Thoughts on the Eurozone situation...

Some excellent analysis in the FT of the basic problem with the Eurozone's 'rescue' deal announced in the early hours of yesterday morning from Wolfgang Munchau and Gavyn Davies. Basically, this deal won't decisively resolve matters because it doesn't involve either of two options to stabilise/backstop the funding requirements of Club Med: (a) the possibility of essentially unlimited fiscal transfer from north to south in the shape of 'joint and several' liability Eurobonds or (b) the ECB committing to buy as many peripheral bonds as necessary and run money supply growth at above-normal levels for several years to ensure reflation. This would essentially mean the ECB assuming a 'lender of last resort' function which it has thus far been very chary of taking on. Option (a) would stop speculative attacks on eurozone sovereign debt and buy significant time (by which I mean up to 10 years) for the eurozone to work through its problems and get it's debt and deficits under control by undertaking gradual supply-side structural reforms to pensions, benefits, and labour markets. Option (b) would essentially monetise the debts to a limited extent, reflating Club Med and allowing real wages in the periphery to fall, partially restoring competitiveness. But Germany and its brethren at the ECB are unwilling to allow inflation of say, 5% for 2 or 3 years to 'jump start' the peripheral European economies by inflating away part of the debt burden.

Instead of this, the Europeans have put their faith in the EFSF issuing partial guarantees (i.e. basically writing CDS) on Italian and Spanish bonds, and asking the BRICs and other Sovereign Wealth Funds (SWFs) to cough up on their behalf....one can only wonder what kind of person thinks this is a clever idea!! To deal with the second point first, the BRICs and any SWFs won't be interested in backing the EFSF if Germany is swearing off any further commitments....the Russians, Indians and Brazilians have actually said they won't be participating in any case. The Chinese may try to be helpful but they won't interested in bailing out Europe if Germany and the stronger European states aren't going to guarantee to take all the losses...and then we're back to Germany not wanting to increase its risk. As to the first point, re. guarantees, the idea is to have the EFSF guarantee by some means the first 20-35% of loses on Italian or Spanish debt. Straight away, the problem that stands out is that Italy's debt is 120% of GDP and it is the third largest debtor in the world - if Italy were to default, it would likely want to write off 40-50% of debt at a minimum to make the immense economic turmoil worthwhile and bring the number down to a manageable level (remember that, back in the mists of time, 60% was supposed to be the Eurozone ceiling!). If the EFSF were to guarantee 35% of the debt issued by Italy it could leverage itself just under three times (on the approx. €250bn remaining in the fund), yet Italy has gross public debt approaching €1.9trn, with an average maturity of 7 years... the problem should be clear... Italy will need to roll over €950bn of debt in the next seven years, yet EFSF capacity is at most €750bn when leveraged three times. Of course, you could leverage it four or five times, just as Angela Merkel has said, but then you run into the problem described above - will the market think that a 20-25% guarantee sufficient to protect buyers from losses in the event of default. And, don't forget, this is just Italy!...Spain's deficit and unemployment is so high that they will be trouble within a few years if this crisis isn't decisively put to bed...

So, my reason for drawing the rather somber conclusion that only Eurobonds or QE will do as a resolution to the crisis is as follows: Markets only respect money - i.e. trades, buying and selling power, but the good thing is, they do consistently respect money. If you're willing to anti-up, you will usually get your way, but the moment your money runs out (or heaven forbid, you're found to be bluffing), the markets will fall upon you with fury...as everyone discovered in the past five years. Hank Paulson's 'bazooka' and Fed QE worked in 2008-09, co-ordinated action by the G5 to weaken the USD worked in 1985, but you have to be willing to put up the readies. Note, you don't have to actually spend the money, but you have to show that you are more than willing to spend the money - then markets will move for you. That is why the Eurozone hasn't found a solution to its crisis...Germany (and France to a lesser extent) has been consistently applying the brakes - the speculative attacks on European sovereign debt won't stop until the market is convinced that a really big beast (read: Germany or the ECB, preferably both) is standing behind the weaker credits, ready to deploy their considerable firepower (estimates vary, but €2-3 trillion would likely be enough) to defend the system. Until that happens, we're just kicking the can further down the road...and closer to the day of reckoning, where international bond markets will finally ask the Europeans to put up or shut up...as to what form this will take - if European growth remains turgid, a speculative attack on OATs (French govt. bonds) would be my presumption. I very much hope that European leaders have the courage and foresight to do what is necessary to stop that day from arriving.