Starting With the Bad News…
Although the usual post-summit rally should not be too hard to orchestrate in the thin markets around Christmas, there was more bad news than good for the dwindling band of bureaucrats and politicians who are determined to save the Euro, regardless of the costs to the democracies and economies of Europe. We will begin with the “bad” news–partly because our bias is to treat bad news for the Euro as good news for the world and Europe, but mainly because this so-called comprehensive and final “fiscal compact” was no more comprehensive and final than any of the previous failed deals. As in all the previous summits, the only truly definitive decision on Friday was to have another meeting in three months’ time, when a new agreement would supposedly be cooked up to resolve all the controversial issues left undecided on Friday. Once the holiday season is over and investors start to think seriously about this “fiscal compact,” the economic and political uncertainties are bound to intensify, building to another crisis ahead of the next summit in March.
The summit failed to satisfy the first (and maybe not the second?) of even the minimum necessary conditions to give the Euro a chance of medium-term survival. These are (i) creation of a fiscal union, which will take at least one to two years to set up, and (ii) unlimited ECB lending to bridge the gap between this multi-year political timetable and a market timescale measured in weeks or months. While the ECB may still end up being more pro-active than Mario Draghi suggested last week (see next page), the summit’s most obvious failure was on the fiscal front. Despite the self-congratulation among EU politicians about their “fiscal compact,” the fact is that Germany vetoed the most important characteristic of a true fiscal union, which is some degree of joint responsibility for sovereign debts. Since Germany refused even to discuss Eurobonds or a vastly expanded jointly-guaranteed European Stability Mechanism, the summit did nothing to reassure the savers and investors in Club Med countries that their money will be protected from either devaluation or default.
Secondly, the summit raises huge political uncertainties. With the UK failing to climb on board, an intra-governmental deal will need to be arranged outside the EU legal framework. Will all 17 countries in the EMU ratify the new treaty and how long will this take? Will Ireland be able to avoid a referendum in a period when Europe is viewed by the public as a hostile colonial power? Will all 17 members insert German-style debt-brakes into their constitutions to the satisfaction of the German courts? If a country fails to legislate or implement an adequate debt-reduction programme, will it be expelled from the Euro? If so, can the Euro be described as “irrevocable” any longer and does it really differ from any previous fixed currency peg? Worst of all, perhaps, how will this deal affect French politics? If Marine Le Pen and Francois Hollande denounce Merkozy’s “fiscal compact” as a betrayal of French sovereignty and democracy, then this agreement will be worthless until after the French presidential election on May 6.
Thirdly, and most decisive in the long run, is the economic and political incoherence of what Merkozy are trying to do. Even if the fiscal compact could be immediately put into practice, even if it contained provisions for joint-liability debts and even if the ECB backed it with unlimited monetary support, it would aggravate the Club Med’s economic nightmare of unemployment and economic stagnation. Small open economies such as Ireland and Sweden may be able to deflate their way out of a debt crisis, but for large continental economies in the Eurozone this is arithmetically impossible. In this respect at least, Keynes’s key insight of the 1930s—that workers and taxpayers are also customers—remains as relevant today as it was then. By imposing permanent austerity, the fiscal compact guarantees permanent depression—and that in turn guarantees that the citizens of Europe will eventually turn against Merkozy and the Eurocrat elites.
…And Now for the Good News
Now let us turn to the good news, at least for the Eurocrats and perhaps, in the short-term, for the European markets. The potential support from the ECB is the one part of the summit deal that could turn out to be much stronger than it seemed at first sight. While Mario Draghi’s public statements were less than helpful, they were presumably directed at a German audience, as was Bundesbank president Jens Weidman’s astonishing decision on Thursday to vote against even a -25bp rate cut. This seemed to confirm our longstanding view that, whatever the preferences of Angela Merkel and other politicians, the Bundesbank would like to sabotage the Euro if it can. Behind this macho posturing, however, the ECB may be moving towards a programme of sovereign debt monetisation and quantitative easing on a scale that even Ben Bernanke and Mervyn King would never contemplate.
The three-year unlimited liquidity operations announced last Thursday could provide infinite monetary support for European banks and through them, their sovereign debt markets. Once these three-year repos get started, banks in the Club Med countries will be able to borrow as much as they want from the ECB at 1% and use this money to buy government bonds now yielding 6% or more. Because of the unprecedented maturity of these repo-operations, banks will now be able to theoretically acquire unlimited government bond portfolios without exposing themselves to rollover or maturity risks. Banks will therefore be able to pick up 500bp of carry, with zero risk-weightings, by hoovering up all the debt their governments can throw at the markets. Of course there would be risks—we cannot say banks will want to jump on this deal, but in theory they can.
This Ponzi scheme could potentially result in an even bigger money-printing operation than anything the US, British and Swiss central banks have done on their own accounts. It would allow the banks to rebuild their equity with no dilution to shareholders. And if the banks in Italy or Greece became too “profitable” by using cheap ECB funding to buy up their entire sovereign debt markets, then the Italian or Greek governments could always recover the “excess” profits with special taxes. The governments could thus effectively reduce their own cost of funds to the 1% rate offered to banks by the ECB. Of course if the Italian government defaulted on its debts, Italian banks would go spectacularly bust. But these banks would go bust anyway if the Italian government ever defaulted. All the incentives for Italian bank management will therefore be to go for broke in their sovereign debt markets, making maximum use of the new ECB credit lines.
That said, however, the European Banking Authority’s recent stress tests forced banks to assume mark-to-market losses in the stressed scenarios. These demands from the EBA may inhibit banks from adding more sovereign risk—unless the EBA uses the “fiscal compact” as an excuse to ease up on the stress tests.
And it is crucial to remember that banks are likely to use the ECB credit