Why is the eurozone unraveling after the October 26 Summit?

2011-11-19

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The latest Euro summit was supposed to provide a “comprehensive solution” to the spiraling crisis in the eurozone. Considering the increasing borrowing costs of Italy and Spain, the mounting pressures on the AAA credit rating of France and Austria, the spread of the crisis to Belgium and the failure of the EFSF to raise the desired amount of funds from issuing its own bonds within the process of “levering”, no one can possibly argue that the summit was effective anyhow, in at least calming down investors for a short period of time. I was among those who argued from the very beginning that the last summit was a massive failure not only because it did not really produce any definite measures to put a circuit brake to the feedback loops between stressed sovereigns and hardly-pressed banks; but mostly because desperate European elites, found in a desperate situation they had created, produced a series of measures or guidelines that would result in much more problems that they were willing to solve.

The first of these degenerating policies was the further expansion of the scope of the EFSF, the region’s bail out fund. Without increasing its actual funds, European leaders gave to this mechanism, which is structured just like the infamous toxic derivatives of Lehman Brothers, an even greater burden effectively assigning to its €250 billion remaining funds the impossible task of covering a €3-4 trillion gap (including bank recapitalizations). I have stated on many occasions my belief that the very structure of the EFSF is toxic, thus from the outset it makes the task of increasing its firepower and scope ever-more degenerative. In the latest summit, European elites came up with the terrible idea of levering up the EFSF, by transforming it into an insurance instrument, which would have the capacity to guarantee the first 20% of the Italian and Spanish debt, to use it in order to issue bonds that would increase its funding capacity from the currently available €250 billion to an estimated €1 trillion. Had the leverage of the EFSF been done by the European Central Bank, the plan could have worked at least in the short-to-medium term. Yet the current setting is disastrous since investors understand that Italy and Spain, by being the third and fourth largest contributors to the EFSF, will effectively be guaranteeing their selves; while also they have the option of investing their money in the much safer German Bunds, so there is no real incentive to buy the bonds of a mechanism that is highly unstable and could easily implode given the amount of pressure it is put on it and the fragile foundations it is established on (the credit ratings of countries who might be downgraded, leading the whole plan to jeopardy) – [for more on the EFSF see Only the ECB can be a bazooka in Europe – EFSF is a tower of cards and The four sources of contagion in the Euro Area].

The second issue is the manner in which the restructuring o the Greek debt will be done. The demand to label the 50% haircut “voluntary”, so as to prevent a “credit event” that would trigger the payment of the CDS (Credit Default Swaps) contracts has had a very negative impact on the world economy. It has resulted in the sort of moral hazard, whereby the checks and balances of the global financial system are being violated and undermined by politicians. This has two effects: (i) investors can no longer hedge their investments in the eurozone, by buying CDS, since they have now lost faith in them, implying that they will be much more cautious in providing liquidity to desperate sovereigns, (ii) European elites, succeeded in losing credibility their selves, since there is no guarantee whatsoever that similar “voluntary” haircuts will not be imposed on private investors of Italian, Spanish, Portuguese, Irish and all other debts. In both cases the effect is to reduce much needed liquidity thus making borrowing costs higher. This in conjunction with the lack of automatic stabilizers within the euro area, provide the perfect setting for a “spectacular” run on sovereign bonds that has nothing to stop it (see Nor the ECB nor Technocrats can save Italy).

The third is the bank recapitalizations programme, which is highly problematic and will definitely have the effect of considerably reducing the supply of money in the midst of an overall slowdown in the economy, which suggests that business activity will be deprived of much needed liquidity, in a period were growth is desperately needed. Asking from all eurozone banks to raise their Core Tier 1 capital – and all at the same time – is the sort of fallacy of composition that will lead to a credit crunch until June 30, 2012, when the deadline is (for more see European Bank recapitalizations: An imminent credit crunch).

These are the three main degenerative policies that are already producing more harm than good, to an already hardly pressed eurozone. Yet it seems that the self-destructive propensity of the European leadership is infinite since according to the latest speech of European Commission President, Jose Manuel Barroso, he will soon present plans for “stability bonds” – bonds that will be jointly issued and separately guaranteed by all member-states. From the outset this sounds like complete madness, since it follows the same path of all of the above-mentioned policies, as it will mutualize the system’s debt, effectively putting even more pressure to the top ranked states to move downwards, while also these bonds will fall into jeopardy by the mere fact that investors will prefer German Bunds, instead of “stability bonds” that will only lead to further instability.

The inanity of European leaders is unprecedented. The series of self-defeating policies they have come up with these last few years will go down in history as a collection of suicide notes, from a political elite that had no capacity to solve a crisis caused by its own arrogance, errors and consecutive failures to act.