Europe's festering wound

When the European Council met on 16 and 17 December 2010, they faced a menu of new ideas on how to better manage the Eurozone crisis. The ideas were suggested by economists and political leaders alike: Eurobonds, allowing the European Financial Stability Facility/Fund to buy debt on the secondary market, increasing the role of the ECB, to name just a few examples.

The EU heads of state chose to ignore all of them. Here is the sum total of what they contributed to the resolution of the Eurozone crisis – a 46-word amendment to EU Treaty Article 136:

"The Member States whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguard the stability of the euro area as a whole. The granting of any required financial assistance under the mechanism will be made subject to strict conditionality."

Nothing new was said on how this mechanism will look.

In other words, the main outcome of the meeting was that EU Treaty will be changed to allow for the establishment of a stability mechanism – however this was never prohibited, so there is really no change to status quo. Leaders remain hopeful that Europe can somehow muddle through.

The purpose of amending the Treaty was to help the German government overcome a potential legal challenge in front of the German Constitutional Court. The fact that the Treaty will mention "strict conditionality” is also redundant since the mechanism will be established by Member States, not by the EU. The new, permanent, mechanism will thus be – like the existing European Financial Stability Fund – an intergovernmental institution which will be run by the creditor countries. This implies that Germany will always be able to impose its conditions, as it did this year with Greece. There was no need to state the obvious in the EU Treaty.

The European Council also confirmed that the "stability mechanism”, dubbed the European Stability Mechanism, will be like a permanent European Financial Stability Fund (the existing fund which was used to help Ireland). In particular, the new Mechanism will only be used to bailout governments, and this only at punitive interest rates. Moreover, it will require seniority for itself and will be able to provide assistance only if the country passes a "rigorous debt sustainability analysis conducted by the European Commission and the IMF, in liaison with the ECB”.

The message from this combination for potential investors in the public debt of the peripheral Eurozone countries is more or less the following: "Before you buy the debt of these countries please be aware that we (the EU and the IMF) might find later that the country needs a reduction in debt to become sustainable again and the only ones to take a cut are private investors”.

Under these conditions the crisis is likely to fester indefinitely.

Longer-term investors must fear the double-edged Damocles sword of the debt sustainability analysis and the seniority of the official creditors.

The real issues underlying the crisis remain: the huge public debt in Greece, the actual losses in the banking systems of Ireland, and the potential losses in Spain. They are made more difficult by the lack of growth prospects in these countries, which was not even on the agenda (for a proposal to do so see Amato et al. December 2010).

In the meantime longer-term interest rates have increased throughout the global financial markets. This means that the refinancing costs of these countries will increase even if the risk premiums do not increase any further, but remain at their present elevated levels.

Moreover, as luck has it, these countries will need to refinance several hundreds of billions of euros over the next few quarters. It looks as if the Eurozone is trying to continue to "levitate” as Charles Wyplosz put it recently. It does not look likely that this feat can be sustained for the duration of the coming year.

Originally published on Reproduced with permission.

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