Yet again, a sticking-plaster has been applied to the Euro Area (EA) when far stronger medicine is needed. The latest deal by European leaders may have calmed the markets, but the markets need a few days to digest it properly and when they do, they’ll be disappointed. The devil’s in the detail, some of which is not yet available and some of which is, frankly, unknowable.
Three critical weaknesses stand out: the 50% ‘voluntary haircut’ for Greek bondholders; the failure to ‘leverage’ the fund to the €2tr ‘target’ and—most important—Germany’s continued opposition to the ECB acting as lender-of-the-last-resort. In fairness, some progress has been made—but as with the outcome of the 21 July meeting, the package as a whole consists mainly of half measures falling far short of what’s really needed.
Mrs Merkel’s insistence on ‘haircuts’ has always been a populist ploy designed to placate the German public. As Andrew Watt amongst other has argued on this site, “so-called ‘private-sector participation’ has been the main channel of contagion from one country to the next and from the sovereign-debt to the banking crisis, and back again.”
The 50% voluntary haircut for Greek bondholders negotiated by the German Chancellor with the Institute of International Finance (IIF) has no binding force, which is why it is ‘voluntary’ and will not trigger the CDSs insuring bond repayment. But, when push comes to shove, there’s no reason why bondholders should accept a 50% cut in lieu of a full (or nearly so) insurance payout—and it only takes one major institutional bondholder to reject the ‘deal’ for the house of cards to collapse. Moreover, the whole deal is predicated on reducing Greece’s debt-to-GDP ratio from 160% at present to 120% by 2020. Even assuming the Greek public accepts further pain—and remember there’s a general election in 2013—it’s unclear that a 120% debt ratio will give Greece access to market funding once again.
Turning to the €2tn ‘big bazooka’ meant to shock and awe the markets, what we have in its place is a shakily leveraged €440bn (of which only just over €200bn is effectively available) turned into an €1tr insurance fund covering the first 20% of a loan. Will this sum convince the markets that sovereign debt is now worth buying? The answer lies somewhere between ‘possibly not’ and a ‘definitive no’ depending on how much of an optimist you are.
For those who now fear that the product is too reminiscent of sliced and diced mortgage bonds (aka CDOs), the logic runs as follows. The problem with CDOs was that by 2008, nobody quite knew what they contained and thus how toxic they really were—if you will, how much poisonous bad meat the sausage contained. In this case, nobody quite knows, how much contagion a default (say, by Greece) would bring—eg, would it spread to Italy and then France?— and therefore how much of a haircut they would take on what are currently seen as low-risk sovereigns. If a first default were to lead to serious contagion, insuring the top 20% slice of (say) an Italian sovereign might be far too little.
There’s another problem too. Even assuming only €1tn is enough, the money has yet to be raised, mainly from outside Europe. The big EA countries like France cannot guarantee further funds without risking the loss of their AAA credit rating. This is the main reason for building into the deal a Special Purpose Vehicle (SPV) designed to tap money from the BRIC countries, particularly China. Will the Chinese buy into a shaky insurance fund? Perhaps—but perhaps too, they will want guarantees from the ECB.
This brings us to the elephant in the room: the ECB. Mrs Merkel has doggedly resisted the French proposal that the ECB act as lender-of-the-last-resort, although it is precisely such a role that central banks like the Fed and the BoE play. Although the ECB has been allowed to make limited sovereign bond purchases, it has potentially unlimited funds, enough to guarantee all sovereign bonds. Not only could it borrow on international markets if authorised to do so, ultimately it could print money. As any first-year economics student knows, countries with their own currency can’t go broke because they have recourse to their Central Bank. But Mrs Merkel and most of her advisers believe that the ECB, like the Bundesbank before it, must be independent and focus entirely on fighting inflation (an ideological relic of the 1980s Washington consensus).
The Belgian economist Paul De Grauwe has summarised the situation admirably:
Surely once the ECB decided to buy government bonds … [it] should have announced that it was fully committed to using all its firepower to buy government bonds and that it would not allow the bond prices to drop below a given level. In doing so, it would create confidence. Investors know that the ECB has superior firepower, and when they get convinced that the ECB will not hesitate to use it, they will be holding on to their bonds. The beauty of this result is that the ECB won’t have to buy many bonds.
As long as Germany continues to deny the ECB its central role in resolving the Euro Area’s problems, the crisis will continue. Will Mr Draghi, the ECB’s new head, follow the Germans over the abyss when, as will surely happen, the big bazooka is needed for Italy?
 See Watt: http://bit.ly/u0EMQr
 See Treanor: http://www.guardian.co.uk/business/blog/2011/oct/27/voluntary-haircut-greek-bondholders
 See Münchau: http://on.ft.com/rV8vTW
 See Gavin Davies: http://blogs.ft.com/gavyndavies/2011/10/27/emu-summit-leaves-e1000-billion-to-be-raised/#axzz1byk4pA7e as well as his earlier piece at: http://blogs.ft.com/the-a-list/2011/10/19/the-eurozone-rescue-fund-is-still-not-big-enough/#axzz1brzy6Qdx
 See De Grauwe: http://www.socialeurope.eu/2011/10/european-summits-in-ivory-towers/