Sovereign debt bubble thread

[Sheilbh]

I don't understand why all the "austerity" countries are doing their austerity in the most self-destructive way. It's like they didn't want to do it in the first place, so they're making sure it's as harmful as possible to make the public hate it. The way it is, it's both insufficient and too severe. 

That would certainly explain the coalition

Do you honestly think it will ever happen once the pressure is off?

What will ever happen?  Changing treaties to share sovereignty on fiscal matters?

As I say if the Eurozone collapses it will probably happen in the next year and the events leading to collapse will, in my view, probably be to rapid for Eurozone leaders to contain.  Once it starts I think it'll pretty irreversible and the costs will be huge.  If the goal's to keep pressure up then it's working but I think it's a potentially lethal game of chicken.

[Iormlund]

I don't understand why all the "austerity" countries are doing their austerity in the most self-destructive way.

Yilaborate.

[citizen k]

[Razgovory]

I'll never understand economics.

[Zanza]

Anatole Kaletsky wrote an article last week in Reuters on this division:

Can the rest of Europe stand up to Germany?
By Anatole Kaletsky JUNE 20, 2012

As financial markets slide toward disaster, scarcely pausing to celebrate the "success" of the Greek election or the deal to recapitalize Spanish banks, the euro project is finally revealing its fatal flaw. One country poses an existential threat to Europe – and it is not Greece, Italy or Spain. Every serious proposal to resolve the euro crisis since 2009 – haircuts for bank bondholders, more realistic fiscal consolidation targets, jointly guaranteed eurobonds, a pan-European bailout fund, quantitative easing by the European Central Bank – has been vetoed by Germany, and this pattern looks likely to be repeated next week.

Nobody should be surprised that Germany has become the greatest threat to Europe. After all, this has happened twice before since 1914. To state this unmentionable fact is not to impugn Germans with original sin, but merely to note Germany's unusual geopolitical situation. Germany is too big and powerful to coexist comfortably with its European neighbors in any political structure ruled purely by national interests. Yet it isn't big and powerful enough to dominate its neighbors decisively, as the U.S. dominates North America or China will dominate the Far East.

Wise German politicians recognized this inherent instability after 1945 and abandoned the realpolitik of national interest in favor of the idealism of European unification. Instead of trying to create a "German Europe" the new national goal was to build a "European Germany." Unfortunately, this lesson seems to have been forgotten by Angela Merkel. Whatever the intellectual arguments for or against German-imposed austerity or the German-designed fiscal compact, there can be no dispute about their political import. Merkel's stated goal is now to create a "German Europe," with every nation living, working and running its government according to German rules.

Merkel doubtless believes that she is helping Europe when she maternally instructs the Greeks, Italians and Spaniards to "do their homework" and so become good little Germans. But like its less benign predecessors, this effort to impose German hegemony is guaranteed to fail. Europe's leaders must therefore start considering a previously unmentionable question, perhaps as soon as next week's summit, if the euro crisis intensifies. This question is not whether Europe will agree to live under German leadership, but whether Germany will agree to live under EU leadership – or whether the other nations must form a united front against Germany to prevent the destruction of Europe, as they have repeatedly in the past.

To be specific, the euro's only chance of survival now depends on a decisive move toward political and fiscal union. Angela Merkel plays lip service to such political union, even claiming that democratic accountability is her main condition for financial rescues; but what she means is accountability to German voters, German newspapers and German constitutional judges. She promises to "do whatever it takes to save the euro" but vetoes anything that might actually work, claiming deference to German public opinion or national interests.

Europe must now call this bluff. At next week's summit, France, Italy and Spain can turn the tables on Merkel by presenting her with an ultimatum: Led by President Hollande, who has abandoned President Sarkozy's Gaullist pretensions of parity with Germany, the big three Mediterranean countries could agree on a program that really might save the euro: a banking union, followed by jointly issued eurobonds and backed by ECB quantitative easing. If Merkel tried to block these policies, the others could politely invite her to leave the euro, since Germany's political pressures evidently made membership impossible on terms its partners could accept – essentially the proposition Merkel put last month to Greece. Without Germany, the euro zone would have much smaller internal imbalances and much more political coherence, with a much weaker currency and higher inflation, both of which would make debts easier to resolve.

Merkel would probably insist on Germany's legal right to remain within the euro, ironically echoing the Greek position. At this point the other nations could play their trump card: To reduce interest rates and make their economies more competitive by weakening the euro, the debtor nations could vote for unlimited bond purchases by the ECB. The Germans on the ECB council would doubtless oppose this, but even with support from Finland, Slovakia, and perhaps Austria and Holland, Germany could command no more than 7 votes out of 23. Germany would then face the very same existential choice about its relations with Europe that Merkel has inflicted on Greece and other debtor nations.

Germans will almost certainly support the political concessions that might give the euro a chance of survival, including fiscal transfers and some mutualization of debts, once they realize that their only alternative is isolation from the rest of Europe. But before they agree to a European Germany, voters may need to be reminded that trying to create a German Europe always leads to disaster.

The difference being that Germany, unlike Greece, can't be pushed out of the Euro by cutting it off. Quite the opposite. If France, Spain and Italy would push Germany out of the Euro, I predict the Euro would collapse within weeks, not months. 

[PJL]

Anatole Kaletsky wrote an article last week in Reuters on this division:

Can the rest of Europe stand up to Germany?
By Anatole Kaletsky JUNE 20, 2012

As financial markets slide toward disaster, scarcely pausing to celebrate the "success" of the Greek election or the deal to recapitalize Spanish banks, the euro project is finally revealing its fatal flaw. One country poses an existential threat to Europe – and it is not Greece, Italy or Spain. Every serious proposal to resolve the euro crisis since 2009 – haircuts for bank bondholders, more realistic fiscal consolidation targets, jointly guaranteed eurobonds, a pan-European bailout fund, quantitative easing by the European Central Bank – has been vetoed by Germany, and this pattern looks likely to be repeated next week.

Nobody should be surprised that Germany has become the greatest threat to Europe. After all, this has happened twice before since 1914. To state this unmentionable fact is not to impugn Germans with original sin, but merely to note Germany's unusual geopolitical situation. Germany is too big and powerful to coexist comfortably with its European neighbors in any political structure ruled purely by national interests. Yet it isn't big and powerful enough to dominate its neighbors decisively, as the U.S. dominates North America or China will dominate the Far East.

Wise German politicians recognized this inherent instability after 1945 and abandoned the realpolitik of national interest in favor of the idealism of European unification. Instead of trying to create a "German Europe" the new national goal was to build a "European Germany." Unfortunately, this lesson seems to have been forgotten by Angela Merkel. Whatever the intellectual arguments for or against German-imposed austerity or the German-designed fiscal compact, there can be no dispute about their political import. Merkel's stated goal is now to create a "German Europe," with every nation living, working and running its government according to German rules.

Merkel doubtless believes that she is helping Europe when she maternally instructs the Greeks, Italians and Spaniards to "do their homework" and so become good little Germans. But like its less benign predecessors, this effort to impose German hegemony is guaranteed to fail. Europe's leaders must therefore start considering a previously unmentionable question, perhaps as soon as next week's summit, if the euro crisis intensifies. This question is not whether Europe will agree to live under German leadership, but whether Germany will agree to live under EU leadership – or whether the other nations must form a united front against Germany to prevent the destruction of Europe, as they have repeatedly in the past.

To be specific, the euro's only chance of survival now depends on a decisive move toward political and fiscal union. Angela Merkel plays lip service to such political union, even claiming that democratic accountability is her main condition for financial rescues; but what she means is accountability to German voters, German newspapers and German constitutional judges. She promises to "do whatever it takes to save the euro" but vetoes anything that might actually work, claiming deference to German public opinion or national interests.

Europe must now call this bluff. At next week's summit, France, Italy and Spain can turn the tables on Merkel by presenting her with an ultimatum: Led by President Hollande, who has abandoned President Sarkozy's Gaullist pretensions of parity with Germany, the big three Mediterranean countries could agree on a program that really might save the euro: a banking union, followed by jointly issued eurobonds and backed by ECB quantitative easing. If Merkel tried to block these policies, the others could politely invite her to leave the euro, since Germany's political pressures evidently made membership impossible on terms its partners could accept – essentially the proposition Merkel put last month to Greece. Without Germany, the euro zone would have much smaller internal imbalances and much more political coherence, with a much weaker currency and higher inflation, both of which would make debts easier to resolve.

Merkel would probably insist on Germany's legal right to remain within the euro, ironically echoing the Greek position. At this point the other nations could play their trump card: To reduce interest rates and make their economies more competitive by weakening the euro, the debtor nations could vote for unlimited bond purchases by the ECB. The Germans on the ECB council would doubtless oppose this, but even with support from Finland, Slovakia, and perhaps Austria and Holland, Germany could command no more than 7 votes out of 23. Germany would then face the very same existential choice about its relations with Europe that Merkel has inflicted on Greece and other debtor nations.

Germans will almost certainly support the political concessions that might give the euro a chance of survival, including fiscal transfers and some mutualization of debts, once they realize that their only alternative is isolation from the rest of Europe. But before they agree to a European Germany, voters may need to be reminded that trying to create a German Europe always leads to disaster.

The difference being that Germany, unlike Greece, can't be pushed out of the Euro by cutting it off. Quite the opposite. If France, Spain and Italy would push Germany out of the Euro, I predict the Euro would collapse within weeks, not months.

Given the fact that the crisis is exhibiting a sin(1/x) formula in terms of raised and then fallen expectations, I reckons the euro is likely to collapse within weeks anyway.

[mongers]

I'll never understand economics.

Then by definition you must be an economist. 



edit:
Oops, many of them aren't that self-aware and so think they do understand.

[Sheilbh]

Yilaborate.

Yeah.  With the partial exception of Greece all EU leaders, including Germany, go out of their way to praise the rest of the leaders.  Portugal and Ireland are the model pupils, Rajoy and Monti are seen as ideologically committed to austerity and reform (Monti certainly is, I'm not so sure on Rajoy).

The difference being that Germany, unlike Greece, can't be pushed out of the Euro by cutting it off. Quite the opposite. If France, Spain and Italy would push Germany out of the Euro, I predict the Euro would collapse within weeks, not months. 

Depending on how the Greeks respond you might not even be able to push them out - and they're more supportive of staying in the Euro than Germans are.

As the research I posted earlier suggests currency unions do normally collapse because the 'stronger' member(s) leave.  However Kaletsky wrote about this for his economics research company (bolding his):

Now that the Greek election is over, with the pro-bailout parties gaining enough seats for a slim majority, Europe can return to the regular cycle of panic, relief, disappointment and renewed panic, that we have observed for the past two years. This time, however, the relief rally may be even shorter than usual, since the market's attention will soon shift from Athens to Madrid, Paris and, above all, Berlin. Since Greece has no chance of meeting its financial targets, the new government will soon need significant new concessions from the troika. Assuming that Germany resists such concessions, as well as the much larger ones that will soon be required by Spain, the fundamental contradiction of the euro project will again be brought into focus. A single currency can only be sustained within a fiscal and political union that can mutualise and monetize the debt— something that Germany refuses even to discuss.

If this situation persists, then one of two things could happen. The debtor countries could resign themselves to permanent depression and bankruptcy as they sink further into debt traps and Greek-style crises which will ultimately push them out of the euro one by one. Or they could turn the tables on Germany. Instead of letting Germany impose its economic and political philosophy on Greece, Ireland and Portugal—and in the near future on Spain, Italy and probably France—the Club Med countries could unite and impose their economic philosophy on Germany.

With every day that passes, and especially since the French election, it is becoming clearer that the problem country for the euro—the odd man out in terms of economic structure and the chief obstacle to any political resolution of the euro crisis—is not Greece, Spain or Italy. It is Germany. It is Germany that refuses even to talk about mutual debt and banking guarantees. It is Germany that insists on self-defeating fiscal austerity and intolerable political conditions for the debtor countries. It is Germany that vetoes quantitative easing by the ECB, which could cap bond yields and relieve deflationary debt traps. And it is Germany that makes the other euro countries uncompetitive, discourages devaluation of the euro against the dollar and refuses even to relax its own domestic fiscal policies to reduce its trade surplus and support growth.

Suppose then that Angela Merkel refuses to make any compromise on debt mutualisation or ECB monetisation when a political or market crisis next strikes one of the debtor countries, as it surely will. The obvious answer would be for the Club Med governments to point out that Germany has become the obstacle to a resolution of the euro crisis. Mrs Merkel could then be asked, one last time, to abide by majority decisions that are necessary for the survival of the euro and in the interests of all its members. If she refused to do this, Germany could be politely asked to leave. And if Mrs Merkel refused to fall in line or voluntarily leave the euro, the other countries could easily call her bluff by creating conditions that would be unacceptable to the German public. The obvious way to do this would be to force a vote in the ECB for unlimited quantitative easing to monetise government debts.

German public opinion would surely oppose this, but they could not prevent it because Germany has just two votes on the Council of the ECB —and even assuming support from Austria, Finland, the Netherlands and Slovakia, the German faction would command only 6 votes out of 23. If the two German ECB representatives were forced to resign in protest (again!), it is easy to imagine German public opinion demanding immediate withdrawal. A new Deutschemarks could rapidly be issued by the Bundesbank and, while the German banks and insurance companies would suffer large losses because of a mismatch between their euro assets and their New D-Mark liabilities, they could be readily recapitalised by a government suddenly freed of the contingent liabilities imposed by the rest of the eurozone.

This kind of euro break-up triggered by German revaluation would be much less disruptive than a "break-down" caused by devaluation in Greece or Spain. In the case of a German revaluation, there would be no contagion or capital flight, as there would be if Greece, then Spain, then Italy and France were knocked out of the euro one by one. There would be no lawsuits by disgruntled creditors.

Best of all, from both the legal and the economic standpoint, the legacy euro created by a German withdrawal would survive as a more viable common currency for the remaining countries of the eurozone. With Germany outside the euro, France, Italy and Spain could rapidly devalue their way back to competitiveness within Europe—and also internationally, by encouraging the new euro to devalue rapidly against the dollar, yen and RMB. Without German opposition, the ECB could imitate the Fed and the Bank of England, buying bonds without limit so as to slash long-term interest rates. And if quantitative easing produced an even weaker euro or higher inflation, so much the better, since the Club Med countries have always relied on devaluation to promote export growth and inflation to eliminate debts.

A break-up of the euro caused by Germany's departure would be very bullish for practically all global risk assets, with the obvious exception of German export and bank stocks. German bonds would also suffer huge losses, since the German government could decide to repay its bonds in legacy euros, rather than redenominating all its obligations into appreciating new Deutschemarks. For a government that had just spent hundreds of billions on recapitalising its banks for the losses they suffered in France, Spain and Italy, it would be tempting to burn foreign bondholders, rather than offering them a further currency windfall.

Having said all of that last night's deal looks, from what I've read, to be a really positive first step.  What's even better is that it looks like everyone acknowledges it's a first step - banking union will, apparently, be completed over the summer and a concrete schedule for political union (with fiscal union) will be in place in October (this may be too slow).  We'll probably need more steps over the summit but this deal is very good news - especially for, in Hollande's phrase, the virtuous countries like Italy and Spain.  But other great news is that Monti and Rajoy have realised they've got leverage.

Hollande's €120 billion 'growth plan' is less consequential - also I got Sarko-flashbacks when he gave an hour long press conference while everyone else was still negotiating

One striking feature, however, is that the main opposition last night - after Merkel had given in - was Mark Rutte.  He may only be a caretaker PM but he's facing an election against an anti-Euro populist.  I think that sort of intransigence for that reason may happen more.

Edit:  And Monti's line that 'we've avoided a black Friday' is absolutely true.  Given his Commission history () he seems to get what's happening in the markets a bit better than most.

What would be really helpful is if this could extend to Ireland and even Greece who've had to use €45 billion of their bailout to recapitalise their banks.

[Sheilbh]

Here's Sony Kapoor's useful summary of the deal:

The Good Bad and Ugly from the European Council

The short but important conclusions from the all night summit of Euro area leaders can be found here.

First the good news, four very important decisions were taken 1) A decision to eventually hand the European Central Bank direct supervision of Eurozone banks 2) A decision to allow, in principle, the European Crisis funds the EFSF/ESM to directly inject equity into troubled banks 3) A decision to waive seniority or preferred creditor status that Member States had claimed for the ESM, for Spain's rescue 4) An agreement to activate crisis support for Spain and Italy through the EFSF/ESM buying bonds in order to bring borrowing spreads down.

Then the bad news 1) The decision to give supervision to the ECB will take years to properly implement and raises serious question marks about accountability, concentration of power, manpower and the future of the single market in financial services amongst other things

2) The decision to inject equity, it has been stated, can only be carried through once ECB supervision is in place – hence not in the foreseeable future so its short term impact is rather limited. And it would mean a change in the mandate of the ESM which would take a long time to enact if political agreement can be found at all. Also, as a prerequisite for this, subordinated and even senior bondholders in banks being considered for aid would probably be asked to take haircuts, something for which the legal mechanisms don't yet exist and the political willingness may never come about.

3) The decision to waive seniority for Spain is being given a lot of importance by commentators but we think it's not quite that important as I have highlighted in my note "The Spanish Bailout and the myth of Seniority". It would in any case have been impossible to have kept a preferred creditor status while injecting equity – as by definition equity is junior to bondholders. Also, what really matters is whether seniority will be waived for Italy as the support there is expected to come in the form of bond purchases not equity injection into banks.

4) The decision to agree to activate the purchases of Italian and Spanish government bonds by the EFSF/ESM is not fleshed out i.e. whether this would happen when interest rates hit a certain ceiling? What this ceiling might be? Whether these would be senior or pari-passu with private bondholders? Without these it's impossible to say how important this is. What is very clear however is that the limited firepower of the EFSF/ESM and the fact that 25% of their backing comes from the crisis ridden countries limits how much this program can achieve.

Why is this good news? And why it may be bad news? Let us consider each of the conclusions in turn.

The ECB as supervisor for Eurozone banks

In the run up to the crisis, banking supervision standards across EU member states were generally shoddy but with  a great difference in exactly how shoddy. The variance in the quality of supervision has been high with the quality of supervision inversely related to the cosiness between the banking sector and regulators and with competence. This has continued after the crisis hit and has manifested itself in several forms, including the very different standards that supervisors have applied in the European Banking Authority stress tests and recapitalization exercises.

Hiving off supervisory authority to the ECB would mean that the quality of supervision across the Eurozone would become more even and hopefully also uniformly better.

Central banks, in their role as lenders of last resort, are supposed to lend as much as needed to solvent but illiquid central banks. But often, as in this crisis, the hardest thing to do is to distinguish between insolvency and illiquidity. One of the reasons the ECB has offered for not having done (even) more to support the banking system is that it's trust in national supervisors is rather limited. Its fear that national supervisors would overplay the strength of their wards and understate their weaknesses has come true for example when the truly shoddy state of Spanish and Irish banks was revealed soon after they had been given a clean bill of health by their national regulators.  It has said that it would be more willing to support banks and sooner if it had greater confidence that it knew the true state of affairs. The decision to put supervision in the ECB's hands will thus make it more comfortable playing its lender of last resort role.

Central bankers are, particularly if they cannot be fired as those at the ECB can't be, more likely to be independent and less beholden to particular political or financial interests to which national supervisors have been shown to be vulnerable. So ECB supervision may not just be more uniform but tougher and more independent.

The less good news takes several forms. The first and foremost is that any realistic effective transfer of supervisory powers to the ECB will take several years. The ECB has no capacity on this yet, and given the experiences internationally it would really take a long time for it to develop effective capacity no matter how accelerated a program of recruitment it carries out. A compromise in the form of the ECB being given power over national supervisors may be politically effective but all of the current problems with national supervision will remain.  This can be no more than an interim solution.

The second concern we have is about institutional overstretch. Supervision is manpower intensive and the ECB's six-person executive council is already complaining of being overstretched when one out of their six seats is vacant. How will they ever do a quality job with the same top management when the job expands so much? And ultimate responsibility cannot be given to hired staff as it has to rest with the executive board itself.

The third concern we have is that with this move the European Central Bank is becoming the European (Super) Central Bank. As a central bank which is the sole backer of a currency with no equivalently powerful fiscal authority that sits atop or besides it, the ECB is already disproportionately powerful compared to other central banks. Also, given that nothing less than a treaty change could take power away from the ECB and its well-nigh impossible to get treaty change in the EU, the ECB enjoys much more independence than the Bank of England or the Fed do. The 8 year terms for its executive council members are also longer than those at most other central banks and they cannot be fired in most states of the world. This is an unprecedented concentration of power and with the ECB's letter to PM Berlusconi asking for reforms in exchange for ECB support, many people feel that the ECB has been overstepping its powers and prescribing to fiscal authorities what they should so even as it reasserts its independence from what they may ask it to do.

The fourth related concern is that of the very limited accountability the ECB has to any democratically elected body. The president of the ECB makes regular presentations to and takes questions from the ECON committee of the European Parliament but is not formally accountable to them. Nor it is obliged to answer the questions they ask the ECB. In practice, the situation is even worse with most Members of the European Parliament being deferential in how they speak to the ECB – almost as bad as Bundestag Members are when they speak to the Bundesbank. The complete lack of democratic accountability and the very little transparency in how the ECB works should be matters of grave concern that need to be set right before the ECB is given more powers.

The fifth and the last concern is that the narrow inflation specific mandate of the ECB is insufficient for it to be an effective supervisor and would need to be expanded to include growth and financial stability, without which the ECB's supervision of banks may be lop-sided.

Injecting equity into banks

We have long complained about the vicious sovereign-bank dance of death underway in the Eurozone and the need to break the far too strong links between banks and sovereigns. In order to do this, we have long called for ESM to be given the ability to inject funds directly into Eurozone banks. This has finally been agreed to in principle which represents significant progress. Also, this would apply not just to Spain but also to countries such as Greece and Ireland and could significantly reduce the burden of debt on the sovereigns by taking the support they have been providing their respective banks off the books and on to the balance sheet of the ESM instead.

However there are several caveats here. First, this will happen only after the ECB has been handed supervision powers – which as we have discussed in the previous section may take years. So this is not going to translate into real support in the short term, but could possibly be used as a mechanism to take over bank stakes from weak sovereigns thus reducing their debt burden and weakening the links with banks.

Second, it is unlikely that this would be allowed to happen without a clean-up of the banks in question first. This would mean a bigger upfront recognition of losses and possible haircuts for subordinated bondholders and even senior bondholders. This would almost surely involve a writing-off or writing down of some of the equity holdings, including some held by the sovereign so the reduction in the debt burden of sovereigns may not be as large as hoped for. Also, as things stand now, there is no European resolution mechanism, which would need to be set up. Even national resolution mechanisms, which may work in the interim, don't exist in most of the troubled economies.

Third, this would make the EFSF/ESM much more risky and subject them to real risks of losses which would make the whole process highly contentious politically. Any country could choose to pull the plug so the long-term viability and effectiveness of this mechanism remains in doubt.

Waiving seniority

The most important point to remember here is that there is less than meets the eye. Seniority, as I have explained extensively in my note "The Spanish Bailout, the Eurocrisis & the myth of Seniority" was never a big problem with the Spanish bailout. It was that it took the form of a loan rather than equity injection. If the European Council had merely agreed to waive seniority without changing what form this bailout would take, the effect on market confidence would have been very limited.

It's the decision to allow the ESM to inject equity which is the critical one. This of course, as any sensible person would tell you, cannot happen when it is senior. Equity injections are by definition junior to bonds so the ESM, once it is allowed to inject equity will effectively become subordinated to the claims of existing bondholders.

What really would matter, in terms of the discussion on seniority, is whether or not this would apply to Italy. As I have explained in my note yesterday, "Yet another European Council! Recuing the Eurozone", renouncing seniority for Italy really matters particularly if the support for it will be in the form of bond purchases by the EFSF/ESM. Secondary market purchases of the kind the ECB made through its SMP program are not effective when they are 1) limited and 2) have embedded seniority. Because an ESM/EFSF program would always be seen to be more limited than an ECB program, the renunciation of seniority for Italy is very important.

Another point I have made in my note on seniority is that it's one thing to waive it, and it's quite another thing for markets to believe it. It's difficult to see how a credible commitment can be made about this, particularly as the amount of support provided to Italy starts to rise.

Supporting Italy and Spain through bond purchases

This part of the declaration of the European Council has almost no flesh on the bone whatsoever. With such few details it hard to make a judgement but we will try.

The good news is that something will be done to lower the borrowing costs for Italy and Spain, which were threatening to snowball. The bad news is that it will at best buy some time and will almost certainly not be enough.

Politically, it is important for the leaders of Spain and Italy not to be seen to be prescribed conditionality by the European Authorities. The governments of each of the countries that went for an EU program with conditionality were voted out of power. So an in-principle agreement that the only conditions that would apply for activating this program would be policies that the Member States are already legally obliged to adhere to under the newly beefed up EU economic governance rules. We have shown how, for example in the case of Spain, these are almost as far-reaching as explicit new conditionality prescribed in the case of a country such as Portugal.

The agreement which will simply transpose existing commitments into a memorandum of understanding and add a timeline for results to be delivered is a good compromise between the interests of the creditor and debtor countries and one which Re-Define has been promoting for several months. There is another added caveat, which is that only countries 'with good behaviour' will be able to access these facilities. This is good in terms of discipline and will help hold Monti's successor government to account, but at the same time undermines belief in the effectiveness of the support by introducing an element of uncertainty.

We don't know yet, whether the scheme would be automatically activated to provide a ceiling on borrowing costs, which would be good policy. We also don't know what this ceiling, if agreed, may be – A 4%-5% ceiling would be good, a 7% ceiling would be bad. We have discussed this topic of capping borrowing costs in a note we did on the ECB that can be accessed here.

Another limitation of this scheme that we discussed extensively in our note yesterday is that its size is limited and that this would reduce its credibility and effectiveness.  As we wrote yesterday

"The limited size of the ESM/EFSF is yet aspect of this strategy that may limit its effectiveness , as borrowing costs can best be credibly brought down if it is demonstrated that the sovereigns in trouble have access to reasonable cost funding for as long as they need it.

Another complication is that fact that when one includes Italy and Spain, the effective capacity of the crisis funds could shrink by almost 25% as then the bailed-out countries would constitute nearly a quarter of the fiscal capacity that supposedly stands behind these funds."

[citizen k]

The Long Memory of "The Sick Man of Europe"

It's astounding just how distorted the coverage of Germany's role in some grand Eurozone bailout scheme has been—well, at least in the English-speaking mainstream media. Time after time, we're confronted with the inanest headlines and reports that place German politicians, and particularly Chancellor Angela Merkel, on some kind of invisible verge where they will suddenly, and under tremendous international pressure, come to their senses and ... blink.
And by blinking, Germany would agree to, guarantee, and fund all the panaceas regularly trotted out by those that need them, particularly Spain, Italy, and now loudest of all, due to its shaky megabanks, France. The lasted blast came from the Wall Street Journal where Berlin Blinks on Shared Debt. Others regurgitated it, including MarketWatch. Yet, it contradicted everything that either German Finance Minister Wolfgang Schäuble or Chancellor Merkel had ever been quoted saying in the German press. And indeed, not much later, a spokesman at the Ministry of Finance made it clear, once again: "This is not true," he said.
In addition to Eurobonds, the basket of panaceas includes other forms of "mutualization" of debt, a Eurozone-wide banking union with the power to bail out banks with taxpayer or ECB funds, a similarly endowed modified version of the still non-existing ESM bailout fund, and an ECB that can buy even the crappiest sovereign bonds of the most bankrupt Eurozone countries to keep them afloat another day (similar to the Fed and its purchases of treasuries and other securities).
But the 17-member Eurozone isn't a country. It's but a monetary union within a 27-member free-trade block. And any mutualization of debt would simply transfer financial responsibility from those who spend to those who end up having to pay for it, without any kind of reciprocal control. Even in the US, California can't shuffle off its pile of debt and its never-ending deficits—though it's supposed to have a balanced budget—to the Federal Government and its taxpayers. So why should Spain be able to shuffle off its debt to taxpayers in other countries?
That's how it's seen in Germany—where Eurobonds are despised by 79% of the people. The ESM, which continues to be pushed by Merkel, has been running the gauntlet ranging from street demonstrations to the Federal Constitutional Court, where it is currently hung up. It should have been ratified by July 1, and while it is likely to get through the process with some delay, any steps beyond it, such as Eurobonds, are considered unconstitutional.
But as if all these reasons still weren't good enough, George Dorgan—a portfolio manager based in Switzerland—has put his finger on another powerful reason:

The first full-blown bailout Germany undertook, namely the integration of East Germany (only 17 million people), caused the German debt to nearly triple from €430 billion in 1989 to €1,200 billion in 1999, a decade during which even the US managed to reduce its debt for a couple of years. Germany greatly underestimated the integration costs. It led the country into a long phase of slow growth till 2006; and still now the west pays subsidies to the east. Spain, Italy, Portugal, Ireland, Cyprus, and Greece might be better developed than the former communist GDR. But they count over 100 million people and might need even more time to adjust than the 20 years the former Eastern Germans needed.
Merkel hails from former East Germany and experienced firsthand how difficult the adjustment has been for East Germans—and how expensive for West Germans. Reunification wasn't only funded by debt that will be around for generations, but also by a special income tax, the Solidaritätszuschlag—lovingly called Soli—introduced in 1991. And it's still around as well. As George points out, the entire period until 2006 was tough on Germany—by then "the sick man of Europe." That's what it took to bail out a country of 17 million people, raise the standard of living, and make its industries competitive in a globalized economy.
Bailing out in this manner the growing stable of Eurozone countries will be beyond the feasible. As with East Germany, costs will be underestimated, but will then balloon for years or decades. Merkel knows that. Hence her limits on how far Germany would be willing to go.
But the beleaguered Chancellor just can't catch a break. She has already committed hundreds of billions of taxpayer euros to propping up collapsing countries. In return, she wants them to live within their means and restructure their economies so that the bailouts wouldn't have to continue for years. For that, she got tossed into the Axis of Evil. And then the Swiss Minister of Defense spoke up.
"These hordes of Eurocrats should be summarily fired and their agencies totally abolished," said Doug Casey during a pungent interview. Governments in the EU "are all bankrupt," and Europeans "will be indentured servants of the Chinese." Europe is like a skydiver, and if they pull the bailout ripcord, "they'll find there's no chute... just a bunch of dirty laundry their economists packed as a joke."

[Syt]

"Global joy - Merkel makes Eurobonds possible!"

[Iormlund]

What would be really helpful is if this could extend to Ireland and even Greece who've had to use €45 billion of their bailout to recapitalise their banks.

I would say the deal was specifically aimed at excluding Greece, setting its dubious compliance track record as an example of what makes a country non-eligible for this favored status.

[Sheilbh]

I think the markets are assuming it's a bit wider.  Ireland's yields are down 80 bps, I think on the basis of the bank deal. Which is great for them but could also mean they can return to the market's on schedule which would also, I think, be good for the Eurozone as a whole.  It'd be very useful if there was a demonstration, for both sides, that there is an end.

Edit: You could be right that it excludes Greece. But they need a third bailout/renegotiation anyway. I think it would make sense to use this tool as part of that.

Edit: Irish yields are now lower than Spanish ones. This really totally changes the picture for them.

[Iormlund]

Regarding Greece, this could be seen as a carrot to encourage compliance. However, I doubt any European decision maker has any faith left in their Greek counterparts.

[MadImmortalMan]

I put a small spec bet on that Angie will succumb to the gangbang and agree to eurobonds or something similar tomorrow or Friday and spike the market.

50 calls. $11,000. Thanks Merkel!


Edit: 13,500 at the close.