The Eurozone Deal

With euphoria over last week’s eurozone deal rapidly fading away, here are four sober takes on what it means – and what it doesn’t.  First, The Economist’s widely cited leader this week (and here is a link to the Economist’s collected articles on the crisis):

YOU can understand the self-congratulation. In the early hours of October 27th, after marathon talks, the leaders of the euro zone agreed on a “comprehensive package” to dispel the crisis that has been plaguing the euro zone for almost two years. They boosted a fund designed to shore up the euro zone’s troubled sovereign borrowers, drafted a plan to restore Europe’s banks, radically cut Greece’s burden of debt, and set out some ways to put the governance of the euro on a proper footing. After a summer overshadowed by the threat of financial collapse, they had shown the markets who was boss.

Yet in the light of day, the holes in the rescue plan are plain to see. The scheme is confused and unconvincing. Confused, because its financial engineering is too clever by half and vulnerable to unintended consequences. Unconvincing, because too many details are missing and the scheme at its core is not up to the job of safeguarding the euro.  This is the euro zone’s third comprehensive package this year. It is unlikely to be its last.

At the Weekly Standard, senior editor and Financial Times columnist Christopher Caldwell assesses the long-run, the social and political economy implied by the deal.  This means particular attention to the implications of asking the BRICs to invest in a fund that has run out of domestic money, as well as the questions that the demography of Europe raises from the standpoint of long-run bondholders (emphasis added):

Years ago, China might have fallen for the trick that Europe intends to pull, basically trying to get money for Greece and Italy by waving around the triple-A credit rating of Germany and other countries that have stocked the EFSF. But today it is likely that China will insist on guarantees that it be paid before European taxpayers in any default scenario. In an interview with the Financial Times the day after the agreement, Li Daokui, a member of the central bank monetary policy committee, gave evidence of a real canniness. “The last thing China wants,” he said, “is to throw away the country’s wealth and be seen as just a source of dumb money.” Li indicated that the Chinese might ask European leaders to refrain from criticizing Chinese economic policy as part of the deal.

Perhaps Europe has reached the point where its only route out of bankruptcy is this kind of vassalage. To escape a debt crisis, an economy needs to be capable of growing. It is far from clear that Europe can do that. It has two problems. One is technological. Much of Europe lacks the technological wherewithal to claim an ever-increasing share of the world economy. Spain, for instance, during its long, construction-based boom, developed a good deal of national expertise in .  .  . what? Pouring concrete?

A second problem is demographic. Italians have one of the lowest birthrates known in any society since the dawn of time; what it will look like in 40 years is anybody’s guess, but one fairly conservative demographic projection shows its population decreasing by 10 percent, to 54 million, at midcentury. Debt, alas, is contracted on a per-country, not a per capita basis, and this kind of population loss (especially when accompanied by rapid aging) can render debt impossible to pay down.

At the Telegraph, in London, Liam Halligan  brushes aside the giddiness of the equity markets to explain why the credit markets see the deal as merely another stopgap that will last weeks at most:

Global bond markets, by character more sober and smarter than the excitable equity guys, were voting against the deal. This is alarming. For it is only by selling more bonds that the eurozone’s deeply indebted governments can roll-over their enormous liabilities and keep the show on the road.

Some say Western governments shouldn’t “accept” what the market says. “Who do these trading people think they are,” I hear from the lips of the educated but financially-illiterate political elite. Let’s be clear – if global bond markets stop lending to a number of large Western economies, we are in the realms of unpaid state wages and pensions, transport chaos and closures of schools and hospitals – sparking the prospect of serious civil unrest. Forgive my intemperate tone, but these are the dangers we face. And I’m afraid the only rational response to Thursday’s announcement is that the probability of such undesirable outcomes has just been increased.

Finally, we have George Soros, with regards to the prospects of this deal stabilizing the situation.  He does not bear glad tidings, and his most important warning is that from the banks’ point of view, it might now be preferable – even a matter of the bank board’s fiduciary duties to their shareholders – to prefer a “credit event” that would trigger the full protection on the credit default swaps that they hold as insurance on the sovereign debt (emphasis added).

“Unfortunately, the 50pc haircut is effectively less than a 20pc reduction in the overall debt [for Greece] because it only involves the private sector and excludes all the debt that is held by the ECB [European Central Bank] and the other public authorities and also the debt held by Greece because the banks, of course, will now be insolvent and the pension funds also,” Mr Soros said.

“It is not at all clear that the private sector will actually deliver this voluntary cut because many of the banks are hedged by holding credit default swaps and this doesn’t trigger the credit default swaps. As a private institution you could argue that it is the fiduciary responsibility of the board to look to the benefit of the bank rather than the common benefit.”

So, from the banks’ point of view it is better to have a credit event where the CDS become active and protect them from the loss. That is an unsolved problem which may emerge in the next few weeks. The failure in terms of governance and the lack of understanding among the leadership how to deal with the market is really quite astounding. You have to lead markets, that is what they don’t understand.”

(Comments are open; please be civil and no rants.  I am particularly interested in serious comments on (a) the nature of the credit default swaps in this instance – who are the counterparties, who pays, any reasons why the banks wouldn’t simply hold out to trigger them; (b) the consequences of a failure of this deal in any of its three parts – Greek debt write-down, the stability fund, and the bank recapitalization – for the US economy; and  (c) whether there is anything concrete and material the US could do to help stabilize the situation, and whether should it do so.)