Only the ECB can be a bazooka in Europe – EFSF is a tower of cards

2011-10-31

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In the latest summit, what was made evident is that European elites have agreed on three policy areas to respond to mounting market pressures primarily on Italy and Spain with France being in the horizon, who sees dark clouds gathering over its triple-A credit rating. These three areas of policy are (i) the leverage of the EFSF to expand its available funds (ii) the reaffirmation of the faith in fiscal consolidation, (iii) the impartiality of the ECB, in the sense of not allowing it to act as a lender of last resort. The rationale that permeates these decisions is that debts must not be monetized since that would (ostensibly) lead to inflation, but above all, it would be a very bad precedent regarding the responsibility each state has towards its own finances. In other words whatever deterring effect the impartiality of the ECB currently has vis a vis the fiscal responsibility of member-states, will vanish.

Though the concerns about the economic and political aspects of the matter are to a large extend spot on, the package of measures that European elites have in their mind, is logically and technically flawed. The reason is that it rules out a priori the option every currency area has to rely on its central bank, in this case the ECB, to act as a backstop to the free fall of states and the deterioration of the currency itself. In practice the drafters of the euro had erected a Maginot Line against inflation by creating a very conservative central bank, which current policy-makers do not even consider of revising (see Stricter rules are good – Stabilizing Mechanisms are much better). Our leaders are trapped in the fallacy of following the exact same dogma the drafters of the euro had, by producing measures to address inflationary pressures. This would have been very effective had the issue been one of inflation. The point here is that what we are dealing with and what our leaders fail to grasp is a series of existential pressures, not inflationary ones. Market pressures are mounting due to the lack of confidence in the euro architecture itself to overcome its own rigidities and institutional gaps. Inflation is secondary in importance when the very existence of the euro is challenged. It makes no difference at all to reinforce the Maginot Line, since the weak spot is elsewhere. That is the lack of a final backstop in Europe, a role only the ECB can effectively fulfill.

The EFSF which is supposedly the mechanism through which the fall of states will be prevented is from the outset an unstable structure as it relies on the guarantees of all member-states, including those who are in need of funds. In effect Italy, Spain and the three countries that are under bail out programmes, are providing guarantees to their selves, which are only accepted thanks to the combined gold-platted AAA credit rating of France and Germany, the eurozone’s two largest economies. The fundamental flaw in this structure is that France and Germany are in their selves in an unsafe position, since not even their own finances are very stable, either because of the exposure of their banks, which will indirectly bring the need for recapitalizations that have the effect of increasing public debts, or because of the burdens they carry with every country coming to the need of the EFSF, since those are the ones who provide the bulk of the funds.

The Achilles Heel in the EFSF is exactly its dependence on the triple-A credit rating of its two biggest contributors. France in particular has a banking sector that is heavily exposed to the debts of the European South, effectively raising questions of the capacity of the country to cling on to its excellent credit rating. These doubts are further reinforced by (i) the deterioration of Italy and Spain, with Italy being forced to lend money from the markets at an exorbitant interest rate of more than 6%, implying that the area’s third largest economy is making steps towards a bailout programme via the EFSF, (ii) the anemic growth in the whole euro area, which is to a large extend caused by the simultaneous fiscal austerity of all member-states, leading to a unique, euro-wide fallacy of composition, reinforced by the overall slowdown in the global economy. With respect to the latter, French President Sarkozy made reference to the need for further fiscal consolidation in his country, suggesting that the national economy will effectively enter a period of contraction. Understandably this setting, leads to a self-fulfilling path to depression, bringing down the whole system, unless some “Good Samaritan” (call me China) shows up. But a Good Samaritan will only show up, if the chances of saving the euro are also good, otherwise he will prefer to invest his capital in other ventures.

The only way to restore faith in investors that the euro will not implode, is by providing a credible backstop, a real bazooka so to speak, that will drive away whatever doubts may exist. Only the ECB acting as a real central bank, with all policy tools necessary can provide this ultimate resort. For as long as the system lacks a final backstop, markets will remain cautious and exponentially more investors will bet on the collapse of the euro, an ambitious project that was only safeguarded from inflation but was not sufficiently equiped to cope with a crisis of this kind.

The EFSF can never be the backstop in the region. It is nothing more than a tower of cards. The removal of a single card from its base, which practically is the credit rating downgrade of France, should things go for the worse – and they will – leads to the collapse of the whole edifice. Thus the EFSF will never be a bazooka, regardless of the funds it ultimately manages to have at its disposal. Only the ECB can restore faith in the markets and allow European elites to take a deep breath and search for solid and decisive ways to address all other issues, alleviated from the pressure they now have which leads them to the adoption of half-measures, and in many ways, of self-defeating policies.