel said. “I am firmly convinced that the mandate of the European Central Bank cannot, absolutely cannot, be changed.”

A second possibility, then, for increasingly desperate politicians, was the IMF.

Headquartered in Washington DC, the IMF includes all 187 members of the UN and has a mandate to help member countries meet balance of payments needs. Needless to say, it has been fairly busy responding to requests for assistance since 2008, including from within the eurozone.

According to an HSBC analyst, the IMF ‘as it is financed today is clearly not in a position to shoulder the bulk of any eurozone bailout plan.’ This is due partly to the fact that the eurozone is its largest donor, so as more member countries come to the IMF with cap in hand, their contributions are removed from the overall pot.

But the IMF is also responsible for aiding economies outside the eurozone that are struggling from the effects of the current financial crisis.

One solution that has been put forward is for richer economies to make an extraordinary contribution to the IMF, earmarked for use in propping up failing eurozone economies. Complex rules governing IMF funding activities, however, make it difficult for that organisation to be used in such a targeted way: it is not, for example, allowed to buy bonds in the secondary market, and contributing countries and organisations are not allowed to specify where their money will be used.

Blood from a stone
So, in May 2010, all 27 member states of the EU agreed to establish a third ‘special purpose vehicle’, the European Financial Stability Facility (EFSF), with a mandate to safeguard financial stability in Europe by providing financial assistance to eurozone member states in trouble. It was initially backed by guarantee commitments from the eurozone members to support a borrowing capacity of €440bn.

The solution of choice, it seems, is to borrow yet more money by issuing bonds through the EFSF; the capital raised will be used to make loans to eurozone countries on request, which they will use to cover their existing troublesome debts. Will this work? According to one eurozone spokesperson, “the EFSF is providing financial support, following well-established and well-known IMF practices, to buy time for a member state experiencing problems with getting fresh capital.” The hope is that reduced interest rates and extended payback periods on these loans will give the weakened economy time to get its fiscal house in order.

Remarkably, the €110bn bailout of Greece in 2010 fell outside the EFSF guarantees, yet looming crises in Portugal, Italy and Spain triggered a re-evaluation of both the size of its fund and its mandate. It had been estimated that if both Portugal and Spain needed to be bailed out, the fund’s lending capacity would have dropped from €440bn to just €240bn. At a special conference in October the total guarantees by all eurozone countries were increased to €780bn and the EFSF was granted new powers, including rights to offer pre-emptive credit lines to countries not under a bailout plan, to buy bonds of member states in the secondary market and to recapitalise banks.

There are problems, of course. The risk of default falls squarely on the shoulders of the guarantors, or more specifically, on the tax-paying citizens of the guarantor countries. In Slovakia, the head of the minority Freedom and Solidarity party, Richard Sulik, refused to approve the new deal, claiming it was “an attempt to use fresh debt to solve the debt crisis [and] that will never work. But for me, the main issue is protecting the money of Slovak taxpayers. We’re supposed to contribute the largest share of the bailout fund measured in terms of economic strength.”

The share of risk is divided among eurozone members based on complex ECB formulae but, critically, as members apply for assistance under the terms of the EFSF, their quotient of guarantee is absorbed and presumably redistributed among the remaining, already vulnerable members. Nor has anyone yet worked out what the implications are of the recent Standard and Poor’s withdrawal of nine eurozone country’s AAA ratings, along with the threat of downgrading the EFSF itself.

Thus far, the EFSF fundraising record has been mixed. Although it is claiming several successful bond sales in support of Ireland, Spain and Portugal, observers point out that its target of €3bn for Ireland was only met after the fund bought several hundred million euros worth of bonds itself. Sales in early 2012 reported strong interest, but at significantly higher interest rates than were offered on a sale in January 2011.

A wing and a prayer
This is where the fire-fighting analogy breaks down. Rather than removing fuel from the fire, the policy of providing low cost debt seems to be adding it. To theoretically avoid the danger that borrowing nations will simply use the cheap credit to pay for continued profligacy, the EFSF is talking tough on the issue of enforcement, but the real issue for the guarantor countries, and the entire global economy, is whether it can ensure that sovereign governments in receipt of EFSF (or ECB or IMF) funding implement the reforms needed to meet their obligations for fiscal prudence.

In order to get agreement from 27 different member nations, the authors of the enforcement terms in the EFSF agreement were somewhat vague. Before assistance can be given to a euro area member state, a support programme must be drawn up and unanimously accepted by the euro area finance ministers. It will only be approved under the strict condition that for the time the country is supported, the government will have to get its act together. Recipient countries will have to agree to quarterly visits and reviews by a troika of representatives from the IMF, the European Commission and the ECB who will arrive with a list of conditions and requirements that they expect to find. But what happens if the recipient country does not meet the requirements?

The punishment if the country fails to meet the requirements set for it, according to our eurozone source, is that the financial support will be withdrawn. It is difficult, however, to see how that can happen without triggering the immediate collapse of that sovereign economy, which would default on its obligations, triggering the guarantees of its fellow eurozone members. The prospect is not encouraging.

Under the new pre-emptive powers granted in October, the EFSF is able to intervene in secondary bond markets to support member states teetering on the brink at short notice, i.e. without the four to six weeks needed to negotiate a financial plan with the sovereign state’s government. Agreeing compliance terms after the fact could well be an exercise in futility.

Perhaps instead of studying economic theories, we should be looking to behaviourists for solutions. Through technology and clever financial wizardry, Western economies have managed to produce an unprecedented run of abundant years that have sustained not just a growing population, but a prosperous one. The trouble is, now that the abundant years are over, no one wants to volunteer to accept the hardships of cutting back. Politicians are no heroes. Unless we can find a way to ensure that everyone takes an equal cut there will be no easy solution.

A call for a single market
Austerity measures are not vote winners. They require a huge amount of political will and probably political sacrifice, something that is unlikely to be found among today’s career politicians, yet eurozone bureaucrats seem remarkably confident that the politicians will lead Europe through its crisis in the end. The interview with the above-mentioned eurozone spokesperson, who wishes to remain anonymous, continued something like this: What is the fallback if a recipient government doesn’t toe the line and the EFSF walks away? Presumably then we’re in a worse position than we are with the Greek crisis? Spokesperson: Right, but as a responsible politician, you would put the political cost much higher. What would happen if a country like Greece defaults? What would happen to the country itself and for you as a politician?

The country will implode and you will have no career? Spokesperson: Probably. You have to be aware that the consequences are worse if you risk going for the default, so you do everything to avoid this. Apart from all the political questions within your country, being part of the eurozone means you are also part of the EU.

You are very closely linked into the European structure and you have your obligations there as well as access to the market. I mean would you put that at risk? Do you think that if you don’t follow your reforms you can still be a member of the EU? I don’t know whether that is so easily possible, so I think you will do your utmost to follow up the terms and reforms.

But will that be enough? Several noted economists believe the euro is doomed. A recent OECD analysis of the euro project suggests that without a genuine single market across the EU the euro cannot function properly. It claims there is not enough price harmonisation or labour flexibility, pointing out that since the monetary union began the sovereign member economies have been diverging rather than converging. Other critics believe that the euro’s value is based on the relatively strong economies of its dominant members, making it too strong for weaker members whose economies are rendered uncompetitive as a consequence.

So the question is, should we just let the fire burn?