Damned with faint plans

Euro-zone government bonds have not been made safe—and the euro project remains in peril

Dec 17th 2011 | from the print edition

The Economist

… Yields on the ten-year bonds of Italy and Spain, …have risen again…

… The pact’s rigidity would make recessions worse, and the new fiscal rule would not have kept Ireland or Spain out of trouble…

… the money available would be barely enough to cover the borrowing needs of Spain and Italy over the next two years….

THERE were hopes, however faint, that Europe’s leaders might, in the space of a few days, manage to persuade investors that euro-area government bonds were safe assets, not toxic waste, thus putting paid to fears that the currency zone would disintegrate. The verdict, a week after meetings of the European Central Bank (ECB) and European Union leaders on December 7th-9th, is that they failed.

The new measures that emerged from these meetings fell short of what is required to save the euro, though they may be enough to support the zone’s stricken banks and sovereigns for a while. The bond markets’ initial response is not encouraging. Yields on the ten-year bonds of Italy and Spain, the big euro-zone countries that investors are most wary of, have risen again after falling in the run-up to the summit.

The euro has also dropped to its lowest level (below $1.30) against the dollar since January. The likeliest trigger for the next stage in a deepening crisis is a blanket downgrade of euro-zone government bonds, which would strip France and even Germany of their prized AAA credit rating.

The gatherings in Frankfurt and Brussels did not deliver the “comprehensive” solution to the euro’s ills that was billed, but optimists point to some modest progress. The ECB lowered its benchmark interest rate from 1.25% to 1%, the second quarter-point cut in as many months, to try to mitigate the coming recession. It agreed to provide unlimited cash to commercial banks for up to three years, at its main interest rate, to replace the medium-term funding that private investors are unwilling to extend. The central bank will now accept higher-risk asset-backed bonds as well as loans as security for cash, and it has lowered its reserve requirements for banks to ease their funding pressures.

Such measures will help to address a shortage of liquidity in the euro-zone banking system. But they are unlikely to avert a nasty credit crunch, because banks are inclined to shed assets, rather than make new loans, as they strive to comply with new capital rules by next June. And although the ECB is now an aggressive lender-of-last-resort to banks, it will not extend the same privileges to governments. The bank’s president, Mario Draghi, scotched the idea that the ECB might step up its “limited” purchases of the bonds of troubled euro-zone countries if a binding fiscal pact were to be agreed by governments at the Brussels summit. The EU treaty forbids monetary financing of governments, said Mr Draghi, thus ruling out large-scale bond purchases as illegal.

If the ECB is squeamish about funding governments, it is quite content to provide banks with cheap, long-term cash that might be used to buy sovereign bonds. Yet the ECB’s offer of unlimited liquidity to banks is not a close substitute for direct bond purchases.

The ECB’s qualms put the onus on governments to bolster the euro zone’s rescue resources to stem a self-fulfilling run on the bond markets of Italy and Spain. But the EU summit fell short of what was required, just as all previous such gatherings had. Much diplomatic effort was wasted on securing a new “fiscal compact”, which tries to build upon the rubble of the failed stability and growth pact. The new pact commits euro-zone members to a structural budget deficit (ie, allowing for the economic cycle) of no more than 0.5% of GDP a year. This fiscal rule is to be hard-wired into each country’s constitution to make compliance likelier. Fines for breaching the “old” pact’s limits of a 3% of GDP budget deficit will be automatic, unless voted down by the bulk of the euro zone.

Hello kitty

The pact’s rigidity would make recessions worse, and the new fiscal rule would not have kept Ireland or Spain out of trouble. The commitment to the compact might at least have eased bond-market tensions if it were presented as a staging post to a fiscal union or to common bonds. Sadly, there was no mention of Eurobonds in the summit’s final communiqué. Nor was there enough progress in increasing the rescue funds for troubled sovereigns.

The summit pledged up to €200 billion of new money for the IMF to deal with the crisis in the hope that other contributions from outside Europe might follow. The euro zone’s permanent rescue fund, the European Stability Mechanism (ESM), may come into operation as soon as June, a year earlier than planned, and will be able to respond to a new emergency as soon as 85% of the euro zone (by voting weights) gives it clearance. But any increase in its €500 billion kitty will not be considered until March.

Even if the summit’s pledge of €200 billion to the IMF is matched by others and then combined with the €250 billion or so that is left in the euro zone’s temporary rescue fund, the money available would be barely enough to cover the borrowing needs of Spain and Italy over the next two years. It is well short of what was needed to persuade sceptical investors that big euro-zone countries are safe from runs on their bond markets. And though the Brussels summit ruled that private-sector “involvement” (ie, losses) would not be mandatory were a country forced to tap the ESM, reliance on IMF funds to augment the euro zone’s own resources will make investors nervous. The IMF usually gets its money back first, leaving private investors to take any losses.

This package was supposed to save the euro but is clearly inadequate. Unless a more impressive cure for the euro’s ills is agreed soon, it is hard to see it surviving the next year intact.