Shock and awe may not be enough to save Europe

Monday, May 10, 2010
By Paul Martin

By Edmund Conway
May 10th, 2010

This is a big moment for Europe and for the single currency. The events of the past 24 hours are quite likely to sound the starting gun either towards a more federal Europe or, just as feasibly, to the break-up of the euro – so high are the stakes. We’ve covered the full run-down of what has been decided elsewhere, so here are a few thoughts:

The European finance ministers are attempting to emulate the G20 summit in London back in April 2009, and to give the impression of throwing a massive amount of cash at the problem. Just as was the case in London, some of this is new, some is old, some is questionable. But the leaders hope that the details will be less significant than the “shock and awe” effect of coming up with such a big total bail-out. The London effort was at least a part-success, in that it left markets in little doubt that the politicians would stop at nothing to ensure that the financial system would not be allowed to collapse entirely, and helped stifle fears at least temporarily.

It is gratifying that the euro governments have finally wised up to the scale of the problem facing them. For years, the IMF and others have warned that Europe had a major exposure to the financial and economic crisis, both in its banking system and in its economic management, but had failed to take measures to write down bad debts and tackle the issue head-on. That denial period is over, but perhaps too late.

The provenance of the actual money is questionable. There are two plans under consideration here: 1. An extension of an already existing fund which was already used to help Latvia, Hungary and others by Eur60bn. 2. A far bigger plan to pledge around Eur 440bn of bilateral loans from eurozone members to support each. However, there is very little detail at all on where the money would come from, and the detail we do have is slightly suspicious (for instance, the fact that the euro members need to set up Special Purpose Vehicle to do this is not at all encouraging). The IMF has also apparently pledged to provide a further slug of cash – up to Eur250bn – and this money, should it actually arrive, is more solid. The first segment will affect the UK, but Britain, as a non-member of the euro, can opt out of the second.

This (bigger) plan is nowhere near approved by euro area governments. It involves significant further integration, so is very unlikely legally to be able to be pushed through without the approval of EU members. Given the no votes to the EU constitution from France and the Netherlands (and Angela Merkel’s defeat in the Bundesrat elections), can we really be assured of getting this approval? Moreover, there is big potential for legal challenges to the plan. The IMF will also have to approve the disimbursement, and one should not take that for granted either.

This could fatally undermine the European Central Bank – and potentially monetary policy for the eurozone. The ECB has agreed to embark on a kind of quantitative easing programme, buying up government and private sector bonds around the euro area “to ensure depth and liquidity in those market segments which are dysfunctional”. You cannot overstate how significant it is that this was something ECB president Jean-Claude Trichet seemed to be entirely opposed to at his press conference appearance last week. It looks to all extents and purposes as if the ECB has been overruled by the politicians: in other words, the Bank’s independence has been critically damaged.

The events in Europe are completely overshadowing the rather parochial matter (as far as investors are concerned) of the UK hung parliament negotiations. Gilt yields are up today, the pound a bit stronger too, but all attention today is really on dissecting the European plan. That’s not to say it won’t swing back to Britain once we hear about a deal.

The only reason the Bank of England got away with as much quantitative easing as it did over here is because Mervyn King managed steadfastly to maintain the appearance of being completely independent from the Government. Had there been any doubt about that, it would have raised the prospect that the Bank was buying government debt complicitly in order to monetise the budget deficit. For which read Weimar Germany. Britain managed SO FAR to avoid that accusation but only thanks to the Bank keeping its footing on that tightrope of credibility (King’s occasional swipes at the Government on the deficit are no mistake).

But the ECB has started its QE journey on the worst footing imaginable, appearing to be forced into taking the decision, rather than doing it off its own back. This is distressing, since the decision to actually engage in QE is the right one. But then there are also doubts about precisely how the scheme will work: we don’t know anything about the total amount; we are told that the scheme will be sterilised (meaning it won’t actually be true QE (printing money)) but not how. When the BoE embarked down this road last year, it was criticised by many for a poor communications strategy, but at least it did all it could to be clear about what it was doing and how. Nothing of that sort from the ECB.

More fundamentally, these schemes are not pre-emptive in the slightest. When the Bank of England started QE, it was in order to prevent the UK economy succumbing to deflation and a depression. Because of where we are now with sovereign default on the radar, it is difficult for the ECB to refute the accusation that it is doing this to prop up troubled governments.

Finally, the most amusing thing, to me, is the idea that these measures will help clamp down on the “wolfpack” of speculators baying around the wreckage of the euro area. If anything, they are rather likely to make billions for the speculators, who will have made a killing on the big increases in equity prices today, and will make another killing when (as I suspect will happen before too long) there is another dip as the questions above start to become discussed more widely. Once again, it is the long-term investors, who were only now leaping into CDSs to protect their holdings, who will be hit most badly. Once again, the swifter-footed hedge funds will be laughing.

UPDATE: 16:00

I gather that the European Commission was pushing very hard indeed for the big bail-out fund (in other words the eur440bn one) going onto the EU’s budget. In other words, for it to be supported by the UK, potentially exposing Britain to further tens of billions of pounds of exposure. The idea was fought off over the course of two hours by Britain, Sweden and other EU non-euro member states, as well as the Germans (who had constitutional reservations) and even the European Council legal service (who can’t stand the idea of the Commission getting more power). However, ever irrepressible, the Commission tried to sneak it back in at about 1.30am this morning, before it was struck out again. As we wrote yesterday, Alistair Darling called George Osborne to consult him on the proposals. They were broadly in agreement that he should resist any attempts to set up a big permanent bail-out fund for Europe, but Osborne was also rather sceptical about the eur60bn extension of that existing fund.

My impression is that there are likely to be severe challenges – both legally, constitutionally and politically – to the eur440bn European Stabilization Fund in the coming days as lawyers and investors tease it apart.

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