What Happened In Europe?

There has been a lot of rather vague opining.  The vagueness seems to me a symptom of the deal announced this morning, which is less an agreement than a plan to make a plan.

Certainly, the power of the EU has been in theory, beefed up.  The new rules are supposed to have the teeth that the old rules were supposed to have, but didn't.  Why should we suppose that the teeth have a firmer grip this time around?  Well, in part because there are more institutional supports--the new setup will make enforcement the default.

Also, the Germans and the French were the ones who led the charge to breach the Maastricht criteria.  Presumably, this time they will hold back, even at the expense of a deeper recession.

My remaining euroskeptical worries:

1)  Who will play auditor?  Greece has already found a way around tough deficit criteria: lying.  Eventually it catches up with you.  But by then, you're so completely and thoroughly hosed that everyone has to spend years scrambling around to figure out how to keep you from going under entirely, and taking the currency with you.

I don't mean to suggest that they'll deliberately get themselves into big trouble in order to get a bailout.  Rather, I think the risk is something like what happens in companies that get into accounting scandals: you fudge the numbers a bit to hit your targets, and hope that next quarter's growth bails you out. (Sometimes it does!)  Then you've got an even bigger hole to explain, so you fudge again . . .

And of course, if you're a Greek prime minister, there's a good chance that even if something bad happens, it won't happen when you're in charge.

2)  If the Italians and Greeks can't collect taxes, how are the Germans going to do it?  You can command countries to live within their means, but that doesn't mean that the command will (or even can be) obeyed.

3)  What stops the Italians from eventually saying "Basta!" and checking out after another four years of austerity and low growth?  That's four years away, you may say, but the great gift of finance is to let you enjoy the future right now.  If bondholders think that Italy will leave the euro four years from now, they will demand a hefty premium on Italian bonds today.

4)  The latest deal has opened up new fractures in the EU.  Britain has refused to go along with a treaty requiring new financial regulation that would hurt the City of London, and three other nations have said they need to consult at home before they agree.  Now instead of an add-on eurozone run by the central bank, sitting atop a continent-wide system of market regulation, we have euro members, non-member "ins" who are willing to go along to shore up the troubled currency, and non-member "outs" who aren't.  This is only going to heighten the internal tensions.

The existing institutional infrastructure worked imperfectly, but adequately, before the euro.  But a common currency implies much deeper government and institutional integration, which includes a transfer of considerable sovereignty to the currency zone.  It's hard to have a supranational state in which only some of the membership have that deeper integration.

5)  I heard this morning that the non-euro members who did go along did so mostly because they hope to join the euro.  Talk about the triumph of hope over experience!  This is like supporting the death penalty because you're hoping to end up on death row.

6)  Austerity solves exactly one problem: Italian and Greek credibility on their debt.  It would be much better if they did austerity later.  The problem is, no one trusts them to do austerity later, so they have to do it now to signal that they are serious.  This will increase the misery, and also, I think, the chances that someone gives up and defaults anyway.  The larger tension--the structural differences between the peripheral and the core--remains unresolved.

7)  The governance structure preserves sovereignty at the expense of making it much less likely to work.  Fine, they've considerably weakened sovereign veto power.  But I do not have much faith in a system that requires all these heads of state to fly to Brussels and hash things out every time there's a problem.

It seems to me that we may now be looking at only two futures: the EU gives up the euro; or the EU eventually includes only members who are using the euro.  That's not something I'd thought before, but it's increasingly apparent that it's hard to share a common market and a common semi-government where only some of the members also share a currency.

Of course, what really matters is what markets think. And we won't know that for a few days. Past deals have offered temporary respite, before bond yields resumed their climb--traders always like news of a deal, but when the investors delved into the particulars, the mood soured.

In the short term, what the markets think will happen, will happen.  If they think that Italy will repay all her debt, bond yields will drop and she'll stay solvent.  If they don't . . . hello, new lira.

But fundamentally, this is not about the budget (it is for Greece, but not for the others).  It's about the euro.  Investors want to know that their euro-denominated debt will be repaid in euros, and not some debased national currency.

Ultimately, what investors need to know is that Germany and the ECB will do anything to save the euro.  And I think that right now, most investors are assuming that, when push comes to shove, they will.

Is that true?  I have no idea.  Anything is quite a blanket guarantee to offer places with Italian and Greek level governance issues.