The great European experiment – still experimenting

The Eurozone is still struggling to avert crisis after billions of Euros in loans have been extended to its weakest members. Only two weeks after its most recent summit on 21 July, Italian and Spanish government bonds came under pressure leading to increased speculation that they may be the next countries to need a bail-out. More recently, France too is also appearing to be weakened as is Cyprus. European leaders continue to slowly chip away at a problem that seems to grow two sizes bigger with each seeming solution.

The main European vehicle to fund the struggling states of Greece, Ireland and Portugal has been the European Financial Stability Fund. The EFSF is a Luxembourg company and its stockholders are the Euro-zone states. Its remit is to raise money, primarily through issuing bonds, which it then loans to Euro-zone member states. The EFSF currently has a piggy bank of €440 billion to draw on, backed by collateral guarantees from the Euro member states up to 165% of their contribution.

In recent weeks, it has become clear that even at €440 billion, the EFSF is not big enough. Last week it was reported that the fund at €440 billion could not rescue both Spain and Italy. This week it was reported that the EFSF could only satisfy Spain’s debt over three years.  Add to that France and Cyprus and the present impossibility of the task of rescuing so many flailing economies is clear.

One leading investment bank has predicted three possible outcomes from here. The first, now a probability, is that the European Central Bank will intervene in the Italian and Spanish government bond markets to buy up bonds. If they fail to do this, yields on these bonds will continue to increase making interest payments unmanageable for these countries. However, the question is how long the ECB can do this and whether this measure will be effective. In the past when the ECB has intervened to prevent bond yields escalating it has only had a temporary effect and bailouts ultimately were necessary.

This leads to the second measure required: an increase in the size of the EFSF.  The same investment bank suggests that it would need to be increased to €3.5 trillion, a leading European think tank has suggested €4 trillion. The probabilities seem stacked against this solution at this point given the debt to GDP ratio it would require the EFSF states to take on. However, if one considers that European politicians prefer backroom deals which preserve their political capital at home, one might just imagine this is a possibility. After all, if the alternative is to tell their voters that the joint-currency is a failure less than a decade after its inception, you can see that the captains might just prefer to let the ship sink slowly.

As an alternative to the above two possibilities, there is the quiet whisper “Eurobond”, which would mean that Euro-area countries would jointly and severally guarantee debt issuance from all member countries. Although many believe this last solution could end the uncertainty that is causing so much instability in the Euro-zone, there is no European leader (that counts) that is prepared to spend their political capital on pushing it through. In the “saving” countries such as Germany, it is viewed as tantamount to giving financially wayward countries a blank cheque without any political control over how such economies would be brought back into the “black”. So at present, it appears the first two solutions are the more likely.

Assuming that the size of the EFSF is increased so that Spain, Italy, France and Cyprus (at present) could be “rescued”, there still remains the question whether Germany could extract the same measure of austerity from such countries. Remembering that at the very beginning, the very purpose of the European Union’s forerunner was to align German and French interests so closely that one could never attack the other again, it seems unimaginable that Germany could wield its power to force France into an austerity program with all the economic hardship and political instability that would entail. Also, given that these austerity programs take decades to be effective in reducing a country’s debt, how long would European leaders be able to insist on austerity in so many Euro-zone countries before the resulting political instability would end up affecting the Euro anyway?

Clearly at some point austerity measures will not be workable. This could be the tipping point that leads to the discussion of a fiscal union, essentially an agreement to transfer funds between European countries so that states such as Greece are floated by states such as the Netherlands. However, a fiscal union requires greater centralised tax planning and fiscal control. So just as the German Debt Management Office signs off on all loans from EFSF right now, you can be sure that Germany is not going to be giving away “free money” – it will extract the measure of political power it wants, in exchange for it bankrolling the weaker economies.

Countries which have adopted the Euro do not have any contingency planning for unwinding their currency union should it fail. Most agree that such a situation would be messy and perhaps less predictable than sticking with what we have presently. Therefore we should assume that those countries that are “in” the Euro will commit greater resources and relinquish more power in order to save it. Of course then the question of centralisation of power remains “when” and “how” not “if”.

Eye on Europe

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