Europe's 750 billion euro bazooka

What’s at stake: For the first time since the Greek debt crisis erupted in October, European political leaders have moved decisively “ahead of the curve”. The following sections summarize the main elements of the package, discuss whether it might get successful at dealing with the eurozone’s structural issues, shed lights on the ECB’s stunning change of position and speculate on what this package might  mean for Europe as a political object.

The “night” deal

Calculated Risk summarizes the 5 points of the deal. (1) The EU will extend an existing balance of payments facility (which was used to help Hungary, Latvia, and Romania) by €60 billion based on article 122 (special circumstances). The IMF will add €30 billion. (2) The EU will create a Special Purpose Vehicle (SPV) for 3 years based on inter government agreements. These are potential loan guarantees backed by all eurozone countries. This will be up to €440 billion - plus a contribution from the IMF up to half of European Union contribution (up to €220 billion). 3) There are apparently agreements from Portugal and Spain to take steps to reduce their deficits. 4) The European Central Bank (ECB) said it will buy "in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments which are dysfunctional." 5) The US Federal Reserve reopened swap lines to provide dollar liquidity.

Charlemagne writes that this new intergovernmental warchest of €440 billion, working with the intergovernmental IMF, is a bit like the mutual defence clause, Article 5, in the NATO treaty that says an attack on one member of NATO is an attack on all. That is hugely important, and commits each member government to big and serious things. But it is not the same as those member countries agreeing to pool their militaries.

Mohamed El Erian writes that market participants will now spend a lot of time analysing the minutiae of this dramatic policy response with a view to assessing its immediate impact, its durability, and the potential range of unintended consequences. Many questions will need to be answered. They range from the operational (how will all these interventions be approved, financed and executed), to the conceptual (what does this mean for institutional integrity), to effectiveness (will the liquidity injection be used to support fiscal consolidation or end up deferring it). Over the weekend, Europe has done much more than boldly step-up its policy response; it has taken it to a completely new level and dimension. We are now in unchartered waters when it comes to how all this will impact the secular workings and make-up of the eurozone.

Europe’s TARP

A number of authors have been criticising the deal as making the classic mistake of treating a solvency problem as if it were a liquidity problem. The Brussels Blog, for example, writes that the eurozone’s difficulties, in the form of yawning budget deficits and huge private and public sector debts, have not gone away overnight. Fiscal retrenchment and austerity will still have to be the order of the day for the next three years at least, and it is very much an open question whether governments have the political nerve and the support from their societies to sustain the unpopular policies that will be required. Simon Johnson and Peter Boone note that the market applauded initially, but now people are doing the sums on the underlying fiscal solvency.

Karl Whelan draws parallels with the 2008 banking crisis. As markets began to doubt the solvency of many institutions, access to short term liquidity dried up for these institutions. Governments provided various liability guarantees to help these banks regain access to markets but these guarantees did not change the underlying solvency picture. Ultimately, the problem of insolvent banks had to be dealt with via costly recapitalisation measures, a process that several countries still have yet to complete.

The ECB’s stunning change of position

Marco Annuniziata says that in the short term, the ECB’s intervention will be a crucial element of the package, bringing immediate relief; the longer term implications however could be extremely detrimental. Much will depend on whether or not Eurozone governments quickly follow through on their pledge to accelerate fiscal consolidation efforts: if they do, the ECB might still be able to argue that it has offered temporary support to offset impending market dislocations; if they do not, it will be hard for the ECB to fight off the charge of monetizing excessive fiscal deficit. So far, however, no strengthening of fiscal discipline mechanisms has been agreed, and all we have is the commitment to enforce the procedures and sanctions of the Stability and Growth Pact – which unfortunately has a rather dismal track record.

Paul Krugman writes that a more expansionary monetary policy could make a real difference – especially if the ECB ends up accepting somewhat higher inflation. Suppose that a generic cohesion country – call it Speece or Grain – needs to get relative prices down 15 percent over the next five years. If the eurozone has 1 percent inflation, that’s 10 percent deflation in the periphery. If the eurozone has 3 percent inflation, all you need is stable prices. Also, a stronger overall eurozone economy means higher GDP and hence higher revenue, making the fiscal slog less grim. So there’s something substantive here; it’s not just a matter of buying time during which nothing good will happen.

A political headache

Charlemagne writes that the politics have shifted dramatically in the last few days, and that the euro is looking less German and more French, even if Angela Merkel has won some late victories on process by insisting that national governments should not give open-ended loan guarantees to the European Commission to play with. The EU has developed a much stronger external narrative, telling markets that they should treat the eurozone as a single whole, which is strong and solvent, and not try to pick off weaker members because they will get their fingers burned. But the political narrative inside the eurozone is still lagging way behind as leaders like Mrs Merkel have yet to make the positive case for saving the euro, instead preferring to make the negative case for punishing speculators.

Felix Salmon fears that the enormity of the facility will only exacerbate tensions between the euro zone countries over the long term. They’re not all partners together anymore: now they’re bifurcating into the rich lenders, on the one hand, and the formerly-profligate debtors, on the other. The mind-boggling sums involved are only going to increase resentments both of the south in the north and of the north in the south. To recast his matrimonial analogy, the parents have promised to bail their wayward children out of jail. And they think that the children will respond overnight with gratitude and with a fundamental change of behaviour. Does that ever actually happen?

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