The aftermath of the October 26 Euro Summit – No Solution

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Expectations were very high prior to the latest EU summit. Mostly because of the severity of the moments and the urgent need for a solution. Expectations were also raised by the promise of French President Sarkozy and German Chancellor Merkel, to deliver a ‘comprehensive’ plan that would finally draw a line under the crisis. In addition the sheer length of the summit was remarkable by EU standards, as it nearly lasted a week, with countless meetings taking place prior and in-between the two-leg official summits of October 23 and 26, giving the impression that Europe was preparing to act big.

Despite the growing expectations of the markets and the mounting pressures in the economy, European elites did not deliver any ‘comprehensive solution’. All they announced was that they have either agreed or are committed to agree on certain principles regarding seven issues. It is important to analyze paragraph by paragraph the official document about the Main results of the Euro Summit to realize the qualitative difference between an agreement on areas of policy that European elites consider important and an actual solution. Emphasis will be given by myself on important phrases of vague or triumphant rhetoric, which however lacks substance since nothing tangible was actually announced. The sad reality is that this summit was yet another failure to act from the side of European elites.

Starting from the first paragraph (all points are taken from the official document about the Main results of the Euro Summit – Note that another 14-page document was published, which will also be used as a reference in paragraphs/points 3 and 6):

1. An agreement that should secure the decline of the Greek debt to GDP ratio with an objective of reaching 120% by 2020. Euro area Member States will contribute to the PSI package up to 30 bn euro. The nominal discount will be 50% on notional Greek debt held by private investors. A new EU-IMF multiannual programme financing up to 100 bn euro will be put in place by the end of the year. It will be accompanied by a strengthening of the mechanisms for the monitoring of implementation of the reforms. </p>

It is important to underline that since no details accompany this debt restructuring process, it is hard to tell whether the 50% figure is actual or indicative, nor is it feasible to accurately estimate its impact. Furthermore what does “nominal discount on notional debt” really suggest? The vagueness of this phrase allows for all sorts of twists and interpretations pointing to the fact that no real haircut was agreed upon.

2. The significant optimisation of the resources of the EFSF, without extending the guarantees underpinning the facility. The options agreed will allow the EFSF resources to be leveraged. The leverage effect of both options will vary, depending on their specific features and market conditions, but could be up to 4 or 5, which is expected to yield around 1 trillion euro (around 1.4 trillion dollar). We call on the Eurogroup to finalise the terms and conditions for the implementation of these modalities in November. In addition, further cooperation with the IMF will be sought to further enhance the EFSF resources.</p>

The use of the phrase “without extending the guarantees underpinning the facility” suggests in a clear way that financial engineering will be used to ostensibly increase the firepower of the region’s bail out fund. Though details remain to be seen, since again nothing tangible was announced, it is important to realize that European elites are oriented towards officially transforming the EFSF into a mechanism that will resemble the infamous derivatives that are to a very large extend the cause of the Great Recession. This will be the greatest failure of Europeans since markets will find out that Italy and Spain, together with all the other weak parts of the chain will be practically guaranteeing their selves, effectively suggesting that the only legitimate guarantees come mainly from Germany, France and from Netherlands, Finland, Austria who are nonetheless much smaller to effectively provide guarantees. Once markets work out the math, they will see that the expanded EFSF will be nothing more than a tower of cards, a toxic financial derivative right at the heart of a plan to provide a solution to the crisis.

3. A comprehensive set of measures to raise confidence in the banking sector by (i) facilitating access to term-funding through a coordinated approach at EU level and (ii) the increase in the capital position of banks to 9% of Core Tier 1 by the end of June 2012. National supervisors must ensure that banks’ recapitalisation plans do not lead to excess deleveraging.</p>

Having already examined the Annex 2 of the 14-page document of the Euro summit, I may say that it contains certain positive elements. The best of them is the acceptance of a system-wide/euro-wide strategy to deal with the banking issues. The point though is that despite the positive elements, it is impossible to estimate whether these are sufficient or not, given that the issues of the Greek debt restructuring and the expansion of the EFSF remain unclear, thus I would remain cautious over the effectiveness of this “comprehensive set of measures”. Moreover the way in which recapitalizations will take place, first with banks being required to raise money from the market, then from national authorities and ultimately from the EFSF, is problematic, since banks will reduce even more the amount of loans they issue, thus affecting the real economy in a very negative way, by considerably reducing liquidity therefore retarding much-needed growth.

4. An unequivocal commitment to ensure fiscal discipline and accelerate structural reforms for growth and employment. Particular efforts are being deployed by Spain. New strong commitments on structural reforms have been made by Italy. Portugal and Ireland will continue their reform programmes with the support of our crisis mechanisms.</p>

5. A significant strengthening of economic and fiscal coordination and surveillance. A set of very specific measures, going beyond and above the recently adopted package on economic governance, will be put in place.

About fiscal discipline I recently published an article titled “Stricter rules are good – Stabilizing Mechanisms are much better” in which I prove – once again – that the rhetoric about fiscal discipline is non-sense and so are the arguments of unidimensional stricter rules. The problem in Europe is not one of public debt, the crisis in Europe is systemic and has to do with the feedback loops between indebted states, quasi-bankrupt banks and the institutional gaps of the euro architecture which ultimately lacks a lender of last resort, plus all those stabilizing mechanisms and shock absorbers that would never allow divergence within the single currency area. Having said that, point 4 above is completely detached from the real situation while point 5 does nothing to provide any effective solution.

6. Ten measures to improve the governance of the Euro area. </p>

These measures are found in Annex 1 of the 14-page document. It basically is a series of steps to improve the coordination of efforts among European offices, laying down how the president of the Eurogroup, the President of the European Council and the President of the European Central Bank will orchestrate their actions. These are indeed positive provisions to hopefully make European institutions and bodies more effective, though judging by the bodies and agencies involved I doubt that bureaucracy will be reduced.

And the final point of the official document about the Main results of the Euro Summit:

7. A mandate to the President of the European Council, in close collaboration with the President of the Commission and the President of the Eurogroup, to identify possible steps to strengthen the economic union, including exploring the possibility of limited Treaty changes. An interim report will be presented in December 2011. A report on how to implement the agreed measures will be finalised by March 2012. </p>

This final paragraph says a lot and at the same time says nothing. Vagueness permeates every sentence while it is clearly pointed out that further action will be taken on future dates implying once again that more needs to be done. Hence expect more dithering and delay.

The Euro summit is now over. In the first days there will be some enthusiasm in the markets. Yet once the dust has set, once the echoes of triumphant rhetoric of European elites fade away, once editorials are written pointing to the inanity of the latest summit, speculation will once again strike back on an unsuspected collective of political elites who have been extending and pretending for nearly two years now.

The ‘comprehensive’ solution that was promised, never came. Nothing concrete exists to backstop the fall of Italy and Spain as well as the deterioration of the position of Belgium and France. The failure to act, the inability to address the systemic crisis systematically, have left us all with a bitter aftertaste. A crisis that could have already been solved if timely decisions were taken and decisive steps were made, is transforming into an existential issue and there is no guarantee whatsoever that its destructive dynamic will stop.

Every postponement makes the crisis worse, allowing contagion to the core. This should have been the lesson from our experience so far – yet somehow European elites manage to repeat the same mistake again and again. What remains to be seen is whether the markets will tolerate this shadow play any longer. I hope they will otherwise the euro is finished.