naked capitalism

The EU announced a €750 billion salvage operation, funds to shore up economies in economic difficulty, with the program consisting of €440 billion of loans from eurozone nations, €60 billion from an EU emergency fund, and €250 billion from the IMF.

There are several layers of complicating factors, however. The first is that the German electorate has signaled its unhappiness with bailouts, presumably restricting future action if this measure falls short. From the Wall Street Journal:

In Germany, projections showed Ms. Merkel’s center-right alliance Sunday lost a crucial regional election amid a voter backlash against aid for Greece. That means her government is set to lose its majority in Germany’s upper house.

Second, even though the rescue is intended for the 16 eurozone members, it requires approval of the EU, which includes 11 non-eurozone members like the UK (presumably, that is for the €60 billion EU loan). The message from the UK seems to be that it will support this deal, but don’t expect any future help.

But what is most striking is the European Central Bank’s vagueness. As we noted earlier, EU banks are experiencing sharp rises in bond spreads and short term funding costs due to worries to about exposures to risky sovereign debt, as well as other dodgy assets sitting on their balance sheets. Representatives of 47 banking groups were “begging” the ECB to act as “buyer of the last resort” of sovereign debt from them to provide relief. As we have stressed before (and as skeptical German voters seem to understand full well) the undercapitalized European banking system is at risk. The public is not too happy with bailouts and austerity programs that are ultimately transfers from them to the moneybags.

ECB participation is crucial to this operation. One reader noted, “But it looks like it’s all coming from euro zone governments. I suppose since nobody is really questioning solvency of France or Germany, that might help, but how do Spain, Portugal and Italy contribute? And God will it be DEFLATIONARY if it’s not ECB money.”

The last point is key. If deflation kicks in within the countries at risk (forget Greece, the eurozone ought to be in triage mode) the debt burden become worse. All the rescue operation has done is buy breathing room while making the eventual outcome worse. While having the ECB support the operation may offend some tender sensibilities, it can offset the deflationary pressures and make Portugal and Spain more viable short term. While the WSJ’s and Bloomberg’s initial announcements contained no mention of ECB action, the Financial Times does:

As part of a massive EU plan to shock the markets into believing eurozone finances were sound, the European Central Bank was also set to play a big role by buying eurozone government debt.

Olli Rehn, European commissioner for economic and monetary affairs, said that the ECB had “taken a decision to intervene in the secondary market for government securities”

Update 10:00 PM: Bloomberg provides more details:

The European Central Bank said it will intervene in government and private bond markets as part of an unprecedented effort to help stave off a sovereign debt crisis that threatens to destroy the euro.

“The Governing Council decided to conduct interventions in the euro area public and private debt securities markets to ensure depth and liquidity in those market segments which are dysfunctional,” the Frankfurt-based central bank said in a statement today. “The scope of the interventions will be determined by the Governing Council.”

The ECB said it will sterilize the purchases and announced it will hold additional longer term operations at three- and six-month maturities. The central bank also said that it will reactivate temporary liquidity swap lines with the Federal Reserve to resume U.S. dollar tenders at terms of 7 and 84 days.

Yves here. Note the Fed currency swap lines; this says the Fed is supporting the operations, something that the markets will applaud. The Bank of Japan is also mulling opening dollar swap lines with the Fed to shore up Euro money markets (since Japan is a military protectorate of the US, and the BoJ has been leaned on in past crises by the Fed to throw in its support, this is not exactly surprising, given Fed involvement, but the show of coordinated action will go over well).

Yves here. This is all well and good, but notice the vagueness of the promise…and no euro signs attached. This may persuade the markets for bit, but how long will it take for market participants to start testing the ECB’s resolve? If it is concerned about tanking the euro, it will not want to go very far down the path of quantitative easing (cynics will argue that the euro is destined to go lower, but there is a big difference between a price decline and a disorderly collapse).

But the real problem is that there appears to be no impetus towards a longer term solution. How do solve imbalances within the eurozone? Without a plan to develop a plan on that front, this simply rearranging the deck chairs on the Titanic.

Nevertheless, Mr. Market is happy for now. The euro has risen from its pre-weekend close of roughly 1.275 to 1.287, S&P futures are up 26 points, and most Asian markets are higher.

Update 11:30 PM: Aha, the fly in the ointment is revealed in a different FT article:

However, the sheer scale of the eurozone and IMF initiative appears intended to avoid forcing the ECB into the so-called nuclear option of buying government debt on the secondary market.

Such a step would gravely compromise the ECB’s reputation as an institution both independent of political pressures and resolutely committed to keeping inflation expectations low.

Yves here. So the ECB commitment is Paulson’s bazooka redux. And we all know how well that worked.

Update 5/10/10, 2:30 AM: Ambrose Evans-Pritchard of the Telegraph has a different reading, namely, that the EU just created a stealth Treasury (hat tip reader Reginald D):

But if the early reports are near true, the accord profoundly alters the character of the European Union. The walls of fiscal and economic sovereignty are being breached. The creation of an EU rescue mechanism with powers to issue bonds with Europe’s AAA rating to help eurozone states in trouble — apparently €60bn, with a separate facility that may be able to lever up to €600bn — is to go far beyond the Lisbon Treaty. This new agency is an EU Treasury in all but name, managing an EU fiscal union where liabilities become shared. A European state is being created before our eyes…

The euro’s founding fathers have for now won their strategic bet that monetary union would one day force EU states to create the machinery needed to make it work, or put another way that Germany would go along rather than squander its half-century investment in Europe’s power-war order.

Whether the German nation will acquiesce for long is another matter.

But he thinks this is insufficient:

The answer to this — if the objective is to save EMU — is for Germany to boost its growth and tolerate higher `relative’ inflation. This would allow the South to close the gap without tipping into a 1930s Fisherite death spiral. Yet Europe will have none of it. The weekend deal demands yet more belt-tightening from the South. Portugal is to shelve its public works projects. Spain has pledged further cuts. As for Germany, it is preparing fiscal tightening to comply with the new balanced budget amendment in its Grundgesetz.

While each component makes sense in its own narrow terms, the EU policy as a whole is madness for a currency union. Stephen Lewis from Monument Securities says Europe’s leaders have forgotten the lesson of the “Gold Bloc” in the second phase of the Great Depression, when a reactionary and over-proud Continent ground itself into slump by clinging to deflationary totemism long after the circumstances had rendered this policy suicidal. We all know how it ended.