It’s too early for Europe’s leaders to crack open the Champagne

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By Ian Fraser

Published: QFINANCE

Date: 26 July 2011

The package of measures thrashed out by French president Nicolas Sarkozy, German chancellor Angela Merkel and other European policymakers at their emergency summit on July 21 was immediately hailed for its boldness. After months of prevarication the continent’s leaders seemed to have pulled out all the stops in their bid to save the euro.

Perhaps they had little choice. Ahead of the summit, there had been bloodcurdling warnings of economic Armageddon if Greece was permitted to go bust, with mounting fears of contagion across southern Europe, including a spiking of bond yields in the “too big to save” countries of Italy and Spain.

To recap, the EU package included:

  • A second, €109bn bail-out for Greece lasting until mid-2014 (banks and other private sector investors to contribute €37bn; €12.6bn to come from bond repurchases at below par)
  • Less punitive interest rates for all three of the bailed-out eurozone countries.
  • An insistence that Greece is a special case and that other eurozone countries are committed to meeting repayments on their debts.
  • Loans from the European Financial Stability Facility to have their maturities extended to 15-30 years.
  • A commitment to finance countries that accept bail-outs for as long as it takes for them to regain market access.
  • The EFSF’s role to be expanded so it can buy eurozone bonds on the secondary market; lend direct to countries before they lose market access; finance bank recapitalizations.

The package calmed markets and triggered a “relief rally”. However, the ink was barely dry on the Brussels agreement when critics and bond vigilantes started to unpick the basket of rescue measures.

Raoul Ruparel of the Open Europe Foundation dismissed it as mere window-dressing that did nothing to sort out the fundamental problem of Greek insolvency, while others expressed concern that, even though the EFSF has been made more flexible and given an enhanced role, its size remained the same.

There were also concerns that the process for approving bond purchases by the EFSF is too cumbersome. Under the agreement, all eurozone governments must give their blessing to such purchases before they can happen — and the European Central Bank must also reassure itself that eurozone financial stability would be at risk without such repurchases.

Within a matter of days, the scheme appeared to be unravelling, with even IMF managing director Christine Lagarde acknowledging that “there is still a level of uncertainty” about it. She said this was because the agreement was “complicated” and because “there is still work to be done.” Matters were not helped by uncertainty over the US debt ceiling. In a speech in New York on July 26, Lagarde said: “The agreement shows that European leaders believe in the eurozone, and will do what it takes to secure its destiny. It has been welcomed by financial markets, as reflected in the stronger euro and lower peripheral bond spreads. But turbulence could easily resurface. For this reason, it is essential that the summit’s commitments should be implemented quickly.”

On cue, the markets started to push up yields on various types of Italian and Spanish debt, with the yield on their 10-year bonds country rising back above the 6% level last seen before the Brussels declaration.

So has the EU’s package already failed? It’s probably too early to say, but the signs aren’t encouraging. The German chancellor Angela Merkel (pictured above) would have us believe that Europe’s leaders had finally tackled the “root problem”. However, this is wide of the mark. As the Daily Telegraph‘s Ambrose Evans-Pritchard pointed out, the Brussels deal skirts around the ‘elephant in the room’ for the euro (the flawed way in which the one-size-fits-all currency was constructed and the dangerous assumption its existence would cause member nations’ economies to ‘converge’).

Evans-Pritchard wrote: “The root problem is that vastly disparate nations with different growth rates, productivity patterns, debt structures, sensitivity to interest rates, legal systems, wage-bargaining practices, and inflation proclivities were meshed together by Hegelian politicians acting against the warnings of the Bundesbank and the European Commission’s economists. The magical convergence did not occur, as any historian of Italy’s lira bloc, or Spain’s peseta block, or Britain’s sterling bloc might have foretold.”

The Economist’s Free Exchange said that the real issue is that peripheral Eurozone countries are being “squeezed from two sides”. “With the cost of debt rising and economies contracting, debt burdens are growing ever less manageable. Markets are understandably reacting by demanding a higher risk premium, which increases borrowing costs, prompting new austerity measures, which reduce growth. What’s actually needed (if the eurozone is to be preserved) is a much greater level of fiscal burden-sharing … What is clear is that until the eurozone demonstrates its awareness of the stresses imposed by currency union and its preparedness to build the machinery to offset them, markets will continue to question the union and push it toward dissolution.”

So even though Merkel, French president Nicolas Sarkozy and their fellow eurozone leaders are proud of the impressive package of measures they unveiled last Thursday — and even though it was head and shoulders above the Band-Aid-style solutions seen so far — it looks like something much more radical is going to be needed if the euro is to have a long-term future.

This article was first published on QFINANCE on July 26, 2011

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