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.
Ironically, the private sector deal that could bring down the insurance deal. As private investors are forced to take write-downs, they will demand higher rates of return on debt from countries like Italy and Spain. This will in turn place greater stress on the solvency of the insurance facility, causing investor fear that the facility might fail, and driving bond yields even higher. This could quickly turn into a death spiral for the EFSF.
As for non-European countries contributing to a rescue fund, it's hard to understand and unpleasant to consider what terms the Chinese would demand for pitching in. It seems safe to guess that concession on intellectual property rights and very favorable returns to its investment would be a place to start.
Nor, interestingly, is there any deadline for achieving this mythical reserve. There is hope that there will be a plan in place by the G20 summit in Cannes next week but that seems an impossibly early target given that European leaders have already had two years to come together.
And let's not leave out the politics. This was an ugly process. The low point seems to have been when France's president told Britian's prime minister that he'd "missed an excellent opportunity to shut up." Italy continues to thumb its nose at France and Germany's demands for austerity. Two years into this mess, the key problem remains unsolved. We have a currency union without a fiscal union.
It's unclear whether the new governance structures the deal puts in place (i.e., a newly empowered Eurogroup) can withstand a shock to the system that any part of the plan failing would deliver, and what Europe's next set of options will be if this unravels. It's also another undemocratic step toward consolidation of power in Brussels, which European electorates seem to have little appetite for at the moment. In short, Europe's leaders are delivering a Europe that its people aren't sure they want.
Angela Merkel and Nicolas Sarkozy--and, surely, Herman Van Rompuy--can huff and puff all they want but they have little power to force Silvio Berlusconi's hand. The government is on shaky ground politically and, frankly, haranguing from Berlin, Paris, and Brussels will likely be met with continued defiance. Earlier in the week, Berlusconi declared, "No one in the E.U. can nominate themselves commissioner and speak in the name of elected governments. No one can give lessons to E.U. partners." That's how it's always been. And that's the problem.
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