EZ rescue: Déjà vu all over again

"EU leaders are at it again. This column argues that the crisis won’t be over until the underlying flaw of the euro is fixed – namely the separation of monetary and fiscal policy. German public opinion has to realise that the euro was built on imperfect foundations and that these imperfections must be corrected. Meanwhile, the Italian president of the ECB will need all his technical and political expertise to keep the Eurozone together.

It is now a habit. Every three or four months, European summits are devoted to ending the Eurozone crisis. Each time tough and controversial decisions are taken and new innovations to European governance are introduced. For a few weeks things seem to get better, but then everything goes back to being as it was, if not worse. Why?

What should be done to solve the problems for real?

The Eurozone core weakness has been known since the beginning – the separation of monetary and fiscal policy. This is the principle upon which the European monetary union was built, but the crisis made it clear – without a central bank acting as lender of last resort, highly indebted countries are too vulnerable to changes in market confidence. Unless this central problem is addressed, the crisis is unlikely to reach a turning point.

Why the EFSF has failed to fix the problem so far

The EFSF was created as a remedy to this structural flaw of the Eurozone. After realising that its size was insufficient, its capacity was enlarged. A new idea came out of the European summit, namely to extend its scope, concentrating the resources of the EFSF in order to partially guarantee newly issued debt of countries at risk. This would allow both Italy and Spain to issue debt which would be partially guaranteed until the end of 2013.

The next failure

There are reasons to believe that this remedy – like the innovations of the past – will fail to restore market confidence.

• First, the resources of the EFSF will be exhausted in a few years – but confidence cannot have an expiration date.

Knowing that there could be a confidence crisis in a couple of years, why should one trust the solution today?

• Second, without guarantees, the debt that has already been issued would be penalized, making European banks even more fragile.

This would worsen the vicious spiral we are seeing at work, namely distrust towards debt and banks, higher cost of capital, lower investments and growth, and further slippage towards debt unsustainability.
To cope with this problem, the summit agreed to rely on a special purpose vehicle that would buy sovereign debt in the secondary market. But it is not clear whether its resources would be sufficient for the task, nor where they would be coming from.

• Third, the guarantees that have been proposed – which cover the losses only up to 20% – are modest.

Experience teaches that, when debt is really restructured, losses are much higher – on average around 50%..."

at http://www.voxeu.org/index.php?q=node/7171