Monday, May 10, 2010

Europe blinks

The EU stared apocalypse in the face yesterday...and blinked. This weekend's summit represents policy turnarounds on three major issues.

One, the ECB has agreed (undoubtedly under pressure) to monetize government debt (by buying in the secondary market, but it has nonetheless lost its virginity). Such a policy was not contemplated when the ECB was established. 

This is a hugely positive step, because it represents a capitulation by the no-bailout hawks to the save-the eurozone doves. (Note that this does not represent a change in monetary policy, because the ECB will sterilize any such purchases.)  Because the ECB has unlimited resources in euros (because it prints them), it represents a highly credible source of stabilization.

Two, the eurozone has transformed itself from a currency union into a federal state, with the creation of an EMF guaranteed by EZ members on a pro rata basis. The size of the fund (EUR 500B) is sufficient to be credible, if consummated.

Three, the EU has made the IMF a full partner by inducing it to offer a backstop of EUR 250B, and thus letting it into the zone and giving it power to impose conditionality, as it is already doing with Greece. 

Will this work? Right now we're looking at a PowerPoint presentation rather than a treaty; there are many blanks to be filled in and many i's to dot and t's to cross. 

Some questions:

1. Will all member states agree (non-ez states must agree to release the EU contingency fund)? Will this fly with the German Constitutional Court?

2. The plan is for the EMF to issue bonds guaranteed on a pro rata basis, not on a joint and several basis. These bonds will be difficult to rate. You have an underlying credit that looks pretty bad, and then guarantees from countries with different ratings. Doesn't look AAA to me. Or will the ECB buy them without ratings?

3. Greece looks like a bad credit. If it defaults, will Ireland, Portugal and Spain have to pay up? What if they don't, or can't?

4. What happens when Greece misses its fiscal targets, as it will?

I think that this rescue will successfully postpone an explosion, but will not result in a permanent solution. 

Instead of allowing Greece to escape the eurozone and devalue its way out of its problems, this scheme will instead allow Greece to add further to its debt burden, making it increasingly insolvent, while degrading the creditworthiness of its creditors. 

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