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Without wings, sans prayers

Concluding his two-part assessment of Europe's economic woes, Satyajit Das contends that the plan to end the debt crisis is a con.

Concluding his two-part assessment of Europe's economic woes, Satyajit Das contends that the plan to end the debt crisis is a con.

THE initial market response to the EU proposal was positive, with major sharemarkets and bank shares rising sharply. Unlike in the equity markets, debt traders were cautious. On Friday, October 29, an Italian debt auction met with lacklustre demand falling short of the full amount offered for sale. The debt markets registered their doubts by pushing up 10-year interest rates on the bonds of both Italy (up 14 basis points to 6.01 per cent a year) and Spain (up 18 basis points to 5.49 per cent). Greek rates remained high at 22.35 per cent for 10 years, while comparable Portuguese rates were 11.48 per cent and Irish rates were 7.98 per cent.

Implementation of the plan faces significant risks. Many elements of the plan are works in progress and are yet to be agreed to with affected parties.

Germany's Finance Minister, Wolfgang Schauble, and retiring European Central Bank president Jean-Claude Trichet pointedly cautioned that the crisis was far from over.

At best, the plan provides funds to tide over the immediate funding problems of weaker euro zone members. It does little to deal with the euro zone's structural problems. There is still the risk that Europe enters a prolonged period of low growth or recession. The plan does not address the economic divergences that exist within the euro zone or ease the painful adjustment processes that weaker members will still have to undergo within the constraints of the single currency.

A crucial element of the plan is the ability of Spain and Italy to take action to improve their finances and maintain access to funding at reasonable cost. The EU communique specifically refers to the need for action by these members at some length. There is considerable doubt as to whether this will occur.

Spain's economy is weak, with low growth, low productivity and high reliance on debt. As the country has sought to bring its finances under control, Spain's growth has slowed, with an increase in the unemployment rate to 21 per cent, and youth unemployment is above 40 per cent.

Spain is seeking to reduce its budget deficit, adding a balanced-budget amendment to the constitution. But Spanish debt levels are still rising. Regional finances are even worse.

Spain's banking sector is heavily exposed to construction, which was affected when the real estate bubble burst. The need for Spain to provide capital for the banks would place a strain on public finances.

Italy also faces difficulty in reforming its economy. Italy has a relatively low annual budget deficit, but its total debt to GDP is the second highest in the euro zone after Greece. In an emotional letter to the EU, Italian Prime Minister Silvio Berlusconi described hoped-for measures to improve the economy. A commitment to increase the retirement age in Italy from 65 to 67 by the year 2026 highlighted the lack of urgency and intent of the reforms.

The Northern League, a coalition partner of the government, is resisting many of the reforms. In a letter to the newspaper Il Foglio , Prime Minister Berlusconi supported growth and development but rejected austerity measures, declaring that the word "isn't in my vocabulary". This conflicts with Italian commitments to the EU for large cuts in government spending.

It is difficult to see Italy, weakened by internal political strife, making rapid progress in making required structural changes to its economy and cutting public debt.

The EU refuses to deal with fundamental problems. The austerity and balanced-budget measures, reinforced and reiterated in the plan, cannot deal with the primary problem the deflation of the debt-fuelled bubble.

The EU is seeking to enforce the rarely adhered to rules for membership of the euro. The Stability and Growth Pact requires a deficit no larger than 3 per cent in any one year and a debt to GDP ratio no larger than 60 per cent. Based on 2010 figures, Austria, Belgium, Cyprus, France, Ireland, Italy, Portugal, Spain and Greece do not meet one or both of these tests on current measures. Only Germany, Finland and the Netherlands are in compliance and would pass in 2013 on current projections.

Strict enforcement of this rule about deficits would prevent counter-cyclical spending by governments undermining economic recovery and locking the euro zone into a death spiral of budget deficits, further budget cuts and low growth.

The problem is compounded by the competitiveness gap between northern and southern countries, estimated at a 30 per cent difference in costs. The EU's refusal to contemplate a breakup or restructuring of the euro makes dealing with this problem difficult.

For many of the weaker countries, the best option would be to devalue their currency in the same way that the US and Britain are debasing dollars and sterling respectively. Unable to devalue or control interest rates, these weaker countries are trapped in a vicious and ultimately self-defeating cycle of cost reduction.

An additional problem is the internal imbalances exemplified by Germany's large intra-euro zone trade surplus at the expense of deficit states, especially the Club Med countries like Greece, Portugal, Spain and Italy. German reluctance to boosting spending and imports makes any chance of resolving the crisis even more remote.

German hypocrisy, in this regard, is problematic. German banks lent money to many countries to finance exports, which benefited Germany. Germany also gained export competitiveness from a weaker Euro. Reluctance to confront these problems makes a comprehensive resolution of the crisis difficult.

The plan has bought time, though far less than generally assumed. As the details are analysed, weaknesses, unless remedied, will be quickly exposed.

The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies) debt monetisation (the ECB prints money) or sovereign defaults.

The key element of the October 27 plan was the unwillingness or inability of Germany and France to increase the size of their commitments. The communique explicitly states: "[the increase in the European Financial Stability Facility's capacity will be] without extending the guarantees underpinning the facility [paragraph 18]." In other words, any further increase in the bailout facility will be difficult.

Germany is increasingly unwilling to increase its commitments. It is restricted by the German constitutional court's decision, which makes it difficult to increase support for bailouts without a new constitution. On October 28, 2011, the German constitutional court issued a temporary injunction requiring the government to stop relying on a selected group of lawmakers (effectively the Bundestag Finance Committee) to fast-track approval of euro zone bailout funds. If the decision is upheld, then the German government's flexibility to act quickly will be restricted as it will need full parliamentary approval for each decision.

For the moment, Germany cannot or will not go above ?211 billion ($A280 billion) in guarantees for the bailout funds already committed about 7 per cent of its GDP. Fiscal integration would have a higher cost than Germany is willing to pay or can sustain without affecting the country's creditworthiness. Germany's GDP is around $US3.2 trillion ($A3.1 trillion) and its debt to GDP ratio is around 75 per cent. Supporting the financial needs of weaker countries would stretch its financial abilities.

France is at the limit of its financial capacity. France's GDP is around $US2 trillion and its debt to GDP is around 82 per cent. Following the assumption of the liabilities of the failed Franco-Belgium financier Dexia, the rating agencies have indicated that France faces a rating downgrade.

The Netherlands, Finland and Luxembourg are too small to make much difference. Fragile coalition governments in the Netherlands and Finland are increasingly reluctant to increase their commitments to the bailout process.

These constraints make fiscal union difficult.

The ECB is not allowed to print money. Theoretically, it would need a change in European treaties, although the ECB has stretched its operational limits. Under new president Mario Draghi it may be willing to monetise debt as a response to the special circumstances.

Germany's Bundesbank opposes debt monetisation. There would be deep-seated unease about printing money in Germany, which is still haunted by the memory of hyperinflation in the Weimar period.

The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow the printing of money. This assumes that a cost-benefit analysis indicates that this would be less costly than a disorderly break-up of the euro zone. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their own history, Germans believe that this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetisation.

Unless restructuring of the euro, fiscal union and debt monetisation are removed from the verboten list, sovereign defaults may be the only option available.

The coming months will provide numerous tests to the new plan. Details will have to be provided and agreement reached with the relevant parties. Greece, Ireland and Portugal will need to meet tests specified under their bailout plans to qualify for release of funds. Spain and Italy, as well as other euro zone members, will need to issue debt. Economic releases will provide information on the state of Europe's economies. Any slippage on any of these fronts could quickly and fatally derail the process.


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