Follow-up to summit undoes its good work

Euro zone policy makers have failed to follow up the small successes of June summit 29th with a consistent message which could inspire investors’ confidence. There were three main specific policy moves of significance and potential benefit that the summit agreed on: first that the European Stability Mechanism (ESM), when it comes existence as it is supposed to in the coming months, should be able to buy government debt of Italy and Spain without the same arrangements involving wide-ranging programmes of the type applied to Greece, Ireland and Portugal which are monitored by the troika of the European Commission (although there would still have to be policy commitments by the governments). Secondly, such debt if bought by the ESM should not become senior to other debt, which would have taken away any realistic chance that it could actually support the private sector market. And finally that, once the ECB has been given regulatory supervision over the euro zone banks, the ESM can provide capital to support troubled banks without that capital being underwritten by the government of the country in which those banks are based, so avoiding an sovereign debt burden that would weaken confidence in the ability of the country to manage its debt.

All three were significant moves and all should have had a beneficial impact on what at present appears the most intractable problem affecting the euro zone’s prospects, namely the threat that lack of market confidence in the solvency of Italy and Spain becomes self fulfilling by charging interest rates in those countries debts that becomes unaffordable. They did have such a beneficial impact but this was very short-lived and in little more than a weak the spreads between Italian/Spanish and German government debt had risen to even higher than they had been before the summit. This partly reflects the fact that though the agreements should have been helpful none will be decisive. Assuming the ESM comes into existence, it will have a lending power of €500bn against a Spanish government debt of €800bn and an Italian one of almost €2,000bn.

Given this gap, it is possible that there is nothing that can be done to prevent the gradual deterioration of the situation unless or until there is a massive underwriting of the weaker countries’ debt by the euro zone as a whole either through euro bonds or the ECB. This possibility has become more likely as a result of the follow-up from the summit. It is in the interests of the creditor nations to try to prevent this.

A lesson that should be learned is that it is not only important to reach agreements on policy but also to agree on how what has been decided is presented. If each country tries to interpret it in a way most favourable to its own domestic political situation, as has happened, the effect will be to undo any beneficial impact of the agreements on the financial markets.

Some criticism can be made against the governments of Spain and Italy. They both said that they were more favourably treated than Greece, Ireland or Portugal in that they had not agreed to the same Memorandums of Understanding and detailed monitoring. They needed on the contrary to tell markets they are doing just as much as these countries to correct their finances and reform their economies. However, both these countries have, following the summit, introduced swingeing further expenditure cuts on top of those previously put into effect. Given that such measures will intensify and prolong the second recession they are experiencing, it is hard to see how they can be expected to do more.

Criticism can also be directed at the post-summit comments and interpretations  of the creditor member states. The German has been more keen to emphasise what it has not agreed to (euro bonds) that what it has agreed to and Wolfgang Schauble, the German finance minister, has emphasized that the transfer of regulatory authority to the ECB will not happen till next year so that the rescue of the Spanish bank, Bankia, will in the meantime have to be added to Spanish debt. On the other hand the German parliament has given a large majority to legislation providing for the establishment of the ESM. Of great concern has been the apparent attempts of the Netherlands and Finnish governments to pull back from what their prime ministers agreed to at the summit. Both these countries face difficult domestic political situations with populist politicians exploiting voter concerns about the potential costs of participating in the ESM. However, the reality that they should explain to voters is that the whole euro zone is threatened with disastrous financial and economic consequences if major euro zone countries become insolvent. This is likely to be most difficult in the case of Finland. The Netherlands lies at the heart of the euro zone and its banks are heavily exposed to other euro zone countries. Finland is the only Nordic member of the euro zone and the Nordic countries are at present experiencing benign economic conditions. These conditions are still at risk from developments elsewhere in Europe including the euro zone but there is a danger that in order hold back the gains made by the populist and anti-euro True Finns in the 2011 election, the government and parliament will prevaricate in a way which could be highly damaging for the euro zone.  It may be that Finland will have to be treated as a special case able to negotiate special conditions for its contributions, although if other countries were to try to copy Finland the whole exercise could be threatened. But it would be better if Finnish politicians could recognize that Finland’s longer term prospects like other EU countries depend on preventing the euro zone crisis from continuing to deteriorate.

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