CHAPTER 2

International Management of Europe’s Financial Crisis: The Role of the “Troika”

David Gordon and Douglas Rediker

The European financial crisis remains the single most dangerous economic risk—with powerful geopolitical implications—for 2012 and potentially for years to come. The notion that imprudent banks and other investors lending to highly rated European Union sovereigns could generate global financial/economic contagion and the potential collapse of the euro zone would have been considered alarmist bordering on absurd only a few short years ago. But perhaps more intriguing—and troubling—than the origins of this crisis has been the absence of a central entity to keep tabs on, anticipate, and address/prevent such economic crises from spiraling out of control; equally so has been the inability of the main crisis-management structure that has emerged in the crisis—the “troika” of the International Monetary Fund (IMF or the “Fund”), the European Central Bank (ECB), and the European Union—to provide a pathway forward for resolving the crisis. After all, global imbalances and debt crises are nothing new. This essay explores how the troika emerged as the crisis management group for the euro zone crisis, the challenges that this has posed for its component members (especially the IMF), and the continuing fundamental credibility challenges that will likely come to the fore in the remainder of 2012 and into 2013.

BIRTH OF THE TROIKA

Since the end of World War II the broad financial-crisis management function has been basically undertaken by the United States and the International Monetary Fund working in close collaboration. But the euro zone crisis revealed a growing unwillingness and/or incapacity of the United States to play a leadership role, while the supranational European entities (the European Commission, European Council, and the European Central Bank) and individual European states have sought to solve the crisis while also maintaining their financial autonomy and keeping the IMF involved in, but not in charge of, the crisis response in Europe. Institutions such as the ECB and the arms of the European Union—the European Commission and European Council—have served as a means to engage with, but also as a buffer for, member states to soften the potential impacts of globalization and multilateral institutions like the IMF.

While initially rejecting the need for international expertise, funding, and engagement as the European crisis deepened in 2010, European political and financial authorities recognized that they lacked both the financial resources and the credibility to manage the crisis on their own and were forced to partner with the IMF. Thus, the troika was born. It is a historically unique hybrid of global and regional institutions, as well as an uneasy mix of political, financial, and monetary actors. Cooperation between these three players has never been easy and consensus was far from assured—the European Union and the Fund both had to compromise some of their initial mission by working with the other, and the normal role of a program country’s central bank, traditionally seated across the table from the IMF rather than on the same side, has been inverted. Cooperation has seen some successes and the worst of the potential outcomes have thus far been averted. But missteps, competing mandates, and weaknesses among the troika have ultimately prevented a resolution of the crisis, and longer-term outcomes and impacts remain highly uncertain.

The European financial crisis has posed serious challenges to the IMF, which is used to being the “senior partner” when working in conjunction with other global and regional entities, such as the World Bank, the European Bank for Reconstruction and Development, and the Inter-American Development Bank, in country-level financial-crisis response efforts. The IMF has been at the center of global financial stability since its creation after World War II largely because of the market belief in the independence of the IMF’s financial analysis and its overall credibility as a “global truth teller.” Prior to approving financing, the Fund models a nation’s economic future to determine whether the country in question can be credibly put on a path to financial health. Only if a sustainable trajectory legitimately exists is the IMF supposed to make financing available, with progress ensured by regular reviews. The Fund thus provides both a carrot and a stick, with the former certifying the sustainability of a recipient’s path and the latter used to keep the recipient firmly on that path, allowing distressed economies to maintain or return to global markets and access the private financial flows crucial to economic growth and continuing debt service. If the Fund’s analyses are not seen as credible and objective, an IMF program will not spur the private-sector funding without which no Fund program can be successful.

However, in its relations with the ECB and the European Union within the troika, the IMF has been put in the uncomfortable and uncharacteristic position of not singly steering the course of crisis management. Working together with two political and regional entities (which themselves are burdened with complicated and imperfect governance structures) has created the risk that the IMF will be accused of turning a blind eye to financial realities so as to fend off political pressures. It is this risk that compels a discussion of the troika’s competing mandates and weaknesses.

THE IMF’S PARADOX

When the Fund was brought directly into euro crisis management in 2010, supporters believed that its engagement was needed to address Europe’s debt crisis before it spun out of control. In the last two years the IMF has, in fact, played a central role in reducing the risk of a European financial meltdown. At the Fund’s spring meetings in 2012, the question of whether to bolster IMF resources (implicitly to enable it to continue to play a key role in Europe) dominated the agenda. In the end, sixteen countries plus the euro area agreed to commit to more than $450 billion in additional Fund resources to take on this crisis and its progeny. That amount represents a roughly 150 percent increment over the Fund’s entire quota-based resource pool only five years earlier. But, while the resource enhancement appears significant, the potential erosion of market confidence in the independence of IMF financial analysis as a result of its partnership with the European Union and ECB could render these additional resources a sideshow; threat of a loss of Fund credibility could provoke a far greater loss of market confidence, threatening the Fund and the entire global financial system.

Paradoxically, the IMF’s predicament arises directly from its success over the past two years in its engagement in the collective response to the European debt crisis. Tarnishing the Fund’s apolitical, objective image by working in tandem with the European Union and ECB makes private creditors leery of engaging IMF-supported countries and potentially increases the risk that an IMF program could end in failure. Danger signs abound. The market’s initial negative reaction to the Greek debt swap and rescue package of early 2012 and subsequent political setbacks and economic disappointments that suggest that their skepticism may have been well founded indicate that a loss of market confidence in the IMF may already be happening.

In March 2012, when holders of Greek government debt were cajoled into exchanging their bonds for new longer-term paper with lower yields, international institutions labeled the debt swap a success, and the IMF approved its portion of the second bailout for Greece. But immediately after the exchange, the new (supposedly safe) Greek bonds plummeted in value to a level roughly equivalent to where pre-exchange debt had traded. It was a clear indication of market belief that Greece’s financial position was no more sustainable than before the new program and debt swap—and a direct rebuke to the IMF. As it turned out, Greece’s adherence to the program was delayed, in part by a political climate that required two elections in rapid succession, only to result in an uneasy coalition of parties that had historically viewed one another with suspicion bordering on outright hostility. That the Greeks could fall so far off track in their IMF/troika program so quickly, and that the markets immediately saw through the facade and correctly anticipated this dynamic, was a telling sign and one that did not receive the attention that it warranted.

The episode is eerily reminiscent of the IMF’s overlending to several African countries in the 1980s, the most important sustained failure in the Fund’s long history. When the IMF, prodded by the United States and other Western donors, provided significant funding to many countries in Sub-Saharan Africa, it ignored the foundation of its credibility: its financial objectivity. The IMF’s own staff warned that recipients such as the Kenneth Kaunda regime in Zambia and Mobutu Sese Seko’s Zaire were not willing and able to undertake required reforms. Yet the Cold War political concerns of the Fund’s primary donors won out, and the programs went ahead. Trumpeted by Western governments as a positive move, it became a disaster. Markets saw through the questionable assumptions underlying the IMF programs and refused to reopen financing. The result was a widespread loss of credibility, both for the Fund and for recipient countries, leading to large-scale debt restructurings and forgiveness in the 1990s.

Thankfully for the world economy, the sums involved in the African transactions were relatively small, the recipients were not systemically important to the global financial system, and the Fund was able to retain its broader market credibility. The scope and scale of today’s IMF programs in Europe are far larger and far more threatening.

In working with the European Union (a political organization) and the ECB (both an overseer and a market actor), the IMF has been asked to reconcile its financial objectivity with its partners’ disparate agendas. With the European Union and its dominant member states intent on using financial crises to force political changes in the euro zone periphery and beyond, the Fund has found itself in the middle of precarious political situations.

In addressing immediate crisis risks, it can be argued that cooperation among the troika has been successful. But it is an open question whether successful short-term crisis management is worth the risk of squandering market belief in IMF independence. Despite its surface appeal, ongoing acceptance of overly optimistic assumptions contained in the IMF’s economic models for Greece risks creating the vicious cycle seen in the bond exchange, in which markets do not believe in a solution that requires their confidence to be effective. Let’s be clear: The IMF, even with enhanced resources, does not, and will never, have enough resources to address Europe’s financial problems. It shouldn’t. Any solution should necessarily require market funding and, by definition, market confidence, to work.

But the more that political concerns are perceived to influence IMF analyses, the more skeptical that markets will become. This scenario poses a severe threat to the ever more integrated global financial system. If markets lose faith in the IMF’s independence, then the Fund will likely fail in stemming future economic crises—and maybe even the current one. Under the leadership of Christine Lagarde, the IMF appears to be moving in the right direction, having withdrawn the “commitment” of the Fund’s prior managing director to finance one-third of all European rescue packages, and its emphasis on restoring the integrity of European financial institution balance sheets has been seen as a means for the Fund to reassert its independence and financial objectivity.

Over the past year, all three members of the troika have started to take steps toward loosening the Fund’s partnership with other troika members. Most recently, discussions about how to address concerns about the health and market access for Spain and Italy have resulted in open discussion of the IMF playing a more technical and less financial role in future bailout programs. More broadly, the ECB’s recent announcement that it will engage in outright monetary transactions (OMTs), without limit, serves to shift the balance of responsibility back to European institutions and resources—not the Fund. While continuing coordination with the other troika partners, the Fund has moved in the direction of making clear that on financial matters, it remains in sole command of how its resources will be deployed. These steps are critical if the IMF is to help European countries restore investor confidence in their debt.

WHO WILL LEAD IN EUROPE?

So, if the IMF, having risked its reputation, independence, and credibility in support of its European troika partners, lacks the funds to save Europe, what about the actions of the Europeans themselves? Recognizing what is at stake, many Europeans argue that E.U. countries, especially Germany, have moved well beyond previous red lines to put their money where their union is. They have created and funded rescue mechanisms to take on the worst of the problem and ensure that the crisis remains contained. Over the past two years, over the objections that the underlying treaties that govern the European Union and the euro prohibit “bailouts,” Europe has, in fact, proposed and implemented several mechanisms to do just that. The Europeans have repeatedly and proudly announced that they have created a “firewall” that will address concerns surrounding the financial viability of euro members. Political leaders in Europe do not understand why the markets remained skeptical.

But market skepticism was born of a belief that Europe’s actions do not quite match up with European rhetoric. In part, that is because the European “firewall” is not as strong as it looks. Europe’s two rescue funds, the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM), have been rolled out to great fanfare. In some cases, they have also drawn criticism within individual countries, where they are seen as large pools of taxpayer money that are being transferred to governments that find themselves a bit short. The 440 billion EFSF was established in 2010, and the even-larger 500 billion ESM was announced earlier this year and is intended to succeed the EFSF in the near future. Yet markets are skeptical, because both are much less than meets the eye.

The EFSF has no paid-in capital: it’s really nothing more than a pool of guarantees from several euro zone members. To provide funds to needy countries, the EFSF is supposed to raise money on capital markets. But it doesn’t have a great track record for doing so. This is not surprising, as few investors want to lend long term to an uncapitalized entity set to expire in a matter of months, with no predictable cash flow and ultimately based on a dwindling pool of highly rated guarantors. As a result, though the EFSF is authorized to borrow up to 440 billion, it has raised far less (only about 30 billion as of mid-2012), and a significant portion of these funds have been raised on much shorter maturities than the terms on which they are being lent. In the absence of cash, the EFSF has used its own bonds as a proxy for cash. For example, in the Greek bond exchange, some 35 billion of “cash” was actually provided in the form of EFSF bonds. The Spanish bank bailout program may well follow a similar course. Such “funny money” can be forced onto domestic investors participating in an already coercive debt exchange or used to recapitalize banks that have no other option, but investors who have a choice will not easily accept it is a substitute for the real thing.

The ESM presents a similar story. For starters, its ratification has been significantly delayed due to an ultimately unsuccessful constitutional court challenge in Germany, the most financially and politically powerful country in the European Union. But even once it is ratified and commences operation, the ESM’s ostensible 500 billion in funding will be mostly a chimera. The ESM is structured so that 80 billion will be contributed by euro zone countries as “paid-in” capital (via five payments over a period of thirty months), with the remaining 420 billion deemed “callable.” On the basis of this “call” the ESM is supposed to raise most of its funding in the capital markets. The benefit of this structure is that, under E.U. accounting principles, the “call” is not calculated as a budgetary item unless and until it is actually called—which is never supposed to happen—and so it won’t weigh on already strained European balance sheets. So the markets are supposed to fund some 420 billion to the ESM on the basis of financially engineered guarantees provided by the remaining creditworthy euro zone members—several of which, of course, are likely recipients of any money that the fund actually ends up raising. While the ESM funding structure was modeled on the European Investment Bank, which has successfully used this funding structure for years, the EIB lends to commercial projects with real cash flow, not to countries in dire straits.

Europe’s own bailout funds are thus largely built on unfunded commitments augmented by assumptions that capital markets will provide enormous amounts of money under the worst possible circumstances at the time of most acute market stress. There’s not enough time or investor appetite for the EFSF or the ESM to borrow as much as might be needed, and the euro zone states have limited-to-no capacity or willingness to prefund these vehicles. While some type of explicit German guarantee of the rescue funds would likely spur considerable investor interest and lead to sufficient capitalization, Germany can’t and won’t provide such a guarantee. The rescue funds will, in the end, likely manage to convince some investors rolling out of maturing European sovereign bonds to reinvest their capital in these new, somewhat more secure, vehicles, but they just aren’t the backstop that their creators claim them to be.

WHAT ABOUT THE EUROPEAN CENTRAL BANK?

As neither the IMF nor the European Union, through its EFSF/ESM, will be riding to the financial rescue of Europe’s weakened sovereigns and banks, all eyes are increasingly focused on the last member of the troika—the European Central Bank—which does, at least potentially, have the capacity to provide the funding and virtually unlimited positive influence on Europe’s debt crisis to save the day. The ECB can be counted on to be the lender of last resort—the “good guy,” ready to do the right thing—can’t it? At the time of this writing, the ECB has actually stepped up and provided an enormous fillip to the euro zone, significantly altering the trajectory of the crisis and its possible outcome. But, while the ECB has stepped in where others have fallen down, its ultimate role remains cloudy, the crisis remains daunting, and the ECB’s shooting star may yet fizzle.

In assessing the ECB’s role in the troika and in the euro crisis in general, it is important to note that when the euro was created, its original sin could be traced to the ECB itself—through its willingness to blindly provide cash for all euro zone sovereign debt from euro system banks, declaring it uniformly “riskless.” This is the central flaw in the creation of the euro.

From that disastrous, and often overlooked, starting point, over the past year, the dominant narrative of the European crisis has been that the ECB is a reluctant but ultimately willing savior, and that it has strategically deployed the arrows in its quiver to stem the crisis as it sees fit while staying within the bounds of its articles, bylaws, and established mandate. To be sure, the ECB has at various times proactively provided a much-needed response to crisis when things looked particularly bleak. With its loosening of collateral rules, bond purchases through the Securities Market Program (SMP), two long-term refinancing operations (LTROs) for European banks, in December 2011 and February 2012, and its recently announced (and potentially unlimited) OMT initiative, the ECB has already assumed well over $1 trillion in exposure to provide crucial liquidity to creaking European financial institutions and, by extension, to sovereigns. When he announced the OMT in the summer of 2012, Mario Draghi, the bank’s president, pronounced that the ECB would “do whatever it takes” to preserve the currency union; and the markets have reacted favorably. But here’s the thing: while the ECB may finally have provided the ultimate backstop to the crisis where before there was none, the ECB was, until recently, at the center of one of the most vexing problems that has shut distressed sovereigns out of the markets.

In 2010 the ECB began purchasing Greek bonds through its SMP in an effort to help drive down Athens’s borrowing costs (that this was seen at the time as a potentially effective intervention for Greece shows us just how far the situation has deteriorated). Through the SMP, the ECB is assumed to have paid roughly seventy cents on the euro for its Greek bond purchases. Yet, at the time of the Greek restructuring in March 2012, when virtually all other bondholders were forced to take a massive loss (a “haircut”) on their holdings, the ECB refused to participate, citing its prohibition against “monetary financing.” The ECB not only refused to share in the loss, it refused to consider selling back the bonds to the Greek government at the discounted price it had paid in the market—a structure that would not have cost the ECB a penny but would have reduced Greece’s debt by a meaningful (though insufficient) amount. Rather, the ECB declared itself senior to all other creditors (except the IMF). Other troika members reluctantly agreed.

Unfortunately, once the ECB declared itself senior, this meant that everyone else was suddenly junior. This set a precedent that became a significant concern to every market player already wary about providing continuing finance to European countries that desperately needed it: the ECB’s—and potentially all other official sector lenders’—seniority and the risk of subordination. As long as market players believe that any debt they hold will be treated less favorably than the equivalent debt that the official sector holds, they will worry about being paid back, and holding the debt will seem that much less attractive. The ECB’s after-the-fact declaration of seniority thus created a serious impediment to investors returning to the peripheral sovereign debt markets and relieving the funding pressure on distressed economies and financial institutions.

In announcing the OMT and other related crisis-response measures in September 2012, ECB president Mario Draghi has now provided assurances that these subordination concerns will be addressed. According to the ECB, in spite of its previous actions, investors should no longer fear being treated worse than the ECB, or than the rest of the increasingly large official sector holders of European sovereign debt, when they are asked to provide financing to European governments. However, as details remain scarce, it remains unclear how the ECB will reconcile this with its previous position that it had no ability to negotiate this point as monetary financing was absolutely barred by its statutes. The IMF’s and European Union’s inability to get ahead of the markets and put an end to the crisis is rooted, in part, in a lack of financial resources. It remains to be seen whether recent bold steps by the newly assertive ECB, over the objections of the German Bundesbank, its most significant member, is willing to put at risk its own sacred cows and institutional interests for the sake of the greater good of the euro zone.

THE BIGGER PICTURE

The stability of the broader financial system, jobs, growth, and general well-being remain in danger. Despite postsummer optimism borne on the back of the ECB’s bold announcements, but with little in the way of specifics, there remains a risk that Europe’s crisis could still go global. The construction of the troika was a worthy and necessary collaboration in crisis management. While the close cooperation of the IMF raises concerns for the Fund’s future independence and credibility, the European Union’s and ECB’s initial willingness to take moves toward cooperation with this august multilateral international financial institution at a moment of dire need was a welcome move. Between and among these actors, financial, political, and monetary considerations are represented on both a global and a regional basis, and financial firepower and policy-making tools can be brought to bear. This is all to the good. But, as we look to the end of 2012 to 2013 and beyond, the crisis remains as yet unsolved. Rather, three vastly powerful institutions and entities remain locked in a complicated dance in which each must balance its own self-interest against the greater systemic good. Until now, the crisis has been characterized by short-term politically motivated responses, which have papered over fundamental disagreements and narrow self-interest. While perhaps a political necessity and despite the troika’s best efforts, these responses may still worsen and deepen the crisis.

The internal dynamics of the troika serve as a case study in the risks of a so-called G-Zero world, one in which there is not enough global leadership to create long-lasting solutions to a major financial crisis and where short-term political influences overwhelm the need for governments to address fundamental structural flaws and to put real money on the table—concrete policy and financing responses that will allay market concerns and keep the system running. Best intentions aside, we can’t yet know whether the troika mechanism will one day be seen as a positive effort in flexible, adaptive multilateralism or as a harbinger of ad hoc alliances where compromises build on one another and risk lasting damage to the fragile foundations of a posthegemonic world.