Private investors are being forced to eat losses. In return, they'll demand higher interest rates from Italy and Spain. That makes it more expensive to insure Italian and Spanish debt.
The overnight deal to address the Eurozone debt crisis follows an eerily familiar pattern. Waiting until action was long overdue, Europe's leaders have come up with a solution they will sell as final and complete while leaving important -- and potentially deal killing -- details for later. The markets surged yesterday on the news of what appears to be a massive deal. But if past is prologue, it will slowly become apparent that Europe has solved few of its underlying problems, and another round of this seemingly endless game will come later.
The important steps that were taken came months after the need was obvious. The deal covered three main areas, each of which has some potentially fatal flaws:
Shoring up Europe's banks: Key banks are being forced to recapitalize by raising €106 billion (roughly $150 billion) in new capital. While this is less than most analysts believe is needed, it's nonetheless a real step towards fixing a problem. But this was essentially going to happen with Basel III anyway. This wasn't a new policy, but an expedited policy. The big question is where the recapitalization funds will come from. Based on precedent, taxpayers will foot a large part of the bill. How this plays in French and German politics will have a big impact on its success. So far, that argument has not gone well for President Sarkozy, and has been even worse for Chancellor Merkel.
The key problem remains unsolved. We have a currency union without a fiscal union.
Increasing private sector participation: The most ballyhooed piece of this deal, the 50 percent "haircut" that investors will take on Greek debt, must have been excruciatingly hard to negotiate, but it has some crucial pieces yet to define. First, the private sector involvement (or PSI as it's become known) is voluntary. It has to be in order to avoid triggering a "credit event," which would have a range of nasty consequences. But this means banks can choose not to participate. Second, the actual value of the total debt to be written down, and therefore the level of guarantee investors will require to take the deal, are also left to be determined. Greece has a serious solvency problem and cutting its debt enough and at the right rate is essential to giving it room to recover.
The Atlantic's Megan McArdle points to the FT's rather cheeky subhed -- "Officials believe deal could cut Athens' debt to 120% of GDP" -- and wryly observes, "This is hardly the sort of news to make one grab the pan pipes and go dancing through the Mediterranean hills." Indeed.
Selling insurance and panhandling: The most perilous part of the deal will be transformation of the $440 billion European Financial Stability Facility (EFSF) into a €1 trillion ($1.4 trillion) rescue fund. One part of the new plan turns a portion of the EFSF into an insurance fund. The other relies on the kindness of strangers -- basically, the Chinese -- to ride to the rescue.