There was plenty of happy talk later on Friday that helped cheer US markets before the close, and before S&P struck. There was going to be a G7 summit! The European Central Bank (the ECB) would be buying Spanish and Italian bonds! The Italians were going to reform!
This terrific post on the (indispensable) Open Europe blog outlines why all that relief would have been premature even without S&P’s intervention: Politics. The hallmark of the EU’s “ever closer” union has been the way it has bypassed the ordinary voter. Now, finally, the Eurozone’s leadership has to face the fact that what’s left of the EU’s democracy may be about to bite back.
Open Europe’s blogger correctly notes that it was political constraints (i.e. the fear of enraged voters) that stopped the enlarged EFSF (the bailout fund) being expanded by enough to deal with the crisis in the manner that Brussels would have liked. Now the shortfall has been exposed by legitimately skeptical markets, and the Eurozone’s leaders have to decide what to do. Given (1) that they appear unwilling to contemplate the least bad solution (splitting the euro in half) and (2) that they do not have the support necessary to force through something approaching a full fiscal and budgetary union, they are left with two main alternatives, both of which pose immense political difficulties.
The first alternative would be massive buying by the ECB of Spanish and Italian bonds, but:
Given that the ECB already has an exposure of €444bn to the PIIGS, such a move would send it into unchartered territory, and completely into the realm of fiscal policy – which is against its own rules and the promises given to German voters in the 1990s. Several key players in Germany would strongly oppose such a move. The complexity of this is illustrated by the fact that several members of the ECB’s Governing Council even voted against the comparatively modest decision yesterday to start buying Portuguese and Irish government bonds. In any case, in return for taking on this role and the risk it involves the ECB would want a large say over fiscal policy in the eurozone, and would likely push for massive austerity. This would lead to the central bank being heavily involved in political decisions, an undemocratic situation which everyone wants to avoid.
I’m not so sure about that “everyone”, but let’s let that pass, and move on to the second alternative, hugely expanding the EFSF. There are calculations out there suggesting that the facility needs to grow to €2-2.5 trillion (and, maybe, in the worst case, even more). For their part, Open Europe offer up a range of between roughly €900 billion to €1.8 trillion. Billions, trillion, trillions, big money any way you look at it.
And what’s the problem with that? Well, to be credible the EFSF would need to be AAA-rated, and this would mean that the burden would effectively fall on the Eurozone’s six Triple-A rated countries.
[They would] be forced to provide loan guarantees amounting to over a quarter of each of their GDPs. This, in turn, could impact negatively on their own financial position and rating. Such an arrangement cannot be agreed without completely ignoring voters in these countries, who are vehemently opposed to putting more cash on the line. Any increase would need to be ratified by national parliaments, and given the noise the Dutch, Finnish and German parliaments have made over the existing loan guarantees, which have been on a far smaller scale, this is unlikely to happen. These parliaments have not yet ratified the increase in the size and scope already agreed by EU leaders in July and earlier this year.
That will be a hard sell. And don’t overlook that point about the pressure it would put on the ratings of the six AAA-rated countries. Following the S&P massacre, those ratings will be bound to come under added scrutiny. That doesn’t make this the best time to take on additional liabilities, however contingent. Following on from that logic, if, say, France is, like the US, downgraded to AA + (and AA+ has not, in the meantime become the new AAA) or worse, starts to run into difficulties itself, that puts even more pressure on the ratings of the remaining five, a process that cannot but further focus the attention of how much they are really being asked to back-stop.
Some of the numbers are terrifying: If I were a German voter I wouldn’t be too happy to see estimates equivalent to 30-50 percent (or more) of my country’s GDP being tossed around even if only in worst case scenarios. Under the circumstances, (as yet unconfirmed) reports that the German government has decided that Italy is too big to bail out are all too believable. Should Merkel come out and say that specifically, then this drama is about to get a lot, lot worse. But a diplomatic silence on the chancellor’s part won’t help much either. Nervous markets are hoping for something, anything…
Open Europe then goes on to discuss other options (if you can tear your attention away from the US de-rating, the whole post is very well worth reading) to try to clear up this mess, and then, in the final paragraph, gets to the nub:
The impossible short-term choices, pitting the need to soothe the markets against national democratic restraints, perfectly illustrate the flaw that was inbuilt in the eurozone from the very beginning. The choice that was always inevitable is therefore drawing closer: appease markets but run over voters and create a full fiscal union – or break up the eurozone.
It’s come to this.